There is always one group of investors and analysts who argue that value investing has died long ago. They argue usually that the traditional methods of valuing businesses such as price-book value and the price-earnings ratio are now out of date and new metrics are more relevant, metrics that measure things like user subscription growth and recurring revenue. These are important metrics, but by themselves tell you very little about the underlying health of a business.
What is interesting is that over the past three decades, there have been three major bull markets (including the current bull market). In each and every one, evaluations have become extended and analysts have started to use more exotic methods of valuation to justify higher prices.
Warren Buffett (Trades, Portfolio) has been present for every single one of these bull markets. And he has always had something to say about the process of evaluation and the way it has become warped in these euphoric times.
In 1998, just as the dot-com bubble was starting to reach fever pitch, Buffett took part in a Q&A panel session with Microsoft founder Bill Gates (Trades, Portfolio). The session, held at the Michael G. Foster School of Business at the University of Washington, covered many different topics, including the process of evaluation. Specifically, one student asked the Oracle of Omaha: "What's your response to those who say that traditional methods for valuing companies are obsolete in this market?"
Are traditional evaluation methods obsolete?
Buffett responded that at the time he was struggling to find interesting opportunities for the Berkshire Hathaway public equity portfolio. This is not because his method of valuing equities had changed, he told the audience, but because it was hard to find companies "that meet our tests of being undervalued in this market."
He went on to say that finding undervalued securities is the most important part of his job and the reason why he decided to close his early investment partnerships in 1969 is because "I couldn't find anything" worth buying. He also said he closed the partnerships not because he "lost the ability to value companies," but because "there just weren't any left that were cheap enough."
The Oracle of Omaha then gave the listening students his simple framework for valuing companies:
"But I think that there's no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate. There wouldn't be any risk premium, because you'd know what coupons were printed on this "bond" between now and eternity. That method of valuation is exactly what should be used whether you're in 1974 or you're in 1998. If I can't do that, then I don't buy. So I'll wait."
Even though Buffett made this statement around two decades ago, it is still relevant today. Trying to value businesses should not be complicated, or require extensive spreadsheets.
It is simply a matter of trying to work out how much cash the business can generate and whether or not it is worth the price based on this forecast. If the stock looks expensive compared to its cash generation abilities then it is probably a best to avoid it. This strategy might seem exceptionally simple, but it has helped Buffett become one of the world's richest people, and you can't argue with those results. Put simply, no matter what the environment, it pays to stick with what we know works.
Disclosure: The author owns shares in Berkshire Hathaway.
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