Billionaire Warren Buffett: HOW to calculate the INTRINSIC VALUE of a STOCK

Actually, it's very simple. The first investment primer—when would you guess it was written? The first investment primer that I know of, and it was pretty good advice, was delivered in about 600 BC by Aesop. And Aesop, you'll remember, said, "A bird in the hand is worth two in the bush." Incidentally, Aesop did not know it was 600 BC. He was smart, but he wasn't that smart.

Now, Aesop and things... but he didn't finish it because there's a couple of other questions that go along with that. But it is an investment equation: "A bird in the hand is worth two in the bush." He forgot to say exactly when you were going to get the two from the bush, and he forgot to say what interest rates were that you had to measure this against. But if he'd given those two factors, he would have defined investment for the next 2600 years.

Because a bird in the hand is—you know—you will trade a bird in the hand, which is investing. You lay out cash today, and then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush or three birds in the bush, and you have to decide when they're going to come out and when you're going to acquire them.

Now, if interest rates are five percent and you're going to get two birds from the bush in five years, we'll say, versus one now, two birds in the bush are much better than a bird in the hand. Now, so you want to trade your bird in the hand and say, "I'll take two birds in the bush," because if you're going to get them in five years, that's roughly 14 compounded annually, and interest rates are only five percent.

But if interest rates are 20 percent, you would decline to take two birds in the bush five years from now. You would say that's not good enough, because at twenty percent, if I just keep this bird in my hand and compound it, I'll have more birds than two birds in the bush in five years.

Now, what's all that got to do with growth? Well, usually growth people associate with a lot more birds in the bush, but you still have to decide when you're going to get them. And you have to measure that against interest rates, and you have to measure it against other bushes and other—you know—other equations. And that's all investing is: It's a value decision based on, you know, what it is worth, how many birds are in that bush, when you're going to get them, and what interest rates are.

Now, if you pay 500 billion dollars, and when we buy a stock, we always think in terms of buying the whole enterprise, because it enables us to think as businessmen rather than as stock speculators. So, let's just take an A company that has marvelous prospects, is paying you nothing now, and you buy it at an evaluation of 500 billion. Now, if you feel that 10 is the appropriate rate of return—and you can pick your figure—that means that if it pays you nothing this year but starts paying next year, it has to be able to pay you 55 billion in perpetuity each year.

But if it's not going to pay until the third year, then it has to pay you 60.5 billion in perpetuity to justify the present price. Every year that you wait to take a bird out of the bush means that you have to take out more birds. It's that simple, and I questioned in my mind sometimes whether people who pay 500 billion dollars implicitly for a business by buying 10 shares of stock at some price are really thinking of the mathematics implicit in what they are doing.

Let's just assume there's only going to be a one-year delay before a business starts paying out to you, and you want to get a 10% return. If you pay 500 billion, that means 55 billion of cash that they have to be able to disgorge to you, year after year after year. To do that, they have to make perhaps 80 billion dollars or close to it pre-tax.

Now, you might look around at the universe of businesses in this world and see how many are earning 80 billion pre-tax or 70 or 60 or 50 or 40 or 30—and you won't find any. So it requires a rather extraordinary change in profitability to give you enough birds out of that particular bush to make it worthwhile to give up the one that you have in your hand.

The second part of your question about whether we'd be willing to buy a wonderful business at four times earnings—I think I could get even Charlie interested in that some. But let's hear it from Charlie. I'd like to know what that is. He was hoping you would ask that, the fellow that's got all his net worth in this stock and who has a captive audience. Tell us what it is! You got to tell us! We're begging you!

You want the name of the company? We want the name of the company! We're dying to get the name! Where do I get my pencil? [Laughter] It's called National RV, and it's based in California and they sell recreational vehicles.

Okay, well you've got a crowd of people who have birds in the hand, and we will see what they do in terms of National RV. Charlie, do you have anything further on growth and value, etc.? Watch him carefully, folks!

Well, I agree that all intelligent investing is value investing. You have to acquire more than you really pay for, and that's a value judgment. But you can look for more than you're paying for in a lot of different ways. You can use filters to sift the investment universe, and if you stick with stocks that can't possibly be wonderful to just put away in your safe deposit box for 40 years but are underpriced, then you have to keep moving around all the time as they get closer to what you think the real value is.

You have to sell them, and then find others. So it's an active kind of investing—the investing where you find a few great companies and just sit on your ass because you've correctly predicted the future. That is what—it's very nice to be good at. The movie was G-rated even though—is that it, Charlie?