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# Berkshire Hathaway Inc. Message Board

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• Rickson9 Rickson9 Jul 8, 1998 3:29 PM Flag

## Jim - Dollar is always a dollar?

You've opened up a can of worms with that
one.

I'm hardly an expert, but if we examine what Warren
Buffett does, we may get an idea.

Basically,
Buffett determines what an instrument is worth compared
to a bond. First (1) he determine's the instrument's
future worth over a period of 'x' years.

After
that (2), he _discounts_ this instrument by comparing
it to the U.S. long bond. Discounting is a method
used to compare to instruments that grow at different
rates.

If you had \$100 that did not grow at all and held it
for one year, it would have a future value of \$100
after that year. However, if you discounted it over one
year at 10% (akin to comparing it with a 10% bond),
you'll get something like 90 bucks (\$90.91). This means
that if you wanted to have a future \$100 amount in 1
year, you should only pay around 90 bucks for it
today.

Conversely, if your \$100 grew 20% in one year, it would have
a future one year value of \$120. Discounted by 10%,
this would yield \$109.09. Again, this would mean that
if you wanted to ensure a 1 year future worth of
\$120 bucks you should only pay \$109.09
today.

Buffett's intrinsic value calculations is based on one
massive assumption. That is, that the U.S. long bond
yield is the best and safest long-term rate possible in
corporate America; he's probably right.

to your cash question is: it depends. It depends on
what the money will be doing after 3 months and it
also depends for how long will it be doing what it's
doing. I hope that's not too
confusing.

Basically, lets assume that after 3 months the bonds just
sit as dead cash. To determine it's intrinsic value
after 1 year you would find the future value of a bond
that grew at 'x'% for 3 months and then grew at 0% for
the next 9 months. This would yield a future value
for one year. You can then discount (compare it with
the long bond) it back at current interest rates.
However, with such a short-term outlook the difference
between it's intrinsic value and flat \$100 value will be
negligible, but over longer terms, the difference would be
tremendous.

So, in the first case where, say \$100 is
growing at 10% for 3 months and then sits dead for the
next 9 months, it's future 1 year value would be
around \$100 + \$100 x (3 months x 10%/12 months) x 3 =
\$102.50. Discounting back by the U.S. long bond (lets
assume a nice round 6%), you get an intrinsic value of
\$96.70. This is after 1 year. If it sits as dead cash for
longer than 9 months, this value will drop. Alas, the
ravages of time works both ways - do nothing and your

It is probably safe to use
the long bond rate at 6% for one year because the
time span is so short. However, Buffett realizes that
_historically_ the long bond is much higher and has even been
twice as high. This would _dramatically_ change your
discounting process because a 5% yeild and 14% yeild results
in _vastly_ different intrinsic values over a long
time span - say 10 years.

Sorry for the lack of

JimC
The Toronto
Investment Club
http://torontoinvest.ndsn.com

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• Robert Hagstrom calculated intrinsic value in his
book The Warren Buffett Way, but he didn't derive any
mathematical proofs. This was probably to keep it relatively
simple. The equations would show what would happen to the
investment under 3 different conditions:

1) bond
grows faster than the company
2) bond grows slower
than the company
3) bond grows at the same rate as
the company

Hagstrom only had examples of when
#2 was true.

After being confronted by an
individual who wanted the proof (I wasn't able to produce it
at that instant), I went back to my desk and
scribbled it out on a scrap piece of paper at work (I
couldn't concentrate after that kind of
challenge).

Basically it just shows mathematically what is intuitive.
That is, that if a company grows slower than a bond,
buying the bond is more prudent etc.

For anybody
who wants to try it, just derive the Future Value
forumula (using P=present value, F=future value,
I=interest rate, n=time in years). This formula applies both
for the bond and the company. This is supposedly
Buffett's first method of finding the future worth of a
company.

Then equate both future values F(bond) = F(company).
This is equivallent to 'discounting'.

When you
get to the bottom of the solution you will have three
solutions. I(bond) > I(company), I(bond)=I(company) and
I(bond) < I(company).

Cheers,
JimC

• I just came into a sum of money to invest in the
market. I have always been a Buffet fan yet never had
enough \$ to step up and invest in his stock.

Can
somebody step up and tell me if I should or should not
invest in BRKA at this specif time? Should I wait for
the stock to fall?

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