Of price and value and the great divide

In the previous note, we looked at how to go about selecting an economic franchise as against a business. We also learned the concept of 'moat'. Once an investor has zeroed in on a good 'franchise' that he believes will be able to sustain high returns and profitability well into the future, should he go ahead and invest in the company without further considerations? We believe otherwise.

Even the best of businesses bought at expensive valuations will not lead to attractive returns. Now the question is, how does one determine what are 'attractive valuations'? In his 1992 letter to shareholders, Mr. Buffett has explained the concept of valuations in as easy a manner as possible. This is what he has to say on the issue-

Mr. Buffett on Identifying the Value of a Stock

Mr Buffett quotes, "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. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future 'coupons'. Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity 'coupons'."

As evident from the above paragraph, Mr. Buffett seems to be a firm believer in using the 'discounted cash flow' approach or what is more popularly known as the DCF approach to valuations. So, what is DCF and how does it work?

DCF is a valuation technique, the purpose of which is to arrive at future cash flows that the company is expected to generate over its lifetime and adjust it for time value of money. The resultant value is nothing but an 'intrinsic value' (since different people will have different assumptions about a company's future cash flows, intrinsic value might vary from person to person) and which is then compared to the prevailing stock price to judge the investment worthiness of the stock. If the intrinsic value is higher than the actual stock price of the company, then the stock offers an investment opportunity; the greater the discount to the intrinsic value, the more attractive the investment opportunity. Conversely, if the intrinsic value is lower than the current market price, then the stock is 'over valued' and should be avoided.

Mr. Buffett also goes on to recommend further that an investment that appears to be the cheapest under the DCF analysis should be bought irrespective of what the other valuation techniques such as P/E (price to earnings) or P/BV (price to book value) indicate.

Investors who've tried using the DCF would know that cash flows of not all companies can be predicted with great degree of certainty given their past history of inconsistent performances and the nature of their businesses. Furthermore, even in cases where cash flows can be predicted with some degree of certainty, one is not sure whether they will actually fructify. What should be done in such cases? Mr. Buffett has dealt with these two issues as well and this is what he has to say on them.

Mr. Buffett hates changes

Mr. Buffett says, "Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."

The Circle of Competence

Simple, isn't it? Focus on what you know and leave aside what you do not. In other words, define your 'circle of competence'. Mr. Buffett is famously known to have shunned technology stocks in the late 1990s at a time when they were a rage and anyone not owning them was labeled as stupid. At that time, he had argued that technology stocks fell outside his circle of competence and hence, he was not comfortable owning them. It turns out that most people who actually invested in technology stocks, some of who ridiculed Mr. Buffett, did not understand them either! Investors can draw some very big lessons from this incident and develop a discipline that makes them avoid anything that falls outside their circle of competence.

Now that one has performed a DCF on the company that falls under one's circle of competence and has found out that the value arrived from DCF is greater than the market price, should he go ahead and invest in the company? Mr. Buffett thinks otherwise.

The Concept of Margin of Safety

Pay as little as possible for your mistakes

Mr Buffett says, "We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."

Civil engineers, who construct bridges, always insist on using a 'margin of safety' in the maximum load a bridge can carry at any given time. Thus, if a signpost on a bridge says 'maximum payload capacity 1,000 tonnes', one can be sure that the engineers have designed the bridge in such a way that it can carry weight 20% to 30% more than the designated payload capacity. This is done to not only account for any errors that must have crept in while designing but also for the errors made while projecting the future traffic needs of the bridge.

Similarly, since doing DCF involves predicting the future, which as we all know is uncertain, errors are bound to creep into our analyses. Thus, having a margin of safety is important, as in the case of a bridge construction. Mr. Buffett learnt this technique from his mentor Benjamin Graham and widely believes it to be the cornerstone of investment success. Thus, whenever you do DCF next, consider buying only if your estimations are atleast 50% more than the current market price of the stock, so that even if you go wrong in your assumptions, capital loss can be minimised.

The Indian context

Reliance Power IPO - Little room for error

Reliance Power, one of the biggest IPOs to hit the Indian capital markets was a huge draw. Everyone wanted to invest in the company's shares, which were being offered as part of an Initial Public Offering (IPO). Infact, it took just few minutes for the investors to fully subscribe to the US$ 3 bn IPO.

At Equitymaster, the issue was put through our research process to evaluate whether or not to recommend it to our subscribers. When we conducted a DCF analysis on the company, an important but not the only aspect of the process, we realized that there was not enough margin of safety in the issue price. Hence for this and other reasons, we recommended to our subscribers that they "avoid" applying for the company's shares.

In the near term, we could have been wrong in our view, given the investor sentiment surrounding the stock (in the grey market, the stock was trading at a premium of over 100% of the issue price). But we remained honest to our research process. And it paid off for our subscribers.

» Next: Mr. Market and its 'now sullen' and 'now ecstatic' moods

Homepage: Value Investing with Warren Buffett