Berkshire Hathaway
Thinking about "Fair Value"

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By gdefelice
September 20, 2005

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Buffett has said that an investment -- any investment -- is worth the present value of all the future cash that can be taken out of an investment from here to Kingdom Come, discounted at an appropriate rate.

Buffett has said that he uses the same discount rate for every investment that he tries to value. If the future cash flows seem uncertain to him, rather than raising the discount rate, he simply puts it in the "too hard" pile. An investment is either "go" or "no go". Note that uncertain doesn't mean inconsistent, at least, I don't think it means that to Buffett.

The rate he uses to discount investments is that available on long-term, risk free U.S. Treasuries. I have also seen him say that he won't go below, IIRC, about 7.5 - 8% even when rates are as low as they are today -- which are in the 4+% range. I think he uses something in the 20 year range for his rate on the Treasuries. I have seen him say that the value (on day one -- "investment day") of cash received in the 20th year (and beyond, of course), is minimal compared to the value of what you get in the early years. Of course, See's isn't simply worth "nothing" today just because Berkshire has owned it for more than 20 years. It is just that, in 1983 (the year See's was purchased) the value of the cash See's was going to produce in 2003 was far less valuable than what it was going to produce in the first, say, five years after its purchase. As well, for something like NetJets (purchased in August 1998), which seems to continue to lose money, the cash that it must produce in the 8th, 9th and on through to the 20th year after the purchase must be very large, relative to the purchase price, to justify the losses in the early years. At some point, early losses create such a large opportunity cost that future profits can never make up for "what could have been". In older reports, Munger says at one point that no matter how well Buffalo News did in the future, their early troubles could never be made up -- happily, Munger ultimately admitted he was wrong.

In any case, the important notion here is that Buffett believes that the appropriate discount rate is the risk-free rate on 20 year Treasuries but not below about 7.5% (which I suspect is Buffett's estimate of the mean, long-term rate in the 20 years following a low interest rate environment).

Now, he says, for the purchase to make sense (to the enterprising investor), it must be bought at a discount to the present value calculated with the risk-free rate. Otherwise, of course, the intelligent investor would simply buy the risk-free Treasuries.

But, crucially to my mind -- and here is where I am going to diverge with just about all the business school curriculum and many on this board -- Buffett uses this number becuase he believes it is roughly fair-value for an investment and not just because it represents "risk-free" opportunity cost. In the world of Buffett, there is no "equity risk premium"....that's my take.

So, while he won't ever pay the present value of a future stream of cash flows that is discounted at the risk-free rate, I think he believes that the average investor/invested dollar will -- at some point. And, that point is when the weighing machine has caught up to the voting machine -- and that is the point at which one should sell.

In fact, I bet he would argue that often the average investor/invested dollar -- Mr. Market, I guess -- will pay even more than fair value sometimes -- don't we all know he will.

An important additional point is that I believe he discounts the future cash flows before tax. I think he does that because the alternative investment -- U.S. Treasuries -- pay their coupons on a pre-tax basis as well. If Berkshire invested all its capital in Treasuries paying 8%, their after tax take would be only 5.2% (using their 35% tax rate). I think this is an important reason why you always see him reporting numbers pre-tax and discussing the multiples he is willing to pay for businesses on a pre-tax basis. Presumably, he is not willing to pay "fair value" because, if he was, he would simply buy risk free, 20-year Treasuries instead. And, those of you that expect him to trumpet this purported fact must really believe he is a saint rather than simply a sage.

Valuing Berkshire as if every investor/invested dollar invests like Warren Buffett is, politely, absurd.

It doesn't make any sense. Fair value for Berkshire is the present value of all the future cash that can be taken out of Berkshire discounted at a reasonable rate -- the discount rate should be used to discount the pre-tax profits from Berkshire. Since rates are below the 7.5 - 8% range right now, I think that should probably be the floor. In fact, using that rate probably provides a margin of safety given that rates are below 5% right now.

Eventually, the market will pay a price for Berkshire, which reflects the risk-free discount rate -- it will probably pay more. When the market uses the appropriate rate to value Berkshire, I think its operating subsidiaries alone -- including Clayton and MidAmerican -- approach $50 billion. Buffett probably wouldn't pay that for them but that's why he's Buffett. Valuing Berkshire based on what Buffett would pay is interesting and useful but it doesn't determine what fair value actually is.


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