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Berkshire Hathaway Inc. Message Board

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• Novalis_97 Novalis_97 Aug 20, 1998 2:36 AM Flag

The intrinsic value of Pepsi

Like everyone else, I simply want to know for
myself how Buffett determines "intrinsic value." The two
most important clues to me are 1) his reference of
John Burr Williams' "value equation" in Berkshire's
1992 Shareholder Letter (i.e., the perpetuity
equation) and 2) Buffett's actual use of the perpetuity
equation in an example to determine the intrinsic value of
a newspaper in the 1991 Shareholder Letter. These
two facts lead me to the inescapable conclusion that
Buffett does indeed use the perpetuity equation to
determine a company's "intrinsic value." Furthermore, the
fact that he uses 10% as his discount rate in the
newspaper examples indicates to me that 10% is the
appropriate discount rate to use. The newspaper example is
not merely a hypothetical example: the newspaper's 6%
growth rate isn't hypothetical but real, which indicates
to me that the 10% discount rate Buffett uses isn't
hypothetical either.

use the perpetuity formula when g is greater than r
is well-taken, however the case never arises that a
company's g will be greater than the discount rate, r,
forever into perpetuity. A company's g may be greater
than r for a time being but eventually it will fall
below r. The reason is because of a company's life
cycle, wherein a company will experience a growth or
"exponential" stage, followed by a slower "maturity" phase. For
such companies, a "two-stage" dividend discount model
is appropriate, the first stage corresponding to the
company's exponential phase, wherin g > r, and the
second stage corresponding to its maturity phase,
wherein g < r. Buffett himself often talks about
Berkshire not being able to grow at 15% forever. He cites
Carl Sagan's example of bacteria: though they could
double each 20 minutes forever into the future, they
don't because the world (and bacterial substrate) is
finite. Likewise, any company's positive-NPV projects are
finite. Coke will reach its "maturity" phase when every
man, woman, and child on Earth drinks 10 Cokes a day
(like I do).

Excerpt from finance textbook
about dividend discount model (you'll find a similar
paragraph or two in every finance textbook you look at):
"The constant growth DDM is valid only when g is less
than r. If dividends were expected to grow forever at
a rate faster than r, the value of the stock would
be infinite. If an analyst derives an estimate of g
that is greater than r, that growth rate must be
unsustainable in the long run. The appropriate valuation model
to use in this case is a multistage (read:
two-stage) DDM." So you see, g may be greater than r in the
short-run -- but not in the long run.

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