For Buffett, determining a company’s value is easy as long as you plug in the right variables:
- the stream of cash and
- the proper discount rate.
If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company This is the distinction of his approach.
Critics of Buffett’s DCF valuation method.
Despite Buffett’s claims, critics argue that estimating future cash flow is tricky, and selecting the proper discount rate can leave room for substantial errors in valuation.
Instead these critics have employed various shorthand methods to identify value:
- low price-to-earnings ratios,
- price-to-book values and
- high dividend yields.
Practitioners have vigorously back tested these ratios and concluded that success can be had by isolating and purchasing companies that possess exactly these financial ratios.
Value investors versus Growth investors
People who consistently purchase companies that exhibit low price-to-earnings, low price-to-book, and high dividend yields are customarily called “value investors.”
People who claim to have identified value by selecting companies with above-average growth in earnings are called “growth investors.” Typically, growth companies possess high price-to-earnings ratios and low dividend yields. These financial traits are the exact opposite of what value investors look for in a company.
Growth and Value investing are joined at the hip.
Investors who seek to purchase value often must choose between the value and growth approach to selecting stocks.
Buffett admits that years ago, he participated in this intellectual tug-of-war. Today he thinks the debate between these two schools of thought is nonsense.
Growth and value investing are joined at the hip, says Buffett.
Value is the discounted present value of an investment’s future cash flow; growth is simply a calculation used to determine value.
Growth can be add to and also can destroy value.
Growth in sales, earnings, and assets can either add or detract from an investment’s value.
Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created.
However, growth for a business earning low returns on capital can be detrimental to shareholders.
For example, the airline business has been a story of incredible growth, but its inability to earn decent returns on capital have left most owners off theses companies in a poor position.
Which valuation method(s) to use? Which stock to buy?
All the shorthand methods – high or low price-earnings ratios, price-to-book ratios, and dividend yields, in any number of combinations – fall short, Buffett says, in determining whether “an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investments………….Irrespective of whether a business:
- grows or doesn’t,
- displays volatility or smoothness in earnings ,
- or carries a high price or low in relation to its current earnings and book value,
the investment shown by the discounted -flows-of-cash calculation to be the cheapest is the one that the investor should purchase.
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