U.S. Markets open in 1 hr 20 mins

Warren Buffett: Businesses and Birds

One of Warren Buffett (Trades, Portfolio)'s quotes that always pops into my mind, especially when evaluating early-stage startups and loss-making tech companies, is his reiteration of Aesop's advice from 600 B.C: "A bird in the hand is worth two in the bush."

As the Oracle of Omaha went on to explain at the 2000 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting:

"And then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush or three birds in the bush, and you have to decide when they're going to come out, and when you're going to acquire them."

This is particularly important when assessing if a company's promises are realistic or achievable. This is just as important now as it was in 2000.

The process of valuing a business is relatively simple. Investors need to try and work out how much cash the company can produce over the long term, and the appropriate discount rate to use to figure out what those cash flows are worth today.

Or, as Buffett explained, "It's a value decision based on, you know, what it is worth, how many birds are in that bush, when you're going to get them and what interest rates are."

For the average investor, the trick is viewing a stock as a business rather than as a gambling chip in a casino.

Benjamin Graham advocated this way of thinking in his early works on value investing, which were published in the first half of the 20th century. Buffett, who was Graham's student, still uses the same approach.

As he went on to explain at the 2000 annual meeting:

"When we buy a stock, we always think in terms of buying the whole enterprise because it enables us to think as businessmen, rather than as stock speculators. So let's just take a company that has marvelous prospects, is paying you nothing now and you buy it at a valuation of $500 billion. Now, if you feel that 10% is the appropriate rate of return, that means that if it pays you nothing this year, but starts paying next year, it has to be able to pay you $55 billion in perpetuity each year. But if it's not going to pay until the third year, then it has to pay you $60.5 billion in perpetuity to justify the present price. Every year that you wait to take a bird out of the bush means that you have to take out more birds. It's that simple.

And I question, in my mind, whether -- sometimes, whether people who pay $500 billion implicitly for a business by buying 10 shares of stock at some price, are really thinking of the mathematical -- the mathematics -- implicit in what they are doing."

As an individual investor, is very easy to lose sight of the fact that a stock is a piece of a business. It is easy to focus on the valuation or price of the stock rather than the whole company. Not only is this approach flawed, but it can also throw up a misleading valuation.

Another common strategy is to use relative valuation, or comparing the price of a stock to another stock in the same sector or industry. This approach has similar drawbacks. Some companies are worth paying a higher price for than others, and comparing two different businesses is always going to be like comparing apples with oranges. No two businesses are ever the same.

These thoughts from Buffett could help you streamline your investment process by focusing on the company rather than the stock. The valuation of the underlying business is all that matters to the Oracle of Omaha.

Disclosure: The author owns shares of Berkshire Hathaway.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.