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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.

    Your point about not being able to
    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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