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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.

    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

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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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