2007: How does Buffett determine intrinsic value?

AUDIENCE MEMBER: Hello. Burkhardt Whittick (PH) from Munich in Germany.

I would like to get some more transparency on how you make investment decisions, particularly how you determine intrinsic value.

You mentioned that the theoretically correct method is discounted cash flow, but at the same time you point out the inherent difficulties of the methodology.

From other books, I see that you use multiples on operating earnings, or (inaudible) multiples. Your [former] daughter [in law] Mary, in one of her books, describes another methodology where you apply compounding economics to the value of the equity.

Could you give us a bit more transparency which quantitative approach you use and how many years out you try to quantify the results of the investments you’re interested in?

WARREN BUFFETT: I understand the question, but I’m going to pretend I don’t and let Charlie answer first. (Laughs)

I really do.

CHARLIE MUNGER: Yeah. When you’re trying to determine something like intrinsic value and margin of safety and so on, there’s no one easy method that could be simply mechanically applied by, say, a computer and make anybody who could punch the buttons rich.

By definition, this is going to be a game which you play with multiple techniques and multiple models, and a lot of experience is very helpful.

I don’t think you can become a great investor very rapidly any more than you could become a great bone tumor pathologist very rapidly. It takes some experience and that’s why it’s helpful to get a very early start.

WARREN BUFFETT: But if you’re — let’s just say that we all decided we’re going to buy a — or think about — buying a farm.

And we go up 30-miles north of here and we find out that a farm up there can produce 120 bushels of corn, and it can produce 45 bushels of soybean per acre, and we know what fertilizer costs, and we know what the property taxes cost, and we know what we’ll have to pay the farmer to actually do the work involved, and we’ll get some number that we can make per acre, using fairly conservative assumptions.

And let’s just assume that when you get through making those calculations that it turns out to be that you can make $70 an acre to the owner without working at it.

Then the question is how much do you pay for the $70? Do you assume that agriculture will get a little bit better over the years so that your yields will be a little higher?

Do you assume that prices will work a little higher over time? They haven’t done much of that, although recently, it’s been good with corn and soybeans. But over the years agriculture prices have not done too much. So you would be conservative in your assumptions, then.

And you might decide that for $70 an acre, you know, you would want a — if you decided you wanted a 7 percent return, you’d pay a thousand dollars an acre.

You know, if farmland is selling for 900, you know you’re going to have a buy signal. And if it’s selling for 1200, you’re going to look at something else. That’s what we do in businesses.

We are trying to figure out what those corporate farms that we’re looking at are going to produce. And to do that we have to understand their competitive position. We have to understand the dynamics of the business.

We have to be able to look out in the future. And like I’ve said earlier, some businesses you can’t look out very far at.

But the mathematics of investment were set out by Aesop in 600BC. And he said, “A bird in the hand is worth two in the bush.”

Now our question is, when do we get the two? How long do we wait? How sure are we that there are two in the bush? Could there be more, you know? What’s the right discount rate?

And we measure one against the other that way. I mean, we are looking at a whole bunch of businesses, how many birds are they going to give us, when are they going to give them to us, and we try to decide which ones — basically, which bushes — we want to buy out in the future.

It’s all about evaluating future — the future ability — to distribute cash, or to reinvest cash at high rates if it isn’t distributed.

Berkshire has never distributed any cash, but it’s grown in its cash producing abilities, and we retain it because we think we can create more than a dollar present value by retaining it. But it’s the ability to distribute cash that gives Berkshire its value.

And we try to increase that ability to distribute cash year by year by year and then we try to keep it and invest it in a way so that a dollar bill is worth more than a dollar.

You may have an insight into very few businesses. I mean, if we left here and walked by a McDonald’s stand, you know, and you decided, would you pay a million dollars for that McDonald’s stand, or a million-three, or 900,000, you’d think about how likely it was there would be more competition, whether McDonald’s could change the franchise arrangement on you, whether people are going to keep eating hamburgers, you know, all kinds of things.

And you actually would say to yourself this McDonald’s stand will make X — X plus 5 percent — maybe in a couple years because over time prices will increase a little.

And that’s all investing is. But you have to know when you know what you’re doing, and you have to know when you’re getting outside of what I call your circle of competency, you don’t have the faintest idea.

Charlie.

CHARLIE MUNGER: Yeah. The other thing, you’ve got to recognize that we’ve never had any system for being able to make correct judgments on the values of all businesses.

We throw almost all decisions into the too hard pile, and we just sift for a few decisions that we can make that are easy. And that’s a comparative process.

And if you’re looking for an ability to correctly value all investments at all times, we can’t help you.

WARREN BUFFETT: No. We know how to step over one-foot bars. We don’t know how to jump over seven-foot bars.

But we do know how to recognize, occasionally, what is a one-foot bar. And we know enough to stay away from the seven-foot bars, too.