Warren Buffett on How to Calculate Intrinsic Value of a Stock
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? Now, it's crazy not to compare it to things that you're very certain of. There are very few businesses that we'll find that we're certain of the future about, as companies such as that. 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.
Yes, I'm Fred Cooker from Boulder, Colorado, and this is a question about intrinsic value. 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? 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?
If we could see in 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 100 years. 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 trade in, or you can compare one government bond with five percent coupons to another government bond with seven 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 10 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 10, 20, or 30-year period.
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 by, 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 a business. The filters you describe are their number filters, which say to us we don't know what that business is going to be worth in 10 or 20 years, and we can't even make an educated guess. Obviously, we don't think we know the three decimal places, or two decimal places, or anything like that—what 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, let's say, 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 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. In looking at Berkshire, we try to tell you as much as possible about our business of the key factors. Those are the things that Charlie and I—well, 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—come to pretty much the same idea of intrinsic value that he would come to from being around it, you know, for a certain 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. In companies like Coca-Cola or Gillette or Disney, or those kinds 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, and you won't get it, you know, in terms of some high-tech company, but you'll get it with those kinds of companies. Then you sit down, and you try to print out the future.
Charlie, 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% of the other things you see, well, you can just screen out the other 98% because you already know something better. So that people who have a lot of opportunities tend to make better investments than people that don't have a lot of opportunities. People have very good opportunities, and using a concept of opportunity costs, 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 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? There are several possible answers to that question.
Yes, 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? Now, it's crazy not to compare it to things that you're very certain of. There are 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. 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 field that they might not have even heard of, you know, more than a short time before that being promoted to them, said: "Is this better than buying in our own stock? Is this better than even buying Coca-Cola stock or something?" there'd be a lot fewer deals done. But they don't tend not to measure against what we regard as close to perfection as we can get.
Charlie? 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% or less of the amount at which you could have easily liquidated the whole corporation if you owned the whole corporation. Indeed, in the history of Berkshire Hathaway, we bought things at 20% of their liquidating value. In the old days, the Ben Graham followers could run their Geiger counters over corporate America and they could spill out a few things. 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 it at fifty percent of asset value or thirty percent or so on down, you have a lot going for you.
As the world has wised up and as stocks have behaved so well for people, that 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 is a simple company if it's stripped down and analyzed in terms of some elemental forces, but generally hard to understand. Costco either, you know, I mean 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. Charlie talks about liquidity. I'm 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, yeah, I mean if you could have looked at a collection of television stations owned by a Cap Cities, for example, in them—in the early to well, 1974—and it would have been worth, 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've 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 in calculating intrinsic values is if you get the wrong answer when you get through in terms of it says don't buy, you can't buy just because somebody else thinks it's going to go 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. 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, but you would agree with Jordan that it's much harder now.
Yeah, but I would also agree that almost at any time over the last 40 years that we've been up on a podium, we would have said it was much harder in the past. But it is harder now; it's way harder. The part of it being harder now, too, is the amount of capital we run. I mean, if we were running a hundred thousand dollars, 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 just 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 have to be 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.