In the 2000 Berkshire Hathaway chairman’s letter, Warren Buffett puts forth a “formula for valuing all assets that are purchased for financial gain.”
In this letter, he states:
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C.The paragraphs that follow in the 2000 Berkshire Hathaway Chairman’s Letter explain this formula:
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.Buffett’s formula is essentially a net present value calculation in which he uses the risk-free interest rate (i.e. the yield on long-term U.S. bonds) to determine the maximum value of the cash flows from an asset.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
…Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value…. To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.
…we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge …. Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners….
While I don’t know if Buffett actually performs this calculation in his personal investing, if he did, he would probably first establish a range of maximum values for an asset (making sure to use conservative estimates and focus on “industries where business surprises are unlikely to wreak havoc on owners”) and then decide if the current price of the asset represented a large-enough margin of safety (i.e. discount) to this calculated range of values.
I have read other quotes online attributed to Warren Buffett that seem to indicate that Buffett doesn’t actually do the above maximum value calculation. (For example, see the following article that addresses Warren Buffett’s discount rate in discounted cash flow calculations.)
However, even if Buffett doesn’t do this calculation, I don’t believe it changes the validity of it. As Buffett states, if you can establish the necessary formula inputs, you can determine a range of maximum values for any asset. And this can be a very valuable tool for any investor trying to establish the upper-bound value of an asset.
So, the next time you’re wondering what the maximum value of an asset should be, think about Aesop’s investment insight (as expanded and explained by Warren Buffett).