Over the past few decades, Warren Buffett (Trades, Portfolio)'s investment strategy has changed dramatically. He has moved from being a deep value investor to a quality investor, paying a premium price for companies that he believes to have strong management and a durable moat.
Valuing these companies is difficult because many qualitative factors don't have a fixed value, but with his years of experience, Buffett has built a method of dissecting enterprises to work out their intrinsic value.
Unfortunately, Buffett has never set out his valuation process in a simple, easy-to-follow list, although over the years he has spoken on numerous occasions about his process and the steps he follows to come up with an estimate of value for businesses.
Buffett: How to value a business
Giving See's Candies as an example, here's what he said about the process when asked in a Q&A session with MBA students at Florida University in 1998:
"It is a tough thing to decide but I don’t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won’t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don’t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine."
He went on to say that one of the reasons why he and Charlie Munger believed that See's had the untapped pricing power described above was because the company had what he called "share of mind."
Share of mind is very similar to brand power. People know what they're getting and feel reassured by the brand they are buying. By having a share of mind, a company has pricing power and can increase prices without suffering a drop off in sales. It is a beautiful business quality to have.
And it's not just See's that has this beautiful quality:
"Think of Disney DIS. Disney is selling Home Videos for $16.95 or $18.95 or whatever. All over the world—people, and we will speak particularly about mothers in this case, have something in their mind about Disney. Everyone in this room, when you say Disney, has something in their mind about Disney. When I say Universal Pictures, if I say 20th Century Fox, you don’t have anything special in your mind. Now if I say Disney, you have something special in your mind. That is true around the world."
I believe the main takeaway from these quotes is that Buffett does not try too hard when it comes to valuation.
As long as the company he is interested has a wide moat and a "share of mind" it seems he is willing to pay for it.
Of course, this does not mean that he will pay an extortionate price to invest in companies just because they have a moat. Buffett is still a value investor at heart and is always on the lookout for undervalued stocks.
However, it would appear that on most occasions he is willing to pay a premium for a wonderful business as, if the company can maintain its moat, even at a premium price over the long term the returns could be substantial. Put quite simply, it is all about the moat.
Disclosure: The author owns no share mentioned.
