At the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholder meeting in May, Warren Buffett (Trades, Portfolio) said, “What gives you opportunities is other people doing dumb things,” in response to a question regarding how artificial intelligence would potentially change the value investing landscape. His point was that no matter how the world changes, the basic principles of the investing remain the same.
As the guru explained, people were doing dumb things 50 years ago, and they are still doing dumb things today. Although, he did point out that more people do even bigger dumb things now because it is so much easier to get the financing they need.
So the opportunities are plentiful. It is simply a matter of choosing the right ones. This discussion looks at how the Oracle of Omaha does it.
Understanding Buffett's approach to value investing
According to Buffett, the key to successful investing is to buy an undervalued business and hold on to it for the long term. For this very reason, he does not like the term “value investing” because investing should be focused on seeking value over the long term. Anything else, such as buying a stock to sell it later for a profit, he considers to be speculative.
For a business to gain Buffett’s interest, it must fulfill specific criteria: it must have competent management, a solid competitive position and predictable earnings power. Of course, the stock must also be undervalued.
For example, during the 2008 Global Financial Crisis, Buffett invested $5 billion in Bank of America Corp. (BAC, Financial), a move that demonstrated he believed the bank had excellent potential despite the situation at the time. As he aptly put it, investors should be “fearful when others are greedy and greedy when others are fearful.” Most people were very fearful at the time.
How to value a stock
When it comes to valuing a stock, Buffett uses an approach that relies on calculating the company’s intrinsic value, which involves three key components: understanding the time value of money, determining a suitable discount rate and applying a margin of safety.
Time value of money is the principle that a dollar in the present is worth more than that same dollar in the future because of its potential earnings capacity. So if invested in an asset with a 7% annual return, that one dollar might be worth $1.07 in one year and $1.97 in 10 years.
Determining a suitable discount rate is tied to the time value of money because it helps investors calculate how much future cash flows are worth today. Typically, the preferred discount rate tends to be the long-term government rate because it is a risk-free benchmark.
Investors can compare how much they can expect to make from a risk-free government bond with the return of the stock they are analyzing to determine if the risk is worth it. However, a higher rate can be used for riskier businesses.
The margin of safety is a buffer used when calculating discounted future cash flows to reduce the risk of future uncertainties and possible calculation errors. The safety margin indicates how much lower the stock price should be compared to its intrinsic value to make it a good investment.
According to Buffett, a company’s intrinsic value represents its estimated actual worth, not just its current market price. It considers everything from the company’s tangible assets to its future profit potential and is calculated based on the “remaining life of the asset.”
However, since it relies on a series of assumptions pertaining to the company’s future performance and industry and economic conditions, it is challenging to calculate accurately.
A practical guide to applying Buffett's stock valuation method
Applying Buffett's stock valuation methodology is a multistep process that starts with understanding the business and ends with determining whether the stock is undervalued.
Understanding the business
Buffett only invests in businesses he understands because, otherwise, he is not in a position to even speculate on the company’s future performance. Therefore, it is essential for investors to understand everything about the business, including how it makes money, who the competition is and how it is positioned in its industry. Armed with this knowledge, investors can determine future earnings and risks with greater accuracy.
Analyzing relevant information
A cornerstone of Buffett’s process is analyzing as much information about the company as possible. He has said he believes one of the secrets to his success is that he reads 500 pages per week, including annual reports, transcripts, regulatory findings and more, though he also reads business books and other materials.
The key is for investors not to limit themselves only to the information companies share, such as their annual reports. Those are undoubtedly useful, but it pays to go beyond that and look at interviews with company executives, news articles and industry reports to gain a more holistic view of the company’s financial health, strategies, potential risks and the state of the industry.
Calculating the company’s intrinsic value
The next step is calculating the company’s intrinsic value, which involves forecasting its future cash flows and discounting them to the present using an appropriate discount rate. Investors should also factor in potential growth and economic conditions when making calculations. Further, it is better to err on the side of caution than to be overly optimistic.
Comparing the intrinsic value with the market price
The final step is to compare the company’s intrinsic value with its market value to determine whether the stock is undervalued or not. Essentially, if the stock is selling at a price far lower than its intrinsic value, it could be undervalued, potentially making it a good investment.
The limitations of Buffett's approach
While this approach can be highly effective, Buffett himself warns it is not a plug-and-play solution. Investors cannot simply plug some numbers into a formula and be guaranteed a win. Since it is based on many assumptions, it is easy for even the most experienced analysts to make mistakes.
The way Buffett tackles these limitations is that, first, he avoids investing in businesses that are too complex or undergo constant changes. As he explains, in those situations, it is more than challenging to predict the company’s future cash flows, so he prefers to avoid them.
This is also where the margin of safety comes in. Buffett likes to act as if he will not get the calculations precisely right, so he creates a safety net for himself. Once again, determining the margin of safety can be challenging because it is often more of an art than a science. It can be based on the difference between a company’s intrinsic value and the stock price, just as it can be based on the potential return a stock might generate compared to a government bond.
Mastering stock valuation through intrinsic value
Buffett’s approach to stock valuation certainly has limitations, but that is true of any methodology. What sets this strategy apart is the concept of intrinsic value, which few people can successfully master.
Intrinsic value is based on forecasts and those are based on assumptions, meaning there are not really any formulaic or mechanical ways to do it successfully. It is all based on diligence, patience and experience.
Therefore, not everyone can do it successfully, making it easier for those who have mastered the process to make money in the market. However, it is critical to remember that even the Oracle of Omaha uses the margin of safety as a guardrail to protect himself from uncertainties. Aspiring investors would be wise to follow in his footsteps.
