Warren Buffett believes thatintrinsic value can only be determined with a full and through understandingand analysis of the company and its financial statements and the discounted cashflow, not from what the stock price says it is worth.
Buffett gets his view of investing from BenGraham who is considered the father of value investing. Value investing is where an investor looks atthe overall financial condition of a company including; statement of cash, flowincome statements, balance sheets to pull out the financial data and using thevarious fundamental financial equations to determine the what the value of thestock should, you then compare this to the current stock price and if the stockprice is below what you believe the value to be you would then buy. While Buffett holds this philosophy ofinvesting he acknowledges the fact that the financial statements released bythe company are past looking and my not depict the true economic reality of thecompany. Buffett feels it is most importantto understand what he calls the economic reality.
Since these statements adhereto the generally accepted accounting principles (GAAP) certain aspects of thecompany are not considered. He believesthat all aspects of the business should be included in valuing the company,these would the intangible assets, including patents and trademarks held by thecompany, specialized managerial expertise, and what the reputation of thebusiness is can all affect its value. Hejudges an investment on a business by business basis, not on how the market,the economy, or other securities are performing. His analysis judges the simplicity of thebusiness, how reliable the business has operated, is the business have a long-termappeal, the effectiveness of the management, and is the business’s capacity tocreate value. One of the most importantfactors that Warren Buffett uses is the discounted future cash flows.
He believes that this is the best measure ofthe intrinsic value of a company. He defines”intrinsic value as the discounted value of cash that can be taken out of abusiness during its remaining life.” This is easier said than done, evenBuffett says that this is highly subjective and can fluctuate as estimates forcash flow and interest rates change. Onealso must determine to either receive dividends or to reinvest the profits backinto the business. To determine if theinvestment is wise the investor must determine the rate of return of the companyand the cost of equity.
They would thentake the take the discounted cash flow and divide this by the book value ifthis number is greater than one the investment creates wealth for the investorand if the number is less than one value is destroyed and the investor would bewise to look for a different investment choice. In essence Buffett believes that a gain in intrinsic value is more importantthan increasing account profit. As he said in 1992 “… Irrespective of whethera business grows or doesn’t, displays volatility or smoothness in earnings, orcarries a high price or low in relation to its current earnings and book value,the investment shown by the discounted-flows-of-cash calculation to be thecheapest is the one that the investor should purchase.” Investors and regular people look so favorablyon Warren Buffett’s perspectives because he has significantly outperformed themarket no just for short durations but for decades. Looking at the share price of BerkshireHathaway Class A shares from 1977 to 2005 the price went from $102 to $85,500 an83,723% increase or an average of 27.
1% return per year, while, the Standard &Poor’s 500 grew from 96 to 1,194 for a return of 1, 1143% or an average returnof 9.4% per year. The alternative todetermining the intrinsic value of a company and investing in underpriced stocksis the Efficient market hypothesis (EMH) which is where a share price will reactrapidly to publicly known information and as such the stock price is a fairreflection of the company. If EMH were true,there would be no need to determine the value of stocks since there are norbargains and it is impossible to outperform the market. Buffett is quoted in 1990 as saying, “It hasbeen helpful to me to have tens of thousands turned out of business schoolstaught that it didn’t do any good to think.
” This helps to explain Buffett’s above markets for years, when you arethe only one looking it is easy to find bargains. However, with more and more people searchingto value investments it is harder to find one. Warren Buffett is also a detractor of hedge funds that charge high feessaying that managers reap the most rewards not the clients, in 2007 he statedthat an S&P 500 index fund would produce better returns for clients thanthese hedge funds, after a decade the index fund outperformed each of the hedgefunds that took up Buffett’s challenge by a significant amount.