QUALIPORT
Avoiding Buffett Valuations

By Maynard Paton (TMFMayn)
April 26, 2004

Munger: I don't know. We have such a fingers and toes-style around here. Warren often talks about these discounted cash flows, but I've never seen him do one.    

Buffett: Some things you only do in private, Charlie.   

Munger: Yeah. If it isn't perfectly obvious that it's going to work out well if you do the calculation, then he tends to go on to the next idea.   

Buffett: That's true. It's sort of automatic. If you have to actually do it with pencil and paper, it's too close to think about. It ought to just kind of scream at you that you've got this huge margin of safety.

So went a reported exchange between Charles Munger and Warren Buffett at the 1996 Berkshire Hathaway (NYSE: BRK.A) AGM. However, the discussion contradicts Buffett's famous Shareholder Letters, which have included the following text on discounted cash flows (DCFs):

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

"Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business."

DCF in action

To recap, DCF calculations go something like this:

Year	Cash flow (£m)	Net present value (£m)
0	10.00
1	10.80	10.29
2	11.66	10.58
3	12.60	10.88
4	13.60	11.19
5	14.69	11.51
6	15.87	11.84
7	17.14	12.18
8	18.51	12.53
9	19.99	12.89
10	21.59	13.25
Total		117.14
Year 10 multiple		15
Residual value		198.81
Total value		315.95

The calculation is usually a two-stage process. In the first part, the company's cash flows are projected over a specific timescale and then discounted back to today's money (i.e. their net present value (NPV)).

In the above table, a ten-year growth rate of 8% and a 5% discount rate have been used. Thus for Year 1, the cash flow grows from £10m to £10.80m, which is then discounted by 5% (i.e. divided by 1.05) to get £10.29m. For Year 2, the Year 1 cash flow grows another 8% to £11.66m, which is then divided twice by 1.05 to give £10.58m. The process is repeated up to and including Year 10.

The second part calculates the residual value (i.e. the cash flows of Year 11 onwards) and is determined by placing the Year 10 NPV on a suitable multiple (in this case 15). 

The company's overall DCF value is the accumulated NPV of the individually calculated cash flows (Years 1 to 10) plus the residual value (Years 11 onwards). Read more on DCFs.

Gave up

The Qualiport gave up on DCF calculations long ago. Among the problems are:

1. The cash flow projections are invariably based on unrealistically smooth growth;
2. The discount rate is traditionally the risk-free rate of return plus a 'risk premium', the theory of which is a constant source of debate among investment academics;
3. The residual value is based on cash flows earned in the years ahead, in which time differing economic condition could make a suitable multiple difficult to judge, and;
4. The residual value often ends up as a substantial proportion of the company's DCF value. In the example, nearly two-thirds of the final value is made up from cash flows produced after Year 10. The further out the value lies, the less likely the value actually exists.

The final point is crucial. There's no point in doing all the detailed Year 1-10 calculations if a significant part of the end value comes from just slapping a fair multiple on the Year 10 cash flow.

A rating might as well be placed on the Year 0 (i.e. last year's) cash flow. At least that cash flow is fact (and not based on guesswork), while other known factors (e.g. inflation, interest rates and the returns from alternative investments) can help decide a multiple suitable for today.

For its part, the Qualiport combines the advantages of the earnings yield (the inverse of the P/E), dividend yield and DCF by calculating a company's historic free cash flow and capitalising it at 7.5% to give a free cash flow yield. This measure may not be perfect, but it's based on facts and simple assumptions and the portfolio has outrun the market every year since its adoption. So far at least, it's definitely a case of being vaguely right with the recent accounts than being precisely wrong with some long-term forecasts.

None of this, however, sheds any light on how Buffett values his shares or indeed whether he uses DCFs. So if anybody's attending this year's Berkshire AGM -- it's being held on Saturday -- please press him for some definitive answers.

Publishing update

Please note that from next week the Qualiport will be published on Tuesdays.

Where next? Sandman's Place Of Quotes | Discounted Cash Flow | Berkshire Hathaway | Five Big Buffett Mistakes