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QUALIPORT
Buffett, Screaming Value and the Discounted Cash Flow

By Maynard Paton (TMFMayn)
February 26, 2001

Carburton Street, London -- When it comes to choosing companies for their portfolio, long-term investors should avoid making valuation decisions based upon long-term projections.

Fans of TMFPyad will not be surprised at the above statement. However, those who follow Warren Buffett's style of investing (which includes the Qualiport) may raise an eyebrow. Surely Buffett is a disciple of the Discounted Cash Flow (DCF) valuation technique, a process that values a company on the cash it generates far into the future? Indeed, Buffett does occasionally comment upon the true worth of any business in his Shareholders' Letters, the following being a typical example.

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

But does Buffett actually use DCF approach for valuing companies? Over the weekend, I came across this feature on the US Fool, written by Whitney Tilson. Whitney writes:

"If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both.

The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:

Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."

"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close.
"

Although it's nearly five years old, I'd never come across this reported exchange between Munger and Buffett before. Assuming the quotes are accurate (and given that Whitney Tilson is a big fan of Buffett, I've no reason to think they're not), then it appears Buffett isn't the big fan of DCF that his Letters imply.

I've no idea how Buffett values companies. However, over time, I too have come to Buffett's conclusion that if the value of a company "doesn't scream out at you, it's too close".

Obvious value

In the past, I've used DCFs (or similar) within my own personal portfolio, but had limited success. The Qualiport too has used long-term projections to justify various investments, most notably with Dell Computer Corporation (Nasdaq: DELL). Again, success was limited. It's principally these experiences, plus the success of TMFPyad's straightforward PYAD Value criteria that made me resolve to "carry on the straightforward valuation approach" in January 2000.

My straightforward valuation approach is encapsulated in this feature, an article entitled "obvious and immediate value". Essentially, it's about using "shorthand" valuation measures, such as the price to earnings  (P/E) ratio and the dividend yield, to gauge a company's valuation.

The gist of my valuation thoughts is this:

Assume the P/E ratio for the average company is 15. Now imagine finding a company that you feel can double its profits in five years (equating to 15% annual earnings growth) without recourse to acquisition, operates without debt and has 20% margins, and generates plenty of cash too. In general, the company looks to be an above-average business, and so, all things being equal, should be valued with an above-average rating.

However, if that company was valued on a P/E of just 10, way below the average, and offered a dividend yield of 5% too, then its "value" characteristics should be obvious (well, to me, at least!). You wouldn't need to construct a DCF to conclude that the company was undervalued. The shorthand measures instantly tell you there was some margin of safety factored into the current share price.

Of course, you still have to identify inherently strong businesses that can justify your faith in ever-upward profits for the years to come. And admittedly, there are few businesses around that warrant such faith. And if, over time, the company doesn't perform as you expected, then the low rating should help minimise the downside if disaster strikes.

Investment is all about getting a lot more than you pay for. For the long-term investor, this means looking for above-average businesses valued on below-average multiples. Textbook theory about DCFs is one thing. However, practical experience is another. And in my view, the purchase of a long-term investment should not have to be justified by a long-term valuation model.

Your turn

How do you think DCFs and other long-term profit extrapolations compare to the traditional shorthand measures, like the P/E ratio and dividend yield? Here's a poll to express your opinion:

* I always use DCFs, never shorthand measures
* I always use shorthand measures, never DCFs
* I use both DCFs and shorthand measures, depending on the company
* I know valuation is important, but I'm not sure which method I should use
* I always ignore valuation, as it's irrelevant to me.

Click here to vote.

Where Next?

Whitney Tilson on Why Valuation Matters