Valuing a Business “the Warren Buffett Way”
According to Warren Buffett, the best method to value a business was determined by John Burr Williams in his book “The Theory of Investment Value”
which states,
“The value of a business is the present value of all the future cash flows expected to occur over the lifetime of a business which is discounted at an appropriate discount rate.”
This makes perfect sense as investors are investing for the future and that’s why valuation should be done on the basis of future cash flows. It is very similar to valuing a Bond where you calculate all the future coupon payments and calculate the present value with an appropriate discount rate.
Now, there are 2 problems in this valuation approach.
- How to determine the future cash flows of a business?
- What discount rate to use?
To tackle these 2 problems, Warren Buffet has a unique approach.
Problem no.1: How to determine the future cash flows of a business?
Warren says,
Start with businesses where you can project the cash flows with a high degree of certainty.
This is the most important and most ignored suggestion. You cannot project the cash flows of all the businesses. However, you can project the cash flows of some businesses with a great level of accuracy.
How to select these kinds of businesses?
- Select businesses that you understand. (where you understand the business model and the economics of the inherent business)
- Ignore the commodity(cyclical) businesses and businesses with untrustworthy management.
- Inherently these are the businesses with deep moats.
We will see how to compensate for your projections going wrong later.
For now, our starting point is to only select businesses where you can make projections with high accuracy.
Problem no. 2: What discount rate to use?
Now academia teaches us to take the risk-free rate and add the appropriate equity risk premium and you have your discount rate.
Or,You can take the WACC of the business as your discount rate.
Warren Buffett however does not believe in WACC calculation. The statistical measures of risk such as beta or the CAPM model do not make much sense to him.
He recommends using the long-term US government bond rates as appropriate discount rates for present value calculation.
Now, coming to the equity risk premium consideration, Warren argues that since we already have taken stable businesses with deep moats, the long-term risks in those businesses are minimal.
So no need to add the equity risk premium to the discount rate calculation of these select few businesses.
And to compensate for the probable problems that might occur in the future, (because the future is uncertain) Warren recommends buying these businesses with a margin of safety.
One might argue that during periods of low-interest rates, the discount rate might be low and this might give the wrong valuation.
Warren suggests during periods of low interest rates, look at the long-term average US government bond rates. And apply it as a discount rate. (make necessary adjustments)
