Author: Ooi Kok Hwa, a licensed investment adviser and managing partner of MRR Consulting.
According to the latest Forbes magazine, Warren Buffett is currently the richest man in the world. Riding on higher stock prices of Berkshire Hathaway, Buffett has a total wealth of about US$62bil.
A lot of investors are interested to know how Buffett built his wealth. They would like to know how he selects his stocks for investment. One of Buffett’s investment philosophies is buying stocks that are selling below their intrinsic value.
A company’s intrinsic value is derived primarily from discounting all future owner earnings to present value. A rate of return or discount rate will be used to discount all future owner earnings.
He learned this method from John Burr Williams, among the first to apply the theory of discounted cash flow to valuation. In most finance books, these owner earnings are also known as free cash flow to equity (FCFE).
The key concept behind this method is that the intrinsic value of a company is dependent on the amount left after the company reinvests itself for future growth. Buffett defines these owner earnings as a company’s net income plus depreciation, depletion and amortisation, less the amount of capital expenditure and any additional working capital required.
Most of his investment decisions, such as The Washington Post Co (1973) and Coca-Cola (1988), are based on this method.
According to him, the value of a business is determined by the net cash flows expected to occur over the life of the business discounted at an appropriate interest rate. Meaning, after investing in capital expenditure and working capital and taking care of changes in debt, the intrinsic value will depend on the remaining future cash flow to be distributed to shareholders.
Hence, a company’s ability to generate future cash flow to its owners is the primary determinant of its value. However, most of the time, investors have difficulty in deriving the future cash flow and discount rates. Investors always find it hard to determine the amount, timing and probability of future cash flow.
If a business is complex, i.e. it is not simple or easy to understand, predicting its future owner earnings and discount rates with a high degree of certainty will be difficult. Furthermore, it will also depend on the competency of the investors in projecting into the future.
This is one of the reasons why Buffett missed out on the golden opportunity to invest in Microsoft, despite knowing that it is a dynamic company, and the fact that he regards Bill Gates highly as a manager. Buffett has admitted that he encountered difficulty in deriving Microsoft’s future cash flows.
According to Buffett, about 95% of America’s businesses require capital expenditures that are roughly equal to their depreciation rates. To maintain perpetual earnings, a company needs to invest in new equipment and machinery. The company may defer capital expenditure for a short period of time, but it cannot sustain the business for long without making the necessary investments.
Nevertheless, companies in certain industries, for example, the telecommunication industry which needs high capital expenditure, will have low owner earnings. Unless the investment is able to produce high cash flow within a very short period of time, technological changes would mean that more capital expenditure may be needed in the near future. Thus, this will result in low future owner earnings.
As mentioned earlier, this method assumes that future income will exist forever. This assumption postulates that it will exist for at least a substantial number of years in the future, rather than being limited to only a few years. In practice, any cash flow forecast for 30 years is equivalent to perpetual cash flow because the value of any cash flow forecast beyond 30 years will be very small when they are capitalised.
However, not all companies can exist forever. As a result of stiff price competition and technological development, certain companies may go out of business even after just a few years of listing. Thus, this method is only suitable for growing companies or market leaders in the industry that have a very stable and predictable future income.
For example, consumer-related industries like the consumer products industry normally command higher valuation compared with other industries owing to their consistent earnings prospects.
