Warren Buffett is arguably one of the most selfless educators in business history. At the Berkshire Hathaway Annual Meeting each May, he allows shareholders to ask questions without any restrictions, except in regards to his current holdings. When asked about valuing businesses at these meetings and others with students, Buffett has responded by repeating John Burr Williams definition of intrinsic value penned in 1938; intrinsic value is all future cash flows from the company discounted at an appropriate rate. In other words, as Buffett previously said, “If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it’s worth.”
But Charlie Munger has said he has never seen Buffett compute a discounted cash flow analysis, the common practice for attempting to value a business based on the above definition. When recently asked about how he specifically calculated a company’s intrinsic value, Buffett simply laughed at the interviewer and said, “Well, that’s the secret”.
So if Buffett doesn’t use a DCF calculation to find intrinsic value, how does he do it? He has provided us some clues. The first and one of only a few times Buffett has explained his methodology was in his Buffett Partnership letter in 1958. He details “a typical situation” in which he describes investing in the Commonwealth Trust Co. of Union City, New Jersey. I will omit some of the surrounding details, but most importantly Buffett states “it has an intrinsic value of $125 per share computed on a conservative basis.”
He also told us the stock was currently trading around $50 and had “earnings of about $10 per share.” Emil Lee suggested Buffett likes to pay no more than 12.5 times earnings for good businesses. But taking the concept one step further, we can clearly see Buffett simply multiplied the company’s earnings by 12.5 (almost exactly) to calculate the intrinsic value of $125 per share. A coincidence? Possibly.
Lee quotes the following passage from Buffett’s 1991 annual letter:
Ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million.
As Lee tabulates, “Thus, paying 12.5 times that price would be equivalent to buying a dollar for 50 cents and would provide an 8% free cash flow yield (invert 12.5) that should compound over time.” Another 12.5 multiple example.
More recently, Buffett was asked to testify about the estate tax at a Senate Finance Committee meeting. I was in attendance and heard Buffett explain the estate tax’s effect on family businesses when they are held and when they are sold. He used a newspaper company as an example, stating the company that earned $8 million a year would be sold for $100 million. $8 million times 12.5 is of course $100 million. There are likely more examples in other annual letters and meeting transcripts.
After reverse engineering some of Buffett’s more recent investments, the 12.5 (or there about) multiple often appears. Buffett was loading up on shares of Johnson & Johnson, the well-known health care company, in the first quarter of 2007, buying some the previous year, and more after. The price he paid was in the high 50’s to mid 60-dollar range. Johnson & Johnson generated $12.5 billion in free cash flow in 2007. $12.5 billion times 12.5 is $156.25 billion, or about $55.40 per share, very close or equal to what Buffett was paying.
In the Johnson & Johnson case, earnings are less than free cash flow. The implication here might be that the 12.5 multiple can be applied to both earnings and free cash flow on a case-by-case basis. The difference between free cash flow and GAAP earnings is dependent upon both the business and the accounting pertinent to the specific industry. Buffett may have used free cash flow as a metric here instead of standard earnings.
Buffett has also been adding to his already large stake in Wells Fargo recently. The firm’s current P/E ratio is 12.45.
Buffett valued PetroChina, a recent homerun, at $100 billion dollars when he began buying in 2002, while the company was trading only at $35 billion. $100 billion was about 12 times operating income.
You might be wondering, what about purchases such as Burlington Northern Santa Fe, a company that generated about $1 billion in free cash flow last year and trades at a P/E of about 20 with a forward P/E of 14.78? Neither of those numbers looks like 12.5. Well Buffett was buying in the high 70’s and low 80’s when the forward P/E was about 11.5. He stopped purchasing after the stock ran up to loftier multiples.
Don’t like the number 12.5? No problem. Other value investors use a variety of multiples to calculate intrinsic value. Mohnish Pabrai, Managing Partner of the Pabrai Investment Funds, is known for using a 10 times multiple for stable companies and a 15 times multiple for growing companies. He usually applies these multiples to free cash flow but has applied them to earnings as well.
Bruce Berkowitz, manager of the famed Fairholme Fund, recently stated he looks for a free cash flow yield of 10% or more, implying a free cash flow multiple of 10 or less.
Father and son managers Herbert and Randall Abramson of Trapeze Asset Management place multiples on earnings, operating cash flow, and free cash flow to derive intrinsic value. They study comparable companies in a specific industry in an attempt to find a fair multiple for the individual firm being valued. If for instance the team finds a Colombian E&P firm trading at 2 times 2010 projected operating cash flow and the industry average is 7 times, they consider backing up the truck.
Today, a holding company, whose majority asset is a regional bank growing at more than 25%, had earnings of $1.02 last year. The current stock price is $5.05. Using the “Buffett multiple” of 12.5, the intrinsic value is $12.75 or more than double the current stock price. A modern Commonwealth Trust Co. You get the point.
Like the story of Hansel and Gretel, the children in the forest who leave breadcrumbs on the trail to find their way back, Buffett has left investors little hints along the path to understand how he calculates intrinsic value. Now all we need to do is pick them up, digest them, and use them to find our own way to investment success.