Buffett's 5 second intrinsic value calculation

Ves · 17 October 2014

Thanks again RY, you've been very helpful. I can see a few more possibilities that I wasn't aware of this morning by reading your posts.

I like adding new tools to my valuation arsenal. It allows me to attempt to view more business situations and have the maths to evaluate them.

My most important rule in investing and valuation is that I need to think every time I approach a new company. I'm a big believer that making an Excel spread sheet with a standard DCF model and using it routinely every time or using whatever whizz bang formula you come up with effortlessly is the wrong way to go about it. The world isn't full of round pegs and round holes to put them in!

The only real comparison between company models that you need is on an IRR basis - buy the highest expected return on current price from all of your candidates that meet your hurdle rate.

McLovin · 17 October 2014

Is this the same way that the Walter (RM) model works too? By squaring the ROE/r you end up putting a finite time on growth and there's an assumption that high ROE companies will only have their growth persist for a shorter period.

Nice to see Ves back too.

DeepState · 17 October 2014

Ves said:
I like adding new tools to my valuation arsenal.

If this keeps up, we're going to have to start negotiating for a unilateral disarmament for the sake of national security.

Ves · 17 October 2014

McLovin said:
Is this the same way that the Walter (RM) model works too? By squaring the ROE/r you end up putting a finite time on growth and there's an assumption that high ROE companies will only have their growth persist for a shorter period.

Sort of. What you are doing is estimating what you think are the present value of the firm's total future opportunities to deploy capital into a franchise in current dollars and multiplying it by a profitability factor.

The difference is that it can be sourced from any where (whereas Walter only assumes retained earnings). This could be many multiples of what the current retained earnings policy could generate over the next decade etc. The assumption is that a firm with a strong profitable franchise will be able to get finance as there are limited opportunities for such franchises to exist in the first place, so capital supply should be no issue.

Liebowitz does show ways in which you can add a return fade, or duration, and there is also an alternate formula based on sales growth and incremental margin (best for multinationals).

I think it's well worth a read.

Nice to see Ves back too.

Thanks!

Ves · 17 October 2014

DeepState said:
If this keeps up, we're going to have to start negotiating for a unilateral disarmament for the sake of national security.

Lol.

McLovin · 18 October 2014

Ves]I think it's well worth a read.[/QUOTE] Had a quick look at it said:
Take a look at how large the valuation associated with their example is relative to the zero growth (bond) component. This is how big the approximation of the zero growth proposition is being distorted....and this is typical. Zero growth assumptions are not really an effort at valuation for the purpose of investment. They are crash-and-burn calculations in some cases. But which ones? Because they are too optimistic for many. So it doesn't even serve the crash-and-burn purpose:

View attachment 59821

The idea is a close cousin to Ben Graham's approach, which also allows for growth and market/judgment discount rates.

It is a cut down version of Buffett's methods, but you'll see that his approach is not too much more sophisticated.

Hey RY

Is there a simple explanation as to why ^2 is used in that calculation?

TIA.

DeepState · 18 October 2014

McLovin said:
Hey RY

Is there a simple explanation as to why ^2 is used in that calculation?

TIA.

Looking at it again, I think it is because they are essentially fading NROE into RR via magic home-brew formula. The alternative of this perpetually reinvested component of the formulation, where NROE exceeds RR, is for the present value of the accumulated of assets to progress to infinity.

Their method at least allows for value creation when NROE exceeds RR. More value is created when that gap is bigger. However that fade prevents the development of those situations where the company becomes the world.

The fact that they assume a single fade rate for all industries and all companies is obviously an alarm bell.

You cannot tell if this is a conservative formula because it depends on the situation which it is being applied to. It is not quite a single period type analysis in that the growth rates decline on some magic glidepath, so you could cheekily call it an infinite stage DDM. However, the more fitting description is a model which uses only initial conditions for all situations where the premium to required return multiplier is faded at the same proportional rate to the NROE/RR ratio (equaling 2 x the ratio of NROE/RR). Bottom line is that it is just a (Gordon) growth multiplier that has an equivalent single period growth rate which actually converges to a feasible value - not necessarily a sensible one. The relationship between their multiplier and the Gordon Growth formula equivalent exists, but it's not like I can point to some economically coherent argument linking them. You can just calculate it.

Anyway, on the upside, it is simple. It allows for a positive growth rate. It would also be reasonable when comparing two similar companies. It would be much less useful for an absolute valuation.

McLovin · 19 October 2014

DeepState said:
Looking at it again, I think it is because they are essentially fading NROE into RR via magic home-brew formula.

Home brew does seem to be how they arrived at it. I guess it would be nice to have some sort of foundation as to why ^2 is better than ^1.5 or ^2.5 etc. I guess you could adjust the exponential but then you're really just getting out into a world of stick your finger in the air and write down a number. It's also strange the way it implies fast growth than then goes to zero at some period in the future (which is determined by roe/r).

luutzu · 19 October 2014

gordon2007 said:
In all honesty, you're not comprehending this. And what is befuddling to many, curious to others and just downright frustratingly funny to a fair few, is that you don't even realise that you're not understanding this.

To quote a rather simple man of long ago, 'the problem with your thinking, is that you don't even understand that there is a problem with your thinking'.

Yea man, guessing the future then pay at a price that is right if all that future comes true... I sure don't understand why people do that.

luutzu · 19 October 2014

burglar said:
We could start a whole new thread on this "one thing",

INTRINSIC VALUE
intrinsicvalue.asp

No two companies are alike so why use the same model for each?

The cruncher is this :-
Value Investors are like Train Controllers. They love to compare sizes!

How many scale, weighing machine do you need to weigh bananas, then apples, then oranges?

I understand where you're coming from, that depends on the nature of the business, certain interpretations must be use for the same items - e.g. liabilities like deposits is good for a bank, liabilities generally not preferable in other businesses.

At the end of all these, there is only one way to measure a business' worth: how much money does it return to its owner after all expenses.

Those who think they can predict the future go for speculation disguised as intelligence.

luutzu · 19 October 2014

DeepState said:
Ultimately there are two things to note:
1.Warren Buffett assumes a non-zero growth rate for companies that experience growth.
2.He is conducting a multistage DCF valuation.

Key points from the link that you provided include:
1.paragraph 12 indicates that she never saw Buffett create a model of the business (as a detailed forecast template).
2.she goes on to say that he focuses on a small number of factors upon which the success of the company is based.
3.paragraph 15 is key because it relates to a company with 36% profit margins and 70% growth. She asks if such a company could receive a 15% return. The 15% clearly relates to Buffett’s hurdle rate.
4.in paragraph 17 she says that this is how Buffett does a discounted cash flow. There are no models. He simply looks at detailed long-term historical data and determines the price he has to pay for it based on a 15% return minimum expectation. It is for this reason that Munger has said he had never seen Buffett do a discounted cash flow model. It is because the model is very simple as I’ve previously explained. You can, literally, do it in your head.

Key points in the annual letter to shareholders in 2014 include:
1.He needs to calculate a normalised return. In order to have a normalised return you need to start from normalised earnings. He uses an example on page 17 which includes expectations that productivity and crop prices would improve in relation to a 400 acre farm that he purchased. In other words he forecasts or projects. But these need not be complicated. You do not need to produce a detailed model to create a valuation.
2.As if to highlight that expectations for the future are being formed, on page 19 he goes on to say that the ability to estimate future earnings for a range of five years out or more is an important factor for his decision-making.

From the link that you provided, the example given was for a company growing at 70% growth with 36% profit margins. If that growth rate was maintained indefinitely it will quickly become the entire world economy. The price for this is literally infinite. Clearly that’s a ridiculous situation to use as a perpetuity. As a result Buffett would be extrapolating this for a short period of time but feeding it into a longer term return which does not produce such a ridiculous outcome. This is what a multistage DCF looks like.

To conclude, I believe what Alice is saying. She’s saying the same thing as I have been outlining on this thread. Warren Buffett uses a multistage DCF valuation which includes forward-looking forecasts/projections and growth rates which are certainly not zero on a blanket basis. The model is simple enough to calculate in his head, probably within five seconds.

haha...

Munger and Schroder, literally, told you that they have never seen Buffett do a DCF modelling... you interpret that to mean that he must have, he does, he does it in his head.

When Buffett agrees with Munger that he had never use a DCF modelling... because the results will be too close anyway... That is taken to mean he does, he just does it somehow.

When Buffett and Munger, I'm sure you have read this in annual reports or interviews... when they say they cannot, have not, been able to predict the future and won't start now... That is taken to mean... mean the future is more than 5 years away.

Ever wonder if you read into things what you want to read into it?

burglar · 19 October 2014

galumay said:
I took out the word "Value"

Sorry if it was a bit obtuse!

Humorous!

There was me, looking for a new thread!

burglar · 19 October 2014

luutzu said:
Yea man, guessing the future then pay at a price that is right if all that future comes true... I sure don't understand why people do that.

"Work with it. It's the best we got!", Ross the Boss

INVESTOPEDIA EXPLAINS 'VALUE INVESTING'
The big problem for value investing is estimating intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value.

Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.

luutzu · 19 October 2014

burglar said:
"Work with it. It's the best we got!", Ross the Boss

How does a business person value and buy businesses or financial assets before these DCF models? Before the central banks, interest rates, CAPM, beta... before the investment industry and financial analysts and their MBAs?

It's only natural in business to puff yourself up , to make things seems harder and more difficult than they really are - and only you and people with your training and brainpower could do what you're being paid to do. The investment industry has been very good at this... just I think some in it hasn't read the memo saying it's just to fool the public and not themselves.

Wysiwyg · 19 October 2014

luutzu said:
It's only natural in business to puff yourself up , to make things seems harder and more difficult than they really are - and only you and people with your training and brainpower could do what you're being paid to do.

Mate that is so so true. Our CEO favours the word "challenge". There is "extremely" challenging, "to say the least" challenging and plain old challenging. Record production last FY yet we face challenging times ahead. At over 7 million a year you want the share holders to see you (not the workers) putting in the hard yards.

DeepState · 20 October 2014

luutzu said:
haha...

Munger and Schroder, literally, told you that they have never seen Buffett do a DCF modelling... you interpret that to mean that he must have, he does, he does it in his head.

When Buffett agrees with Munger that he had never use a DCF modelling... because the results will be too close anyway... That is taken to mean he does, he just does it somehow.

When Buffett and Munger, I'm sure you have read this in annual reports or interviews... when they say they cannot, have not, been able to predict the future and won't start now... That is taken to mean... mean the future is more than 5 years away.

Ever wonder if you read into things what you want to read into it?

It lives.

I know you think Buffett is an idiot and all. Further, he doesn't do what I have implied. So, let's just dig up some records from this moron and read his actual words. I'll also add some simplification to assist.

Apparently he expects that (unreported) earnings will be fully reflected in the intrinsic business value through capital gains. Whoa. If he expects capital gains and that these reflect expectations embedded in the intrinsic value...gosh...he must be factoring in growth. That's intrinsic as opposed to market growth too...so it's not about looking for movements in prices to zero growth estimates or something as silly as that. Do you understand that? Yes, that was rhetorical. If true to form, you are still going to bang on about how:
1. he factors in zero growth as a central estimate [which is not feasible unless you think the above is a forgery or you have developed your own branch of maths which stands apart from the fabric of space time...yet again. Where is your Nobel?]; and/or
2. He's doing it wrong.

luutzu said:
Ever wonder if you read into things what you want to read into it?

Not really. Perhaps it's because I can read. How about you? There seems to be rather a lot of feedback being provided around the place along such lines. Perhaps they are all wrong too.

(Sigh) Let's move on.

Here's two huge, earth moving, revelations from the above:
1. Intrinsic value is a discounted values of the cash that CAN be taken out...
2. It is an estimate.

luutzu said:
But dude, what if interest rate change

Dude, apparently Buffett moves the intrinsic value. Did the earth move for you too?

Did he use the word "forecast" and the phrase "of future cashflows" in there as well. My gosh! I thought forecasting was stupid and discounting future expected cashflows to arrive at an intrinsic value was absolutely the dumbest, stupidest, most ridiculous thing you could do.

Maybe so. Maybe not. LuuTzu vs [Buffet, Graham, McKinsey, Leibowitz, HOLT Value Associates, Clime...and on it goes because we could list them out for page after page]. Hmmmm. Give me 24 hrs before I make up my mind ok?

Actually, don't bother.

luutzu said:
Anyway, best to always question conventional wisdom and practices... .

Not really. It depends on many things, not least of which is who is doing the questioning.

luutzu said:
...And if Buffett does what you are doing, he too is wrong

What a joke.

luutzu said:
As Buffett says, it's better to be approximately right than precisely wrong.

Do you understand what that even means and implies? Yes, another rhetorical question. In this exchange on valuation, it is (hmmm, should be) clear you do not even vaguely approximate Buffett. That makes you precisely wrong. Or, we could express is as Buffett is precisely wrong. Tough choice.

luutzu said:
I have said that I never work in the investment industry. So if what I say do not make sense, people can see that.

You don't say. But you do say.

luutzu said:
a zero growth would return me zero

This is garbage from an investment viewpoint unless you started with zero in the first place....hang on a minute....you might be on to something here.

luutzu · 20 October 2014

DeepState said:
It lives.

I know you think Buffett is an idiot and all. Further, he doesn't do what I have implied. So, let's just dig up some records from this moron and read his actual words. I'll also add some simplification to assist.

View attachment 59923

Apparently he expects that (unreported) earnings will be fully reflected in the intrinsic business value through capital gains. Whoa. If he expects capital gains and that these reflect expectations embedded in the intrinsic value...gosh...he must be factoring in growth. That's intrinsic as opposed to market growth too...so it's not about looking for movements in prices to zero growth estimates or something as silly as that. Do you understand that? Yes, that was rhetorical. If true to form, you are still going to bang on about how:
1. he factors in zero growth as a central estimate [which is not feasible unless you think the above is a forgery or you have developed your own branch of maths which stands apart from the fabric of space time...yet again. Where is your Nobel?]; and/or
2. He's doing it wrong.

Not really. Perhaps it's because I can read. How about you? There seems to be rather a lot of feedback being provided around the place along such lines. Perhaps they are all wrong too.

(Sigh) Let's move on.

Here's two huge, earth moving, revelations from the above:
1. Intrinsic value is a discounted values of the cash that CAN be taken out...
2. It is an estimate.

Dude, apparently Buffett moves the intrinsic value. Did the earth move for you too?

Did he use the word "forecast" and the phrase "of future cashflows" in there as well. My gosh! I thought forecasting was stupid and discounting future expected cashflows to arrive at an intrinsic value was absolutely the dumbest, stupidest, most ridiculous thing you could do.

Maybe so. Maybe not. LuuTzu vs [Buffet, Graham, McKinsey, Leibowitz, HOLT Value Associates, Clime...and on it goes because we could list them out for page after page]. Hmmmm. Give me 24 hrs before I make up my mind ok?

Actually, don't bother.

Not really. It depends on many things, not least of which is who is doing the questioning.

What a joke.

Do you understand what that even means and implies? Yes, another rhetorical question. In this exchange on valuation, it is (hmmm, should be) clear you do not even vaguely approximate Buffett. That makes you precisely wrong. Or, we could express is as Buffett is precisely wrong. Tough choice.

You don't say. But you do say.

This is garbage from an investment viewpoint unless you started with zero in the first place....hang on a minute....you might be on to something here.

I never run from a fight so don't think I've shied away if I don't reply right away.

I think I've said all there is to say on the matter actually... Anyway, keep doing what you do buddy... One day I might even establish a few prizes and some grants to support these lines of thought - as Buffett once wrote, it helps when the competition aren't even trying, or tries too hard.

Seriously though, you haven't look at any company closely in your career. If you had taken a close examination of any business, be it the local corner store or a multi-billion corporation, you would have known that future forecasts and estimates are either unnecessary or impossible.

But then it's other people's money and you're paid to look smart so we do what we must right?

Anyway, keep up with the wizardry...

burglar · 20 October 2014

luutzu said:
How does a business person value and buy businesses or financial assets before these DCF models? ...

Businesses were simpler.

Less "Intellectual Property",
less Intangibles,
less everythings

Bakeries made bread, ...
Farriers shod horses, ...

luutzu said:
... Before the central banks, interest rates, CAPM, beta...

Rice Futures Market
Regional banks, branches and agents.

luutzu · 20 October 2014

burglar said:
Businesses were simpler.

Less "Intellectual Property",
less Intangibles,
less everythings

Bakeries made bread, ...
Farriers shod horses, ...

View attachment 59930

Rice Futures Market
Regional banks, branches and agents.

I think all businesses are fundamentally the same: One invest money, time and effort to create products/services; market, sell and distribute that in order to make a profit.

As an investor, a capitalist, we simply examine how much profit that business can make now and into a foreseeable future; discount that back at our cost of capital and that is the price.

As you have cited, valuation can be subjective. But subjective in that my understanding of the business might not be as good as yours so I can only see it earn E while you see it could earn E+10; subjective in that I only need 10% return on my capital and you require 12% to make it worthwhile... These two differences will results in a different valuation but they are both of the one model. That is it.

All the intangibles, the brands, the secret recipes, the large sales network and branches... all these are to indicate the business viability and competitiveness; indicate its ability to continue earning what it currently does by not losing market share, by not having its product/services replaced or made redundant, by being able to adjust its price to inflation and other costs... all these so that we're more confident that its real earning from now and into the future is likely to be what it has been regardless of changing economic and technological forces.

If a business had been around for a while, have long established its brand, networks and operations etc. and through the years it had return 10% on equity... how likely is it to suddenly return 11% or 12% on its equity once we bought it? If through some luck it could increase that earning power, is that a permanent shift? If yes then it now worth more, but can we honestly predict that shift? Should we pay for it before it happen?

These fancy DCF models use maths to replace sensible thinking. That since you can't assume a business could grow at 2% or 5% indefinitely else it will take over the world, lets assume it will grow at 2 or 5% for first few years then assume no growth into infinity. Doesn't that just make the results into what you want it to be?

Not only is that mathematically and logically incorrect, it's also dumb in a business sense. What the DCF and its various growth stages tell you is this... that the business is worth $X because next year it will earn E1, then E2, then E3... by E growing at g rate, and by the interest rate and required rate of return being this and that... if you then to discount that imaginary future growth, discount that back at these imaginary rates, you'd pay $X.

An obvious question is: that if those figures are just imaginary? Imagine again and we'd be right next time?

TPI · 26 October 2014

Great contributions to this thread.

On balance, I am sticking to simplified approaches like I = E / r as wells as the Montgomery/Clime approach, with my own slight twists to them.

Might revisit full DCF calculations a bit later, just can't bring myself to do it right now... give me time .

Buffett's 5 second intrinsic value calculation

Ves

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DeepState

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Ves

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luutzu

luutzu

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luutzu

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Everyone wants money

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luutzu

burglar

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