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  • AynRand23 AynRand23 Aug 15, 1998 2:09 PM Flag

    The intrinsic value of Pepsi

    I understand your logic and I appreciate your
    reply to my message. However, you are off the mark a
    little.

    First, the Buffett example about the
    newspaper valuation was not supposed to be an exact example
    of how he does it. He was using that as an example
    of how the market values stocks generally.
    I've
    read that section about 50 times and nowhere does he
    specifically come out and say that's how he does it or how he
    figures out the discount rate. I have read quotes by him,
    however, in which he says you should not use any risk
    premium, but use a margin of safety when estimating future
    growth in earnings. Come to think of it, even the
    Hagstrom book quotes Buffett as saying that. The reason
    Hagstrom's valuations all came out so low (i.e. for Disney,
    Coke, ABC, etc.) is because Hagstrom didn't cut 50% off
    the intrinsic value as an acceptable buy price. He
    just took the full I.V. using the 9% rate as the buy
    price, which of course was higher than the current
    market price of those stocks. Almost ANY stock has an
    I.V. higher than the market price if you do it this
    way. Go ahead and discount Coke's earnings out right
    now using a 12% growth rate for 10 years and 5% after
    that, and a 9% discount rate. You'll see what I mean.
    It gives an I.V. higher than today's market price.
    Would you then conclude that Coke is undervalued at 51
    times earnings?
    Of course not. You have to discount
    Coke's earnings out at about 7%, and then take 50% of
    the I.V. as an acceptable buy price. Even then, it's
    overvalued.

    If you try to predict earnings AND future interest
    rates, you're trying to do the inhuman. No one can
    predict future interest rates more than a few months out.


    In 1991, if rates were 7.7% when Buffett wrote his
    piece and he used a 10% discount rate, that would be a
    30% premium over the then current long bond rate.
    Today's long bond rate is 5.6%, and 30% above that is
    about 7.25%. You have to use the percentage premium he
    used, not the absolute number. Otherwise, the logic is
    flawed. So I guess maybe I should be using 7.25% instead
    of 7%, but again the Buffett example was not meant
    to be that specific.

    I still say you can't
    predict something like interest rates, whether they'll go
    up or down, and so the only thing you can do is use
    the current rate and go off that. It's hard enough to
    predict future earnings. Use a margin of safety for that.
    If interest rates go down from here (they just
    might), you may be using a margin of safety on your
    discount rate that prevents you from buying some great
    stocks at bargain prices.

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    • Forgot to include it in the title again.

    • The purpose of the newspaper example was to show
      how an estimate for intrinsic value can dramatically
      change if the assumption for earnings growth rate
      changes. He's saying that if the newspaper's earnings
      growth rate changes from 6% to 0%, the intrinsic value
      estimate changes dramatically from $25 mil. to only $10
      mil. He's definitely using the "perpetual annuity (aka
      perpetuity)" formula. He says, "(in the past) ownership of a
      media property could be construed as akin to owning a
      perpetual annuity set to grow at 6% a year." Look at the
      math and you'll see that he really is using the
      perpetuity formula.

      In the first case, when g =
      6%:

      PV = C / (r - g) = $1 mil. / (0.10 - 0.06) = $1 mil.
      / 0.04 = $1 mil. / (1/25) = $1 mil. * 25 = $25
      mil.

      In the second case, when g has been reduced to
      0%:

      PV = C / (r - g) = $1 mil. / (0.10 - 0.00) = $1 mil.
      / 0.10 = $1 mil. / (1/10) = $1 mil. * 10 = $10
      mil.

      There's no debate that Buffett uses the perpetual annuity
      formula to calculate intrinsic value. In the 1992
      Shareholder Letter, Buffett states that in his book, "The
      Theory of Investment Value," John Burr Williams set
      forth the "equation for value." And what is this
      equation? It's the equation for a perpetuity! Go look it up
      yourself! Except that Williams uses dividends as C, while
      Buffett in his 1986 Annual Report stated he uses "owner
      earnings."

      In the newspaper example, Buffett doesn't give a
      reason for why he uses 10%. He just uses it. He says,
      "Say that a discount rate of 10% was used to determine
      the present value of that earnings stream." I've
      already pointed out that this is higher than the 7.7%
      long-bond yield at the time. If Buffett uses it, it's good
      enough for me!

      If you recognize what a perpetuity
      is, that its coupons are paid out FOREVER, you'd want
      to make sure your discount rate, r, reflects what
      the interest rate is not just now (or in the past
      several years) but out until Judgment Day. If you're
      using 7% as your discount rate, you're saying that, on
      average, the discount rate from now until Judgment Day
      will stay at 7%. But you don't know this and,
      furthermore, it's not likely to stay at 7% in the future.
      Essentially, you're making a prediction about future interest
      rates but, as you said yourself, no one knows what
      future interest rates will be. Just because interest
      rates have been low in recent years doesn't mean they
      will continue to be low in the future.

      To be
      on the safe side -- not because I or Buffett can
      predict future interest rates -- you want to use a
      conservative (i.e., higher) discount rate. If Buffett uses 10%
      -- which is the historical average -- then people
      who want to calculate intrinsic value like he does
      should use it, too. By using 10%, you aren't using an
      unrealistically conservative discount rate, either. You're just
      using a rate that, over time, will likely better
      reflect future rates than 7%, based on history. As a
      result, your IV calculation based on 10% is likely to be
      accurate rather than an underestimate. On the other hand,
      the danger of using 7% is that your IV estimate is
      likely to be an overestimate and, even if you cut that
      IV by 50%, you're not going to end up truly buying a
      company for 50% of its true IV.

      Here's what
      Buffett said not too long ago at the Univ. of
      Washington:

      �There�s no magic to evaluating any financial
      instrument...If every financial asset were valued properly, they
      would all sell at a price that reflected all of the
      cash that would be received from them forever until
      Judgment Day, discounted back to the present at the same
      interest rate. There wouldn�t be a risk premium, because
      you�d know what coupons were printed on this �bond�
      between now and eternity. That method of valuation is
      exactly what should be used whether you�re in 1974 or
      you�re in 1998.�

      We want to use a discount rate
      that reflects not just recent years but will reflect
      what the likely rate will be from now until Judgment
      Day.

 
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