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1997: How does Buffett estimate intrinsic value?
AUDIENCE MEMBER: Yes. I’m Fred Cooker (PH) from Boulder, Colorado.
And this is a question about intrinsic value. And it’s a question for both of you because you have written that, perhaps, you would come up with different answers.
You write and speak a great deal about intrinsic value, and you indicate that you try to give shareholders the tools in the annual report so they can come to their own determination.
What I’d like you to do is expand upon that a little bit. First of all, what do you believe to be the important tools, either in the Berkshire annual report or other annual reports that you review, in determining intrinsic value?
Secondly, what rules or principles or standards do you use in applying those tools?
And lastly, how does that process, that is the use of the tools, the application of the standards, relate to what you have previously described as the filters you use in determining your valuation of a company?
WARREN BUFFETT: If we could see, you know, looking at any business, what its future cash inflows or outflows from the business to the owners — or from the owners — would be over the next, we’ll call it, a hundred years, or until the business is extinct, and then could discount that back at the appropriate interest rate, which I’ll get to in a second, that would give us a number for intrinsic value.
In other words, it would be like looking at a bond that had a whole bunch of coupons on it that was due in a hundred years. And if you could see what those coupons are, you can figure the value of that bond compared to government bonds, if you want to stick an appropriate risk rate in.
Or you can compare one government bond with 5 percent coupons to another government bond with 7 percent coupons. Each one of those bonds has a different value because they have different coupons printed on them.
Businesses have coupons that are going to develop in the future, too. The only problem is they aren’t printed on the instrument. And it’s up to the investor to try to estimate what those coupons are going to be over time.
As we have said, in high-tech businesses or something like that, we don’t have the faintest idea what the coupons are going to be.
When we get into businesses where we think we can understand them reasonably well, we are trying to print the coupons out. We are trying to figure out what businesses are going to be worth in ten or 20 years.
When we bought See’s Candy in 1972, we had to come to the judgment as to whether we could figure out the competitive forces that would operate, the strengths and weaknesses of the company, and how that would look over a ten or 20 or 30-year period.
And if you attempt to assess intrinsic value, it all relates to cash flows.
The only reason for putting cash into any kind of an investment now is because you expect to take cash out. Not by selling it to somebody else, because that’s just a game of who beats who, but, in a sense, by what the asset, itself, produces.
That’s true if you’re buying a farm. It’s true if you’re buying an apartment house. It’s true if you’re buying a business.
And the filters you describe. There are a number of filters which say to us we don’t know what that business is going to be worth in ten or 20 years. And we can’t even make an educated guess.
Obviously, we don’t think we know to three decimal places, or two decimal places, or anything like that, precisely what’s going to be produced. But we have a high degree of confidence that we’re in the ballpark with certain kinds of businesses.
The filters are designed to make sure we’re in those kinds of businesses. We, basically, use long-term, risk-free government bond-type interest rates to think back in terms of what we should discount at.
And, you know, that’s what the game of investment is all about. Investment is putting out money to get more money back later on from the asset. And not by selling it to somebody else, but by what the asset, itself, will produce.
If you’re an investor, you’re looking at what the asset — you’re looking at what the asset is going to do — in our case, businesses.
If you’re a speculator, you’re primarily focusing on what the price of the object is going to do independent of the business. And that’s not our game.
So we figure if we’re right about the business, we’re going to make a lot of money. And if we’re wrong about the business, we don’t have any hopes — we don’t expect to make money.
And in looking at Berkshire, we try to tell you as much as possible as we can about our business, of the key factors. Those are the things that Charlie and I —
With the things we put in our report about those businesses are the things that we look at ourselves.
So if Charlie had nothing to do with Berkshire but he looked at our report, he would probably, in my view, he would come to pretty much the same idea of intrinsic value that he would come to from being around it, you know, for X number of years. The information should be there.
We give you the information that, if the positions were reversed, we would want to get from you.
And in companies like Coca-Cola or Gillette or Disney or those kind of businesses, you will see the information in the reports. You have to have some understanding of what they’re doing. But you have that in your everyday activities. You’ll get that kind of knowledge.
You won’t get it, you know, in terms of some high-tech company. But you’ll get it with those kind of companies. And, then, you sit down and you try to print out the future.
CHARLIE MUNGER: I would argue that one filter that’s useful in investing is the simple idea of opportunity cost.
If you have one opportunity that you already have available in large quantity, and you like it better than 98 percent of the other things you see, well, you can just screen out the other 98 percent because you already know something better.
So the people who have a lot of opportunities tend to make better investments than people that don’t have a lot of opportunities. And people who have very good opportunities, and using a concept of opportunity cost, they can make better decisions about what to buy.
With this attitude, you get a concentrated portfolio, which we don’t mind. That practice of ours, which is so simple, is not widely copied. I do not know why. Now, it’s copied among the Berkshire shareholders. I mean, all of you people have learned it.
But it’s not the standard in investment management, even at great universities and other intellectual institutions.
Very interesting question. If we’re right, why are so many eminent places so wrong? (Laughter)
WARREN BUFFETT: There are several possible answers to that question. (Laughter)
The attitude, though — I mean, if somebody shows us a business, you know, the first thing that goes through our head is would we rather own this business than more Coca-Cola? Would we rather own it than more Gillette?
It’s crazy not to compare it to things that you’re very certain of. There’s very few businesses that we’ll find that we’re certain of the future about as companies such as that. And therefore, we will want companies where the certainty gets close to that. And, then, we’ll want to figure that we’re better off than just buying more of those.
If every management, before they bought a business in some unrelated deal that they might not have even heard of, you know, more than a short time before that’s being promoted to them, if they said, “Is this better than buying in our own stock, you know? Is this better than even buying, you know, buying Coca-Cola stock or something,” there’d be a lot fewer deals done.
But they don’t — they tend not to measure — we try to measure against what we regard as close to perfection as we can get.
CHARLIE MUNGER: Well, I will say this, that the concept of intrinsic value used to be a lot easier, because there were all kinds of stocks that were selling for 50 percent or less of the amount at which you could’ve easily liquidated the whole corporation if you owned the whole corporation.
Indeed, in the history of Berkshire Hathaway, we’ve bought things at 20 percent of then-liquidating value.
And in the old days, the Ben Graham followers could run their Geiger counters over corporate America. And they could spill out a few things. And you could easily see, if you were at all familiar with the market prices of whole corporations, that you were buying at a huge discount.
Well, no matter how bad the management, if you’re buying at 50 percent of asset value or 30 percent or so on down, you have a lot going for you.
And as the world has wised up and as stocks have behaved so well for people, good stocks, generally, have gone to higher and higher prices. That game gets much harder.
Now, to find something at a discount from intrinsic value, those simple systems, ordinarily, don’t work. You’ve got to get into Warren’s kind of thinking. And that is a lot harder.
I think you can predict the future in a few places best if you understand a few basic ideas that come from a good general education. And that’s what I was talking about in that talk I gave at the USC Business School.
In other words, Coca-Cola’s a simple company if it’s stripped down and analyzed in terms of some elemental forces.
WARREN BUFFETT: When Charlie —
CHARLIE MUNGER: It’s not hard to understand Costco, either, you know —
There are certain fundamental models out there that do not take — you don’t have the kind of ability that quantum mechanics requires. You just have to know a few simple things and really know them.
WARREN BUFFETT: When Charlie talks about “liquidating value,” he’s not talking about closing up the enterprise. But he’s talking about what somebody else would pay for that stream of cash, too, I mean —
CHARLIE MUNGER: Yeah.
WARREN BUFFETT: You could’ve looked at a collection of television stations owned by Cap Cities, for example, in the early to mid — well, 1974. It would’ve been worth, we’ll say, four times what the company was selling for. Not because you’d close the stations, but just their stream of income was worth that to somebody else. It’s just that the marketplace was very distressed — depressed.
Although, like I say, on a negotiated basis, you could have gone and sold the properties for four times what the company was selling for. And you got wonderful management.
I mean, those things happen in markets. They will happen again. But part of investing and calculating intrinsic values is if you get the wrong answer when you get through — in other words, if it says don’t buy, you can’t buy just because somebody else thinks it’s going to up or because your friends have made a lot of easy money lately or anything of the sort.
You just — you have to be able to walk away from anything that doesn’t work. And very few things work these days. You also have to walk away from anything you don’t understand which, in my case, is a big handicap.
CHARLIE MUNGER: But you would agree, wouldn’t you, Warren, that it’s much harder now?
WARREN BUFFETT: Yeah. But I would also agree that almost anytime over the last 40 years that we’ve been up on a podium, we would’ve said it was much harder in the past, (laughs) too.
But it is harder now. It’s way harder.
Part of it being harder now, too, is the amount of the capital we run. I mean, if we were running $100,000, our prospects for returns would be — and we really needed the money — our prospects for return would be considerably better than they are running Berkshire. It’s very simple. Our universe of possible ideas would expand by a huge factor.
We are looking at things today that, by their nature, a lot of people are looking at. And there were times in the past when we were looking at things that very few people were looking at.
But there were other times in the past when we were looking at things where the whole world was just looking at them kind of crazy. And that’s a decided help.