1997: What interest rate does Buffett use to discount cash flows?
AUDIENCE MEMBER: Mr. Buffett, my name is Pete Brown (PH) from Columbus, Ohio, a Class B shareholder.
I had a couple questions if I could. The first is, I don’t have a very good idea in my mind how our typical insurance operations work. I mean, in particular, how money leaves the insurance pool and enters the investment pool, and how our operations are different than the typical, run-of-the-mill insurance operation, you know, around the country.
Why are we able to generate so much more float than, you know, the XYZ Company, you know, somewhere else?
And a second question is, it kind of goes back to an article you wrote for Fortune Magazine back in the late ’70s about the effect of inflation on equity values and that sort of thing. And in it, you asserted that stocks were — in businesses — were really like bonds. They just had their own par. And the par being the average 12 percent return on equity that companies have averaged.
You know, a company does better than that has assets that are worth way more than a hundred cents on a dollar. A company does less, you know, will be less, correspondingly.
My question is, when you’re projecting cash flows of a company as a prospective investment, why would you use the interest rate, you know, of risk-free Treasury bills? Why wouldn’t you use the sort of opportunity cost to discount that maybe Charlie was referring to, maybe 12 percent return on equity of average corporations? Maybe, you know, your 15 percent goal may be Coca-Cola’s return on equity as a comparison.
I mean, doing that would dramatically change the value of the company that you’re, you know, evaluating, as I’m sure you know. Why would you use the risk-free rate is my question.
WARREN BUFFETT: The risk-free rate is used merely to equate one item to another. In other words, we’re looking for whatever’s the most attractive. But in terms of present valuing anything, we’re going to use a number.
And, obviously, we can always buy the government bonds. So that becomes the yardstick rate. It doesn’t mean we want to buy government bonds. It doesn’t mean we want to buy government bonds if the best thing we can find is only — has a present value that works out at a half percent a year better than the government bond.
But it’s the appropriate yardstick, in our view, to simply use to compare across all kinds of investment opportunities, oil wells, farms, whatever it may be.
Now, it gets into degree of certainty, too. But it’s the yardstick rate. It’s not because we want to buy government bonds. But it does serve to make that a constant throughout the valuation process.
WARREN BUFFETT: In our insurance business, we really have a group of insurance businesses. And they have different characteristics.
The consistent characteristic, actually, is that they’re all very, very good businesses. Some of them are a lot larger and have opportunities to get larger. And some of them are not so large and have limited opportunities, in terms of growth. But every insurance operation we have is a distinct asset to Berkshire.
We’ve got smaller — a worker’s comp operation. We’ve got a credit operation — credit card — operation. We’ve got a Homestate operation. We have all these different businesses, Kansas Bankers Surety, whatever.
They’re all good businesses. Some of them don’t develop a lot of float relative to premium volume.
The nature of Kansas Bankers Surety is that it won’t develop a lot of float. It just happens to be the kind of business they write.
The nature of comp is that it develops more float, because comp claims pay more slowly.
We — you really should think of each one, though, as having different characteristics.
GEICO is entirely different than the super-cap business. They’re both good businesses.
In terms of how we invest the money when it comes in, we invest it when it comes in. I mean, we’ll get a large super-cap premium today. It’s invested.
Now, if we have a claim tomorrow, then, we disinvest and in a substantial way.
If you take something like GEICO, the cash flow is always going to be positive, probably, on that, you know.
We won’t have another Hurricane Andrew, because we’ve backed out of the homeowner’s business to quite an extent.
So month by month, the money comes in at a GEICO. And the faster it grows, the more the money that comes in.
We have so much capital that we can, basically, put that money into whatever makes the most sense for Berkshire. So we have none of either the mental or psychological constraints, or regulatory constraints, that many insurance companies operate under.
Many of them think they sort of should have this portion in this and this portion in that and so on.
Investments usually play second fiddle to the insurance business at most companies that are in the insurance business. We look at them as being of equal importance.
And we run them as two distinct businesses. We do whatever makes the most sense on the investment side, whatever makes the most sense on the insurance side. We never do anything on the investment side that will impinge on our business on the insurance side.
But you really should look at each one of our businesses separately. GEICO has entirely different characteristics than the super-cat business. They both call themselves insurance. They both develop float.
But in economic terms and in terms of competitive strengths and that sort of thing, they’re two very different businesses. And our smaller businesses are different businesses. Some of those may grow reasonably well. We’ll keep working on it.
Charlie?
CHARLIE MUNGER: Yeah. That — if you look at a corporate stock, it’s obvious you can buy any maturity of government bond you want. So one opportunity cost of buying the stock is to compare it with a bond.
But you may find that half the stocks in America, you’re so fearful about or know so little about or think so poorly of, that you’d rather have the government bond. So on an opportunity cost basis, they’re taken out of the filter.
Now, you start finding corporations where you like the stocks way better than government bonds. You got to compare them one against the other. And when you find one that you regard as the best opportunity, that you can understand as the best opportunity, now you’ve got one to buy.
It’s a very simple idea. It uses nothing but the most elementary ideas from economics or game theory. It’s child’s play as a mental process. Now, it’s hard to make the business appraisals. But the mental process is a cinch.
WARREN BUFFETT: If Charlie and I were forced — told we had a choice of buying stock A, B, C or D and all 2,500 or 3,000, or whatever it may be, listed on the New York Stock Exchange, or buying a ten-year government bond and we had to hold the stock for ten years or the bond for ten years, probably in at least 80 percent of the cases, we’d take the ten-year Government, you know.
In many cases, because we didn’t understand the business well enough elsewhere. Or secondly, we may understand it and still prefer the 10 percent Government.
So — but we would measure everything that way.
And I don’t know, did you come up with 80 percent or where, Charlie?
Desert island, ten years. Get to fondle a stock certificate or fondle a government bond. Which one are you going to choose? (Laughter)
CHARLIE MUNGER: I think life is a whole series of opportunity costs. You know, you got to marry the best person who is convenient to find who will have you. (Laughter)
Investment is much the same sort of a process. (Buffett laughs)
WARREN BUFFETT: I knew we’d get in trouble after lunch. (Laughter)