U.S. markets closed
  • S&P 500

    +112.50 (+3.06%)
  • Dow 30

    +825.43 (+2.80%)
  • Nasdaq

    +360.97 (+3.34%)
  • Russell 2000

    +66.90 (+3.91%)
  • Crude Oil

    +2.74 (+3.28%)
  • Gold

    +32.70 (+1.92%)
  • Silver

    +0.53 (+2.58%)

    +0.0161 (+1.64%)
  • 10-Yr Bond

    -0.0340 (-0.93%)

    +0.0156 (+1.38%)

    -0.4910 (-0.34%)

    +798.64 (+4.08%)
  • CMC Crypto 200

    +15.47 (+3.47%)
  • FTSE 100

    +177.70 (+2.57%)
  • Nikkei 225

    +776.42 (+2.96%)

Warren Buffett: One metric tells me the most about the future


Warren Buffett made a name for himself and became a multi-billionaire by making some savvy moves in the stock market. So, it might surprise some folks to hear him say that for stock market investors, the most important metric to watch is found in the bond market.

“Everything in valuation gets back to interest rates,” Buffett said to Yahoo Finance’s Andy Serwer in April.

Recently, Buffett has been fielding a lot of questions about stock market valuations and how one should value individual businesses. And repeatedly, Buffett responded by pointing to interest rates.

It’s not as simple as CAPE or market cap to GDP

At Berkshire Hathaway’s recent annual shareholders meeting, an investor asked Buffett about the relevance of two popular measures of stock market value: 1) market cap-to-GDP, which Buffett once heralded as “probably the best single measure of where valuations stand at any given moment” and 2) the cyclically-adjusted price-earnings ratio (CAPE), which was made famous by Nobel prize winner Robert Shiller and was seen as accurately predicting the dot-com bubble and the housing bubble.

“Every number has some degree of meaning,” Buffett said. “It means more sometimes than others. … And both of the things that you mentioned get bandied around a lot. It’s not that they’re unimportant. … They can be very important. Sometimes they can be almost totally unimportant. It’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.”

Having said that, Buffett does see a metric that is arguably more significant than these two heralded measures of stock market value.

“The most important thing is future interest rates,” Buffett said. “And people frequently plug in the current interest rate saying that’s the best they can do. After all, it does reflect the market’s judgment. And the 30-year bond should tell you what people are willing to put out money for 30 years and have no risk of dollar gain or dollar loss at the end of the 30-year period. But what better figure can you come up with? I’m not sure I can come up with a better figure. But that doesn’t mean I want to use the current figure, either.”

Warren Buffett
Warren Buffett

So, what does this all mean in the context of today’s historically low interest rate environment? In an interview with CNBC’s Becky Quick, Buffett said that if these rates were guaranteed to stay low for 10, 15 or 20 years, then “the stock market is dirt cheap now.”

Berkshire’s long-term returns depend on interest rates

Early during Berkshire’s annual meeting, Buffett fielded a question about calculating the intrinsic value and forecasting 10-year forward returns for Berkshire Hathaway (BRK-A, BRK-B).

“If you pick out 10 years, and you’re back to May of 2007, you know, we had some unpleasant things coming up, but I would say that we’ve probably compounded about 10%,” Buffett said. “And I think that’s going to be tough to achieve — in fact — almost impossible to achieve, if we continued in this interest rate environment.”

In other words, Buffett is saying that low interest rates signal low future returns for Berkshire. Indeed, the massive float in Berkshire’s vast insurance businesses would be unable to generate much return when rates are low. And so, knowledge of the path of rates is critical for forecasting returns.

“If I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth, I would not ask you about who was going to be president… a million things I wouldn’t [ask],” he continued. “I would ask you what the interest rate is going to be over the next 20 years on average. The 10-year [Treasury note yield] or whatever you wanted to do.”

It all comes back to interest rates.

“A bird in hand is worth two in the bush”

To be clear, Buffett isn’t so abstract and ambiguous that he won’t share explicitly how he calculates value. On the contrary. He very publicly endorses discounted cash flow analysis, which will get you intrinsic value. He calls it “the ultimate formula.”

Before you get freaked out about the finance jargon, let Buffett do the explaining.

From the Berkshire Hathaway’s 2000 letter to shareholders: “Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”

Still struggling? From Buffett’s 2010 letter to shareholders: “To update Aesop, a girl in a convertible is worth five in the phone book.”

In business, those “birds in the bush” or “girls in the phone book” represent future cash flows, which is roughly future sales less future costs and expenses. All of that is adjusted for the fact that you’re not guaranteed those birds, girls, or cash. Once you make those projections, you then discount those future cash flows to the present by applying a discount rate. Add up all of those discounted cash flows and you’ll have the theoretically-sound value of a business.

bird in hand
This bird is worth two in the bush.

“The trouble is you don’t know what to stick in for the variables,” Buffett said at Berkshire’s annual shareholders meeting this past weekend. So, while the model is theoretically sound — which Buffett loves — the values you’ll get will be fantastically off if your assumptions are wrong. Garbage in, garbage out.

But of the inputs, one variable is by far the most important: the discount rate, which is tied to the market interest rates Buffett has been talking about.

NYU finance professor Aswath Damodaran calls it the “critical ingredient,” noting that “errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation.”

So, once again, it all comes back to interest rates.

To summarize, Buffett has told us: “Everything in valuation gets back to interest rates;” “The most important thing is future interest rates;” and “If I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth, I would not ask you about who was going to be president… a million things I wouldn’t [ask]… I would ask you what the interest rate is going to be over the next 20 years on average.”

Stay with Yahoo Finance for the best ongoing coverage of Warren Buffett and Berkshire Hathaway.

Sam Ro is managing editor at Yahoo Finance.
Read more: