The essence of Buffett’s investment process is putting out cash after careful consideration of the facts with the expectation of a reasonable (or better yet, unreasonable) return. He sees this as fundamentally different from speculation where the emphasis is not on what an investment is intrinsically worth but on what the next person will pay for it. Buffett does not think that there is anything wrong with speculating per se; it’s simply a game he chooses not to play. At the center of Buffett’s investment process is the ability to value an asset. To do this requires that you answer only three questions:
For an investment grade bond, making this calculation of value is easy, because the bond generates a fixed coupon that is contractually bound to be paid on a fixed schedule. However, when valuing a business, it is the investor’s job to estimate the amount and timing of cash that the business will produce. This is an inherently imprecise process, yet it can be very useful.
Even if an investor can only come up with a range of values for a prospective investment, such a range of values may allow the investor to make a profitable investment if the investment can be purchased at a price below those values. For example, if your best appraisal of a real estate investment was very imprecise, for example, that the property was worth between $1 million and $2 million, that estimate would still be very useful if you could purchase the property for $700,000.
Valuation is not primarily a question of how precise it is, but rather how certain it is, and whether you can purchase the asset cheaper than the lowest reasonable estimate of value. That is why Buffett’s first question is about certainty. Buffett thinks about risk first and will not invest in a business that he does not understand or that is subject to a lot of change because it makes the analysis of value impossible. Buffett once quipped that if he were teaching a class on investing, the final exam would include asking students to value an Internet company. Anyone who tried to answer the question would be flunked. It is simply too hard to value a business that is not producing cash in an industry where it could be obsolete in a year or two.
This is why Buffett looks for companies that have a durable competitive advantage – what Buffett calls a moat – because these types of businesses have predictable cash flows. The best evidence that a moat exists is a business that is profitably doing pretty much the same thing today that it was doing ten years ago, generates high returns on invested capital and is unlikely to succumb to the forces of creative destruction in the foreseeable future. Buffett looks for strong management that will work diligently to deepen the moat or, at least, work hard to minimize the effect of any forces that are eroding it. He also wants a business where management’s interests are aligned with those of shareholders. Even a business with strong predictable cash flows can be a poor investment if management is egregiously compensated or is prone to making poor capital allocation decisions.
If an investment fails to meet his standard of certainty, Buffett is happy to walk away. If he doesn’t understand a business or it is in an industry subject to rapid change, he won’t invest, knowing that to do so would be speculating.
Greg Speicher
http://gregspeicher.com/
- How certain are you that your investment will produce cash?
- How much cash will it produce and when will it be paid?
- What is the risk free interest rate? Buffett uses the yield on long-term treasury bonds for the risk free interest rate.
For an investment grade bond, making this calculation of value is easy, because the bond generates a fixed coupon that is contractually bound to be paid on a fixed schedule. However, when valuing a business, it is the investor’s job to estimate the amount and timing of cash that the business will produce. This is an inherently imprecise process, yet it can be very useful.
Even if an investor can only come up with a range of values for a prospective investment, such a range of values may allow the investor to make a profitable investment if the investment can be purchased at a price below those values. For example, if your best appraisal of a real estate investment was very imprecise, for example, that the property was worth between $1 million and $2 million, that estimate would still be very useful if you could purchase the property for $700,000.
Valuation is not primarily a question of how precise it is, but rather how certain it is, and whether you can purchase the asset cheaper than the lowest reasonable estimate of value. That is why Buffett’s first question is about certainty. Buffett thinks about risk first and will not invest in a business that he does not understand or that is subject to a lot of change because it makes the analysis of value impossible. Buffett once quipped that if he were teaching a class on investing, the final exam would include asking students to value an Internet company. Anyone who tried to answer the question would be flunked. It is simply too hard to value a business that is not producing cash in an industry where it could be obsolete in a year or two.
This is why Buffett looks for companies that have a durable competitive advantage – what Buffett calls a moat – because these types of businesses have predictable cash flows. The best evidence that a moat exists is a business that is profitably doing pretty much the same thing today that it was doing ten years ago, generates high returns on invested capital and is unlikely to succumb to the forces of creative destruction in the foreseeable future. Buffett looks for strong management that will work diligently to deepen the moat or, at least, work hard to minimize the effect of any forces that are eroding it. He also wants a business where management’s interests are aligned with those of shareholders. Even a business with strong predictable cash flows can be a poor investment if management is egregiously compensated or is prone to making poor capital allocation decisions.
If an investment fails to meet his standard of certainty, Buffett is happy to walk away. If he doesn’t understand a business or it is in an industry subject to rapid change, he won’t invest, knowing that to do so would be speculating.
Greg Speicher
http://gregspeicher.com/
