Learn to invest with Buffett

Chapter 28

Chapter 4 Section 6 How to find the difference between price and value
Investors from the "Graham and Dodd Tribe" share the core of investing: taking advantage of the difference between the value of a business as a whole and the market price of a stock that represents a fraction of that business.

--Warren Buffett
Intrinsic value is the discounted value of the cash flows that a business can generate during its lifetime.But the calculation of intrinsic value is not so simple.Intrinsic value, as defined, is an estimate, not an exact value, and it is also an estimate that must change accordingly when interest rates change or forecasts of future cash flows are revised.Moreover, it is almost always inevitable that two people making a valuation based on the exact same set of facts will arrive at at least slightly different estimates of intrinsic value.

As Buffett said: "Valuation is both an art and a science."

Buffett admitted: "We are only a little confident in estimating the intrinsic value of a small number of stocks, but this is also limited to a value range, not those numbers that seem accurate but are false."

In 1984, when Buffett delivered a speech at Columbia University commemorating the 50th anniversary of the publication of "Security Analysis" co-authored by Graham and Dodd, he pointed out that in the field of investment, people will find that the vast majority of "coin toss winners" come from In a very small intellectual tribe, which he called the "Graham and Dodd tribe", there were many big investment winners who continued to beat the market in this special intellectual tribe. This very concentrated phenomenon is by no means a "coincidence". Explanation.Buffett summed up the common characteristics of super investors of the "Graham and Dodd Tribe", and these common characteristics are also the basic connotation of value investing: looking for the difference between value and price.

The relationship between price and value applies to stocks, bonds, real estate, art, currencies, precious metals, and even the entire U.S. economy—virtually all assets fluctuate in value depending on how buyers and sellers value that asset.Once you understand this correspondence, you have an advantage over most individual investors, who often ignore the difference between price and value.

From the mid-20s to 1999, the Dow Industrials grew at a compounded rate of 5.0% per year (on retained dividends).That compares with a 30 percent revenue growth rate for the 4.7 Dow industrials companies in the same period.But, on paper, these companies are growing in value at 4.6% a year.It is no accident that the two growth rates are so aligned.

In the long run, the market value of a company's stock cannot far outpace the growth rate of its intrinsic value.Of course, technological advances can improve corporate efficiency and lead to leaps in value in a short period of time.But the nature of competition and the business cycle dictates that there is a direct relationship between a company's sales, revenue, and stock value.During boom times, revenue growth can outpace company sales growth as companies take better advantage of economies of scale and fixed asset facilities.During a recession, firm revenues also fall faster than sales volume due to high fixed costs (meaning the firm is not efficient enough).

However, in practice, the stock price appears to be far exceeding the company's actual value, or expected growth rate.In fact, this phenomenon is unlikely to continue.The gap between stock prices and company value must be bridged.

If rational investors have sufficient information, stock prices will remain close to the company's intrinsic value for a long time.In an overheated market, however, when investors appear to be willing to pay everything for a stock, market prices will be forced to deviate from true value.Wall Street then came to accept the unusually high growth rate that the stock was overvalued, while ignoring other long-term stable trends.

The difference between price and value is extremely important when the trend of market movement is viewed in the context of the entire economy.Investors should never buy stocks whose price is higher than the company's long-term growth rate, or they should stay away from stocks whose price has increased more than the company's value has increased.Although it is difficult to accurately estimate the true value of a company, evidence for valuation is still available.For example, if a stock price increases by 50% over a given period, while company revenues grow by only 10% over the same period, the stock is likely to be overvalued and destined to provide meager returns.Conversely, if the stock price falls and the company's revenue rises, the opportunity to acquire the stock should be carefully examined.If the stock price is plummeting and the price-to-earnings ratio is lower than the company's expected growth rate, this phenomenon may be considered a buy signal.

Stock prices will eventually return to their value, and investors will profit if they take advantage of the difference between price and value and buy stocks when they are undervalued.

Buffett believes that investors must pay attention to the following aspects if they want to scientifically evaluate the intrinsic value of a company and provide a basis for making correct judgments on their investments:

First, the discounted cash flow model.

Buffett believes that the only correct intrinsic value evaluation model is the discounted cash flow model theory proposed by John Burr Williams in 1942.In The Theory of Investment Value, John Burr Williams proposed the mathematical formula for calculating value, which we can distill into: The value of any stock, bond, or company today is determined by, over the entire remaining useful life of the asset, The expected cash inflows and outflows discounted at the appropriate interest rate.Note that this formula works exactly the same for stocks and bonds.Still, there is one very important, and vexing, difference between the two: bonds have a coupon and maturity date, and future cash flows can be determined; while investing in stocks, investment analysts must estimate the future themselves. The "coupon".In addition, the ability and level of managers has little impact on bond coupons, generally only when the managers are so incompetent or dishonest that they suspend bond interest payments.In contrast, the ability of joint stock company managers has a huge impact on the "coupon" of equity.

Second, correct cash flow forecasting.

Buffett once warned investors: "Investors should understand that accounting earnings per share are only the starting point for judging the intrinsic value of a company, not the end." In many companies, especially those with high asset-to-profit ratios, inflation makes Some or all of the profits are in vain.These "profits" cannot be distributed as dividends if the company wants to maintain its economic status.Otherwise, the enterprise will lose the foundation of commercial competition in one or more aspects such as the ability to maintain sales volume, long-term competitive position and financial strength.Therefore, accounting profit only makes sense in valuation if investors understand free cash flow.Buffett pointed out that the cash flow calculated in accordance with accounting standards cannot reflect the real long-term free cash flow, and the owner's income is the correct way to calculate free cash flow.Owner's earnings, consisting of reported earnings, plus depreciation expense, depletion expense, amortization expense and certain other non-cash charges, less the average annual capital expenditure on plant and equipment used by a business to maintain its long-term competitive position and unit of output spending, etc.

The biggest difference between the owner's income proposed by Buffett and the cash flow calculated according to accounting standards in the cash flow statement is that it includes the capital expenditure of the enterprise to maintain the long-term competitive advantage.Buffett reminds investors that the accountant's job is to record, not to value, which is the job of investors and managers. "Accounting figures are of course the language of business, and are a huge help to anyone assessing the value of a business and tracking its development. Without these numbers, Charlie and I would be lost, and to us they will always be to ourselves The starting point for valuing businesses and other businesses, but managers and owners need to remember that accounting data only facilitates, never replaces, business thinking.”

Third, an appropriate discount rate.

After determining the future cash flow of the company, the next step is to choose the corresponding discount rate.To the surprise of many people, the discount rate chosen by Buffett is the interest rate or yield to maturity of long-term U.S. government bonds, which is a risk-free rate of return that anyone can obtain.Some investment theorists believe that the discount rate for discounting equity cash flow should be the risk-free rate of return (long-term treasury bond rate) plus equity investment risk compensation, so as to reflect the uncertainty of the company's future cash flow.But Buffett never makes risk compensation, because he tries to avoid risk as much as possible.First, Buffett does not buy stocks in companies with high levels of debt, thus significantly reducing the financial risk associated with them.Second, Buffett focuses on companies with stable and predictable profits, so that operating risks can be greatly reduced, if not completely eliminated.In response, he said: "I put a lot of emphasis on certainty. If you do this, then the risk factor issue is irrelevant to you. You only have risk if you don't understand what you are doing."

If the intrinsic value of a company is the discounted future cash flow, what should be the appropriate discount rate?Buffett chose the simplest solution: "What is the risk-free interest rate? We believe that the long-term U.S. Treasury bond rate should prevail." Based on the following three reasons, Buffett's choice is very effective: First, Buffett Put all stock investments in correlation with bond returns.If he cannot get a potential return on stocks that exceeds that on bonds, then he will choose to buy bonds.Therefore, the first screening method of his company's pricing is to set a threshold rate of return, that is, the company's equity investment rate of return must be able to reach the rate of return of government bonds.

In the second aspect, Buffett did not spend too much energy setting an appropriate and unique discount rate for the stocks he studied.Discount rates for every business are dynamic; they change constantly with changes in interest rates, profit estimates, the stability of the stock, and changes in the company's financial structure.The pricing result of a stock is closely related to various conditions when it is analyzed.Two days later, new circumstances may arise that force an analyst to change the discount rate and price the company differently.In order to avoid constantly modifying the model, Buffett has always been very strict about keeping his pricing parameters consistent.In the third aspect, if an enterprise has no commercial risks, then its future profits are completely predictable.In Buffett's eyes, the stocks of excellent companies such as Coca-Cola and Gillette are as risk-free as government bonds, so a discount rate that is the same as the interest rate on government bonds should be adopted.

Fourth, economic goodwill.

In fact, according to the bond value evaluation model, when evaluating the value of corporate equity, the tangible assets of the company are equivalent to the principal of the bond, and the future cash flow is equivalent to the interest of the bond.As with bonds, the greater the principal as a percentage of total value, the greater the exposure to future inflation.The greater the cash flow, the higher the company's value.For an enterprise with more prominent sustainable competitive advantages, the lesser the role of tangible assets in value creation, the greater the role of intangible assets such as corporate reputation and technology, the higher the excess return rate, and the greater the economic goodwill.Therefore, the companies that Buffett likes to choose most generally have huge intangible assets, but relatively little demand for tangible assets, and can generate a return on investment that far exceeds the industry average.In short, only a small part of the intrinsic value of Buffett's favorite excellent business is tangible assets, while most of the rest is the excess profitability created by intangible assets.

In the long run, there is a perfect correspondence between price and value.The price of any asset can eventually find its true intrinsic value basis.

Investment motto:

The biggest trap investors face is the deviation between price and value, which is the herd effect.If investors hope to get rich by predicting other people's transactions, they must try to imagine what others want to achieve, and then do it better than all competitors in the market.

(End of this chapter)