Warren Buffett (Trades, Portfolio) has always said that he would much rather pay a high price for a wonderful business than a low price for a terrible business. But determining the price for a wonderful business is not a simple process. There is no shortcut or direct formula to use for calculating whether or not a business is a) wonderful or b) cheap.
Calculating intrinsic value
The topic of this process -- trying to determine whether or not a company is a good company and what price Berkshire Hathaway BRK.ABRK.B should pay to acquire the enterprise -- came up at the Berkshire Hathaway 2013 annual meeting of shareholders. Buffett tried to explain why it is so difficult to place an exact value on a company's worth.
The Oracle of Omaha said that, more often than not, he believes he is paying too much for every business, but if he finds the business so compelling, and believes in management, then he is willing to pay a higher price, although there is "no mathematical formula to it," he added.
Interestingly, he added that a great deal of the time, the price Berkshire pays to acquire wonderful businesses often tends to be lower than what it could have paid based on the acquisition's subsequent growth. Here's Buffett in his own words:
"Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100% for sure.
And so it isn’t as precise as you might think. Generally speaking, if you get a chance to buy a wonderful business — and by that, I would mean one that has economic characteristics that lead you to believe, with a high degree of certainty, that they will be earning unusual returns on capital over time — unusually high — and, better yet, if they get the chance to employ more capital at — again, at high rates of return — that’s the best of all businesses. And you probably should stretch a little.
Charlie and I have had several conversations where we were looking at a building — a business — which we liked, and were sort of gagging at the price, and Charlie or I will say, you know, 'Let’s do it,' even though it kind of kills us to pay that last 5%."
An art, not a science
The underlying takeaway from these comments is the conclusion that investing isn't a precise science, it is an art, and even the world's greatest investor does not have a simple shortcut to evaluating businesses.
Buffett's process of evaluating and understanding companies is based on years of knowledge and research into the sectors that he understands most, a process that is virtually impossible to replicate with a simple formula.
What's more, Buffett is acknowledging that even he misunderstands valuation most of the time, but he tries to counter the risk of being wrong by investing only in companies that he knows and understands that are earning high returns on capital.
No short cut
Put simply, there is no shortcut for finding great businesses and valuing shares accurately. While you may not like to hear it, there is no shortcut to riches. Spending a decade researching companies and sectors might not seem appealing, but building a mental framework for valuing businesses and understanding sectors is vital for long-term investment success. That is the point that I believe Warren Buffett (Trades, Portfolio) is trying to get across in this statement.
Disclosure: The author owns shares in Berkshire Hathaway.
Warren Buffett: How Phil Fisher Shaped His StyleÂ
Berkshire Hathaway Is the 'Wrong Vehicle' for Buying Wonderful CompaniesÂ
Buffett and Munger: Some IPOs Might Be Attractive, but Not for UsÂ
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
Â
