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Buffett's 5 second intrinsic value calculation

Discussion in 'Medium/Long Term Investing' started by TPI, Aug 29, 2014.

  1. TPI

    TPI

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    Hi,

    Buffet has said that he can calculate intrinsic value (IV) in less than 5 seconds, how does he do that?

    According to this article...

    http://www.wikiwealth.com/dictionary:warren-buffett-intrinsic-valuation

    ...A simple formula is free cash flow / risk-free rate.

    Eg. For REA in 2014 cash flow per share is 139.4 cps and capital expenditure per share is 19.9 cps, so free cash flow per share is 139.4 - 19.9 = 119.5 cps, or $1.195 per share.

    If the risk-free rate is the 10 year Australain government bond yield of 3.32%, IV = 1.195 / 3.32% = $35.99.

    With the REA share price currently being $47.95.

    Any thoughts on using this approach for IV calculation given it's simplicity and requiring less assumptions than DCF calculations?

    Perhaps more accurate for companies with more stable and less volatile free cash flow from year to year?

    For some stocks using this approach I get IV figures that seem far detached from reality!

    Thanks.
     
  2. TPI

    TPI

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    Note the article linked to seems to modify this formula by using "free cash flow to equity shareholders", I'm not sure if this is a different figure than what I've used?, and adding interest expenses too.
     
  3. galumay

    galumay learner

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    I think its a mistake to believe that Buffet ONLY uses a 5 sec calculation. I reckon his first level filter is pretty immediate from what I have read, but to get to the point of investment he does a hell of a lot more research.

    I use a Buffet type of filter for my first cut at IV, its not that one. It uses a DCF calculation with some MoS fudging and comparison to risk free investment of the same capital.

    But I would never buy just because it spat out an IV greater than current price - its just the starting point for my fundamental analysis.
     
  4. TPI

    TPI

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    Yeah for sure IV is only a small part of the process.

    I'm just looking at a basic filter to avoid excessive valuation, and that doesn't have reference to the share price (eg. dividend yield or PE ratios).

    I tried DCF calculators but found this formula interesting due to its simplicity.
     
  5. galumay

    galumay learner

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    I reckon thats the most important thing - if an input is price, yield or PE, then its irrelevant IMO.

    Sounds like you are using it the same way as I use my formula, I will stick some known shares thru the one you found and see how it compares.
     
  6. Value Collector

    Value Collector Have courage, and be kind.

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    No, You can't use this formula to value a business. The formula does not take into account the quality of the business, which is one of the biggest parts of a valution.

    Valuations are based on Quality and Quantity. You can use the formula as part of the analysis when deciding a rational price to pay, But other than that it is not useful, and doesn't tell you anything about the companies intrinsic value.
     
  7. pixel

    pixel DIY Trader

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    I am often a-mused, as well as be-mused, when people take a particular uttering of the little Big Man and try to apply them to their day-to-day trades.
    What W.B. can do for a company that's in his sight and sphere of interest is as far removed from the stocks that we ordinary people deal with, as the Space Station is from an Earth Worm Farm.

    For starters, Buffet doesn't buy "at market". When he wants a company, he talks to the current owners - who are usually distressed and distraught, desperately in need of cash. So he buys at a 20% or better discount to his "5-second value calculation". If you or I want to buy a share, we place an order on the board, aka Market Depth, and hope some holder is willing to sell down to us. Alternatively, and worse, we have to buy up at the price the most willing seller has indicated is his or her dream price. What we think may be fair value has no bearing on the price we have to pay, whether it took us 5 seconds or 5 weeks of research to figure it out.

    Based on the above, I find it far more cost-effective to gauge the Market consensus of a share's value. If that consensus appears to rise, I consider buying; if it wanes, I sell. Simple as that.
     
  8. ROE

    ROE

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    If you know enough about the business, you usually know what price to pay for it
    there is no Warren Buffett secret, people talk about it, he throw pointers here and there
    and people think there is some sort of formula he uses.

    I doubt he use any such formular ... most business he buy he has a fairly deep understanding of
    it and its management and hence he know what price he willing to pay and that is his 5 second calculation :)
     
  9. galumay

    galumay learner

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    Thats really not relevant as its not a fundamental approach to investment, you are using an entirely different, in fact diametrically different approach to selecting shares to purchase, or sell.

    Buffet's economies of scale and later approach of buying whole companies doesnt mean FA isnt accessible to smaller investors. Dont forget Buffet tried TA and found it wasnt for him.

    Personally I dounbt Mr Market considers value very often when pricing shares, the response is more often base emotional and irrational. Eventually, if a company is well enough run, and has some competitive advantage, and is able to generate growth, then pricing and value should approach equality. Of course most of the time, with any given company, price and value are out of synch (in one direction or the other), thankfully as this creates the opportunity for the FA!

    I guess this has the potential to degenerate into a religious debate if we continue down this path, so lets just leave this to a discussion about filter type formulas that can be used to take an initial stab at assessing value!
     
  10. pixel

    pixel DIY Trader

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    That wasn't my point at all, galumay; nor was it implied in the title whcih clearly makes reference to Buffett's valuation, not any old filter. My point is that trying to adopy Buffett's approach won't do us mere mortals any good. We don't even talk the same language when we and WB use the word "value".

    By all means, let's drop the reference to Buffett in the topic header and discuss various definitions of "value" in the context of companies' present and future. In most cases, I use market consensus and expectation as usable first approximations. I don't expect everybody to agree, so I'll shut up and let others explain their views.
     
  11. galumay

    galumay learner

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    Sorry for misunderstanding you, I do disagree with the contention that we cant use Buffet's approach. He has written extensively over the years about his style of fundamental analysis, he has often described that approach in terms of a mortal investor rather than from his personal scale. I think he means exactly the same thing as most FA's when he talks about value. He has also talked about a simple formula that lets him apply a high level filter to stcok valuation.

    I still dont see how "market consensus and expectations" have anything to do with value, they have everything to do with price - but that is getting back to the religious debate which belongs elsewhere!
     
  12. TPI

    TPI

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    Thanks galumay, that's what I was intending with this post.

    I certainly agree with all the sentiments made about the quantitative and qualitative aspects both being important in determining overall value.

    And that the qualitative aspects are perhaps even more important as if you are invested in the wrong type of business to begin with, that you don't really understand, in the wrong sector and at the wrong time... then all the quantitative factors including performing some sort of intrinsic value calculation become less important/less relevant.

    With the formula described it seems to make sense to me as it is very simple, quick to calculate, uses an important and freely available quantitative measure as it's basis (ie. free cash flow), is standardised by the use of a transparent risk-free rate, avoids the huge discrepancies in intrinsic value that can arise out of complex DCF calculations with numerous inputs based on varying assumptions and forecasts, avoids the requirement for costly software or complex spreadsheets to compute valuations, and avoids using current share price as an input (like dividend yield and PE ratios).

    And also perhaps one that is more useful when applied only to companies with relatively stable and rising free cash flows to begin with...
     
  13. burglar

    burglar

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    Intangibles and Charlie Munger!

    Two most important things forgotten so far!

    Intangibles prevent IV from being anything near accurate.
    That is why Value Investors always talk about a Safety Margin.
    Why they are endlessly calculating.
    And why they are endlessly debating "Lambda Corrections"

    WB can dream up what he likes but he has to get every transaction past Charlie Munger.
    CM is the genius behind WB
    Charlie Munger prevents the mistakes!!! ||*appropriate emoticon*
     
  14. galumay

    galumay learner

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    The point about Charlie is well made, they were both very lucky to 'discover' each other as they both brought so much to the table, and I suspect the sum was greater than the total of the parts.

    Ultimately its an illustration of the potential of teams in human endeavour.

    On the other hand I think you are overstating the impact of intangibles, obviously those of us who practice FA dont believe "Intangibles prevent IV from being anything near accurate.". I dont think many of us are looking for a specifically very accurate IV, its more of an indicicative and relative value as a tool to share selection.

    Safety margin is a risk management tool, and yes amongst other things it acknowledges no calculated IV is perfectly accurate.

    I dont know about others but I am not "endlessly calculating", but then I would be guilty of accusing TA's of endlessly looking into the past in a forlorn attempt to predict the future! So maybe that says more about our preconceptions of those who dont share our world view!

    I know as much about Lambda corrections as candles and teacups!

    For my purposes a simple, quick and dirty IV calculation lets me filter out companies that are currently priced by the market well above their IV, if they look on first cut to be fairly valued or below fair value, then I will start looking into the company in more detail, reading through the Annual Reports, analysing the financials, understanding the business, looking for competitive advantage, assessing the risks such as legislative and technological and reading what others have to say about the company and its products.
     
  15. TPI

    TPI

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    Reading in more detail, the author modifies the basic formula for interest expenses and uses "free cash flow to the firm" (FCFF), which seems easy to calculate though involves a bit more time (>5 seconds!) than the basic formula.

    Here's a link to how this is calculated:

    http://www.financeformulas.net/Free-Cash-Flow-to-Firm.html

    For practical purposes the basic formula seems ok to me as a rough screen.
     
  16. burglar

    burglar

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    Neither a "cup and handle" nor candlestick person per se.
    Like to think i'm well grounded!


    I see from your reply that you are also well grounded.
    While not trading TA, you seem to admit that it exists in your universe
    and effects your entry and exit points.

    That is all I expect from my spike ... an admission that predators exist and need to acknowledged!

    Wish you well, and if I were a younger person, I too, would like to get rich slowly! :p:
     
  17. luutzu

    luutzu

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    That's it. Seriously. But with some clarification.

    Video below of Alice Schroeder - his official biographer - explaining what she saw from his papers while researching "The Snowball". Though having seen and explain it, when asked later how she value she uses the DCF, even though she said she had never seen him do it.

    --
    FCF
    I don't think Buffett took it to be a strict calculated FCF. I think he simply view the company's entire history, or some meaningful operating history, and ask that given its position, its standing, its history of earnings... what does this company earn right now. Earns after paying all expenses, after the tax... what does it return to me as the sole owner of the business... that is its FCF, its earnings.

    Remember "little or no debt".

    With that figured out, next question is... I need a return of 10%, of 15% etc... on my capital... that if I put this cash at the bank, or put it in this other business I know about, it would return me x%...

    With E earnings (normalised earnings I guess you can call it) and my required return of r... since the business has been able to achieve this, the company is in a strong financial position, has good competitive advantages to retain its position... given that its history would suggest it will remain, what does a business that earns E at my r be worth?

    Hence the IV = E/r

    Mathematically, more fancifully put, this approach is the Perpetual Annuity calculation. Like a bond as Buffett said in one of his lectures (youtube it, it's where he wear a light purple Hawaiian shirt). And you could look that up and prove it mathematically to be IV = E/r.

    This can then be converted to a simple Price/Earning ratio, or capitalisation multiplier. So a 4% return is equivalent to PE of 25; 15% = 6.67 etc.

    this is why he could work it out in a few seconds... or given the financial statements and the business, in five minutes.

    ---

    So while it sounds simple... it really is not.
    First you got to know the business thoroughly.. know what its possible earnings is. This is often not the latest reported earning; it's not even the average of the past 5 or 10 years or some projection based on these mathematical averages.

    What I do is use a few scenarios... e.g. I require 10% return. Worst case scenario this company would earn $100 per year... so value at worst is $100x10 = $1000;
    Or I know this business and its assets well... if this bad luck or failures were over; if expenses like legal issues or damages is just a one off, this business will likely earn $150 next year... at 10% required return... $1,500.

    What about quality and expansions in the future... I don't know what Buffett say about this, but Graham have said that the future is to be guarded against rather than to pay for. That and personally I think this approach already take into consideration future growth, already taken into account brand name and market position - without strong operations and market position, you wouldn't assume survival in 5 years let alone eternity.

    So given its strong position and quality, enabling it to survive and grow... the best thing to do is to not pay for that future prospect, but to see it for the now or very immediate future... and future growth and expansion will simply mean higher value for the company, higher return on your investment if you sell out.

    --

     
    Last edited by a moderator: Dec 30, 2016
  18. TPI

    TPI

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    Great post luutzu, thanks!

    I really like the logic and simplicity of what you have written about this approach.

    I will watch that video this week and read a bit more about Alice Schroeder's work and post back.
     
  19. DeepState

    DeepState Multi-Strategy, Quant and Fundamental

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    How do/should you allow for different rates of FCF/Earnings growth? What is the impact of this choice?

    FCF <> Earnings in all but the most unusual situations in the nearer term although they should asymptote over longer periods.

    Growth in earnings is the most influential factor on stock price movements.

    In the 2013 Annual Letter, the number of times "earnings" was used: 54. The number of times "Cashflow", "Cash", "FCF" was used in total: 0. What does that imply about investment focus?

    How should you determine the equity risk premium over the gov't bond rate?

    There is a ton on DCF in another thread "Present Value of Future Cashflows".
     
  20. luutzu

    luutzu

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    There's a free app you can use to download youtube videos. I use 'YTD Video Downloader'.

    She describes it around minute 16 or 17 i think.


    That's the approach I use, others would, and have, disagree with it.

    Retired Young laughs at it, haha... but he was paid handsomely and probably by the hour and when you're paid by the hour, you got to look busy and act smart and pretend you could forecast the future. Else your work day kinda end at brunch. :D

    As RY's word count show, Buffett doesn't mention FCF, but earnings... FCF should be define as Earnings, or Earning Power, of a company.

    Read the post RY mention for long debates on the pro and con...

    but i'm free so let me summarise the other fundamental approach for you.


    The Discounted Cash Flow (DCF) approach:

    Conclusion: Only useful, only work, when applied to valuing bonds or mortgages - where you are very certain of each periodic payment/repayment/FCF/Earning power; and where you can value the changing growth character, the ending sale price or value of the company at your exit point; that and can predict interest rates.

    if you could predict all of that, you might as well try to predict the next mega lottery numbers and spend the rest of your life.

    DCF cannot apply to valuing a business... and if it could, as Buffett have said, the value you get on a business would be too close for comfort.

    As Graham said somewhere, the idea is to know if the price is too much or too cheap, like knowing if a person is too heavy or too thing by looking at him, without knowing his exact weight... and probably without measuring his diets and measuring then comparing it to some charts and skin/fat ratio.


    RY... how are things? Back from another vacation? hahah
     
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