ALEXANDRIA, VA (Oct. 12, 1998) -- Recall from the Friday column that today we were going to discuss why Warren Buffett eschews the use of any kind of risk premium in his calculations for the expected return on the assets that he evaluates. From Outstanding Investor Digest's report on the 1997 Berkshire Hathaway (NYSE: BRK.A) annual meeting:
"We use the risk-free rate merely to equate one item to another. In other words, we're looking for whatever is the most attractive. In order to estimate the present value of anything, we're going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate."
This, of course, results in a situation where the present value derived is a great deal higher than what would typically be found if one where to attach a risk premium to the discount rate. As one astute observer inquired at the 1997 Berkshire Hathaway shareholders meeting, an important consideration arises:
Shareholder: Following up on that other question -- if you don't adjust for risk by using higher discount rates, how do you adjust for risk -- or do you?
Buffett: Well, we adjust by simply trying to buy it at a big discount from the present value calculated using the risk free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway -- and he's correct), then we'd require a substantial discount from that present value figure in order to warrant buying it.
If you had the ability to augur all the future cash flows of a business perfectly, then as an investor you wouldn't need a margin of safety; in fact, you wouldn't need to worry much about anything -- thanks to the unlimited amount of money you'd be able to earn pricing various securities.
The difficulty in all of this is not so much in determining the proper discount rate (though even single points can vary the present value significantly over time, and there is substantial room for debate on the topic of discount rates), but in assessing the free cash flows in a over the life of the company. Due to these difficulties and the increasing lack of visibility in forecasting these numbers, many investors simply resign themselves to the following lament, "You can't predict returns one year out, much less ten, what's the point?"
To see what expectations are imbedded in the share price of a company, these kind of calculations are crucial, even if often wide of their financial mark, as Buffett notes, "In the first edition of Security Analysis, as I recall, Graham used the example of J.I. Case and said, 'Maybe it's worth somewhere between $30 and $110.' He said, 'That doesn't sound so great. How much good does that information do you?' Well, it may do you some good if it's selling below $30 or above $110."
Returning to intrinsic value, it can be frustrating to hear investors refer to this concept as if it were a readily accessible value, like, "The company is trading significantly below its intrinsic value." Which in essence amounts to stating it is not trading at one's estimation of the net present value of the sum of all future free cash flows the company can generate, using one's particular discount rate. Intrinsic value varies from person to person, depending on their own required rate of return on investments. One must disclaim one's own biases and estimates in talking about intrinsic value.
Again, the crux of the matter in evaluating the future returns of any business is knowing it so well that a reasonable estimation can be made about its growth rate and its prospective economic characteristics. Buffett's notion of an understandable business is a rather high hurdle for the rest of the investment world -- it's one in which cash flows can be accurately predicted for the next ten years. With how many businesses today can an investor reasonably attempt to do that? We close with a comment from Warren Buffett's right hand man and head of Wesco Financial (AMEX: WSC), Charlie Munger:
"The concept of intrinsic value used to be a lot easier to implement because there were all kinds of stocks selling for 50% or less of the amount for which you could have easily liquidated the whole corporation if you owned it. Indeed, in the history of Berkshire Hathaway we've bought things at 20% of the liquidating value. And, in the old days, the Ben Graham followers could run their Geiger counters over corporate America and they could ferret out a few things. And you could easily see --if you were at all familiar with the market price of whole corporations -- that you were buying at a huge discount.... But as the world has wised up and stocks have behaved so well for people and have generally gone to higher and higher prices, that game gets much harder. Now to find something at a discount to intrinsic value, those simple systems don't ordinarily work."
Next time, Dale will discuss why we like to look at companies in terms of return on invested capital versus the cost of capital. As always, for continuing discussion or if you have questions, please visit the Boring message board. We don't run columns on Tuesday and Thursday specifically so we can focus on discussion on the message board.
Stock Change Bid ANDW + 13/16 12.13 CGO +2 1/8 27.13 BGP +1 5/8 23.69 CSL + 13/16 34.31 CSCO +2 5/16 52.38 FCH + 7/8 20.50 PNR + 3/16 30.63 TBY + 5/16 5.88
Day Month Year History BORING +4.47% -7.35% -20.72% -0.24% S&P: +1.36% -1.90% 2.81% 60.50% NASDAQ: +3.59% -8.72% -1.55% 48.52% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 52.38 118.63% 2/28/96 400 Borders Gr 11.26 23.69 110.44% 8/13/96 200 Carlisle C 26.32 34.31 30.34% 3/5/97 150 Atlas Air 23.06 27.13 17.64% 4/14/98 100 Pentair 43.74 30.63 -29.99% 5/20/98 400 TCBY Enter 10.05 5.88 -41.51% 11/6/97 200 FelCor Sui 37.59 20.50 -45.46% 1/21/98 200 Andrew Cor 26.09 12.13 -53.53% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 11784.38 $6394.39 2/28/96 400 Borders Gr 4502.49 9475.00 $4972.51 8/13/96 200 Carlisle C 5264.99 6862.50 $1597.51 3/5/97 150 Atlas Air 3458.74 4068.75 $610.01 4/14/98 100 Pentair 4374.25 3062.50 -$1311.75 5/20/98 400 TCBY Enter 4018.00 2350.00 -$1668.00 1/21/98 200 Andrew Cor 5218.00 2425.00 -$2793.00 11/6/97 200 FelCor Sui 7518.00 4100.00 -$3418.00 CASH $5750.59 TOTAL $49878.72