The secret to Warren Buffett’s investing approach is buying quality businesses (or shares in them) at reasonable prices. But accounting nuances can make valuation something of a dark art.
Fortunately, billionaire investor Buffett has an important rule that can help investors get past a lot of the difficulties. And it’s one that everyone can apply.
Valuation
According to ‘Oracle of Omaha’, how much a stock’s worth comes down to the company’s future cash flows. Applying a discount rate to these gives the intrinsic value of its shares.
That however, isn’t always easy to calculate. Future cash flows are uncertain and the correct discount rate varies from one business to another depending on how risky they are.
Buffett though, has a rule for getting around these difficulties. It’s that investors should only buy a stock when they can see that it’s cheap without actually carrying out the calculation.
At the 1996 Berkshire Hathaway [Buffett’s investment vehicle] shareholder meeting, Charlie Munger said that he’d never seen the CEO actually do a discounted cash flow valuation. And Buffett agreed.
According to Buffett, if you can’t see that a share price is too low just by looking at it, the stock isn’t cheap enough to buy. Sticking to this provides a margin of safety in investments.
That doesn’t however, mean investors don’t have to look carefully at the underlying business – they do. The point is that this is where the real work gets done, not in doing calculations.
An example
To see all this in action, let’s take a look at an example. After falling 39% in the last 12 months, Adobe (NASDAQ:ADBE) shares currently trade at a free cash flow multiple of around 14.
That’s certainly eye-catching. But there are some things about the underlying business that investors need to look closely at, rather than taking this number at face value.
Since the start of 2025, Adobe has issued around $1.45bn in shares to employees (incurring $380m in taxes in doing so). This offsets over 25% of the firm’s $7.5bn in free cash flow.
Given this, the headline cash flow multiple doesn’t quite reflect the business accurately. But while the number might be closer to 20, it’s probably fair to say it’s below this.
Is that an obvious bargain? The company’s facing some significant challenges, with artificial intelligence (AI) competitors offering similar services at a fraction of the cost to customers.
Given this, investors need to think seriously about the firm’s growth prospects. Things almost certainly won’t be as straightforward as they have been.
Value investing
Buffett’s first rule of investing is to avoid losing money. And a good strategy for doing this is to avoid making things unnecessarily complicated. That doesn’t mean not looking at potential investments closely. But it does involve being willing to move on from opportunities when they aren’t obviously attractive.
In the case of Adobe, that’s where I am – I don’t think the stock’s clearly overpriced, but isn’t obviously undervalued. So I’m focusing on more obvious opportunities right now.
