How Buffett Values Stocks

Many valuation methods have been put forth over the years to determine the intrinsic value of a stock, but Buffett only respects one of them. Buffett’s method is a development of John Burr Williams’ discounting of future cash flows method. In Buffett’s case it is not dividends, or earnings as such that he discounts, but Buffett’s owner earnings , discounted

by an appropriate interest rate.This method, which is not at all unlike methods used for the valuation of a bond puts all investments on an even keel. The purpose of owning a business is not so you can profit from its breakup and cash in its assets (something deep value investors buying at below book value do), to sell it to the next speculator in line or even to flog a whole bunch of stock options then nick off to start a new life in Thailand, but to benefit from the revenues generated by the business.If you are investing in stocks because you see them as businesses that you want to own then this is the only rational point of view. You don’t buy a business because businesses are becoming expensive, you buy them because they make profits. Applying all of Buffett’s avenues of research to try to make best guesses about what future owner earnings are going to be and discounting them by likely interest rates, the problem is reduced to a simple equation.Here we see why Buffett is so mad about companies that are simple and reliable and predictable, and why he has shunned esoteric technology companies for so long. Buffett refuses to lose money, he takes no chances at all, and hence he has such an affection for companies with earnings that can be readily estimated for a while into the future, and have a good track record and good management to back this all up.How do you value a technology company? What earnings streams do you apply to something that hasn’t earned any money at all yet? It is entirely speculative, and hence the intrinsic value of this business is really anyone’s guess. This is why so many of Buffett’s companies make simple consumer goods and provide understandable financial services. Many of these businesses seem to operate like clockwork, steadily increasing their earnings over many years because they are mature and dependable blue chips.What is the appropriate discount rate to use? Buffett’s answer is simple, the rate that is risk-free. For a long time Buffett used present rates for long term bonds. The likelihood of the US government defaulting on long term loan obligations is virtually nil, and hence this is the rate he used.When interest rates are low, Buffett adjusts this number upward, so when bond yields dipped below 7% he started discounting at 10%. If interest rates start to rise over time he has successfully matched his discount rate to the long term rate. If not, he has merely bought with a greater margin of safety.

Many would argue that another risk premium is justified, to increase the discount factor even further using a higher interest rate. That is up to the individual, but Buffett doesn’t use one because he always buys at a substantial discount to intrinsic value anyway.