Berkshire Hathaway Inc. Message Board

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.

The answer
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
buying power erodes.

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
any concrete answer. :P

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