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Warren Buffett: How to Really Value a Business

- By Hoang Quoc Anh

Warren Buffett (Trades, Portfolio)'s advice is always timeless and invaluable. Every single value investor listens wholeheartedly to and learns from what he says about market conditions, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)'s positions in the stock market and value investing philosophy. In the 2019 annual meeting, he again gave some great lessons about value investing and how to value a business.


Value investing philosophy has existed for a very long time, dating back to 600 B.C. At that time, Aesop said: "A bird in the hand is worth two in the bush." It is the same for investing. According to Buffett, investors need to figure out how many birds are in the bush, when they will come out and what interest rates are. The interest rate and the number of birds in the bush should be positively correlated. If the interest rate is high, investors need a high number of birds in the bush. If the interest rate is low, they do not need as many birds.

In the 2000 annual letter to shareholders, he also wrote:


"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 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. Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."



If we need a 10% return per year on a $500 billion business, it should pay out $50 billion from year one to perpetuity. If the payment gets delayed until year two, it should pay out $55 billion to perpetuity. If it gets delayed until year three, then it should be pay out $61.5 billion. In order to pay out $50 billion, it needs to earn around $80 billion pre-tax.

Thinking about the $80 billion pre-tax earnings on $500 billion, this is a 6.25x pre-tax earnings valuation. Factoring in a 35% tax rate, the business could earn around $50 billion after tax, with a price-earnings ratio of 10x. The main question is how sustainably the business can earn at least $80 billion pre-tax per year, every single year.

The general market interest rate relates directly to our demand for 10% return. In a 2-3% current interest rate environment, a 10% annual return is marvelous. In a 15% interest rate environment, a 10% return should not be considered at all. In the beginning of June 1981, the U.S. federal funds rate nearly reached 20%. At that interest rate, every single investor could have considered putting all of their savings into the Treasury. At that time, Berkshire Hathaway was trading around $520 per share. With the trading price of $306,355 per share now, this translates into an 18.28% compound annual return for 38 years. Thus, looking back, it was better to bet on a U.S. Treasury at a 20% rate rather than Berkshire Hathaway at that time.

Source: Macrotrends.net

As of May 16, the federal funds rate is only 2.39%. Warren Buffett (Trades, Portfolio) also commented that at the current interest rate, stocks are ridiculously cheap. But the situation can change quickly. When the rate is very low, the only direction to go is up. When the interest rate rises, all asset valuations definitely go down. Thus, any long-term investors should really hold cash and wait for the interest rate to go up and valuations to go down, then invest in the market.

Disclosure: The author is long Berkshire Hathaway B-shares.

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This article first appeared on GuruFocus.