I was read the book "The Buffett Way".

The book claims that Warren Buffett uses a simple calculation to calculate the intrinsic value of a company.

The regular way is to estimate future earnings & then use a discounting rate to calculate the present value of the free cash flow. The discounting rate is typically one higher than that you receive for fixed income instruments - called a Beta - a premium.

Buffet's formula is to just divide the owner's earnings for the current year by the discounting rate & the discounting rate he uses is the rate on long term US govt bonds.

So on one hand, Buffet uses a low discounting. But on the other hand, he doesn't use future earnings - i.e. that may mean that he isn't accounting for any growth in earnings.

I am wondering if these 2 things (using a low discounting rate but also not assuming any growth) cancel each other out & help him arrive a decent rough estimate? Is there any mathematical justification to this? The cancelling is my assumption - the book doesn't say anything about why he uses a low discounting rate.

  • Can you show the calculation as dividing by the discount rate in your question is not clear. It could be your understanding of discount rate calculations is incorrect. – Mark Oct 18 '18 at 9:41
  • @Mark - If the US long term bond rate is 6%, then Buffett uses (Owners Earnings)/0.06 as valuation of the company. – user93353 Oct 18 '18 at 12:35
  • Remember that owner earnings are the amount you could pull out of the business after all necessary maintenance capex. It is the amount you can pull out without damaging the business in any way. Since most businesses require repair and replacement, owner earnings is less that the raw earnings per share. – zeta-band Oct 22 '18 at 18:59

It's possible (I haven't read the book to know the context) that the additional risk of the investment is equal to the growth. The formula for the present value of a growing perpetuity is D1/(r-g), where D1 is the income in the next period, r is the discounting rate, and g is the rate of growth of the income.

So just using a risk-free rate in the denominator means that g is 0, or that g is cancelling out the additional risk of a higher r .

However, knowing what I know about Buffet, it's just a quick rule of thumb that involves very few, easy to calculate variables, so that he can do it on thousands of companies at a time, looking for a "value". I doubt there'a a lot of science behind it.

  • What is D1, r & g here? – user93353 Oct 18 '18 at 13:26

It is not justified. If the US long term treasury rate reaches 0, as it has been in some countries, the formula would result in division by 0. With the traditional formula, a positive risk premium or negative growth rate can allow you to get a finite price despite 0 (or negative) risk free rate.

Second, consider a power-plant scheduled to be shut-down in 5 years. It would not make sense to discount 5 years of cash flows with the long term rate.

It may be a useful rule of thumb (and therefore useful as a screening tool), but it is not theoretically justified.

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