Sunday, February 22, 2009

The Warren Buffett Way: Part VI

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

In this part, we consider the value tenets of Warren Buffett as per Robert Hagstrom.

Value Tenets

This is where you determine whether the company is a good value and should be purchased.

What is the value of the company?
This is where John Burr Williams’ DCF model comes into play. You take the Owner Earnings (determined above) expected over the life of the business (often you go out a number of years, and then say beyond this, we expect this constant rate of growth), and then discount by an appropriate interest rate (Buffett uses the long-term government bond rate, or 10%, whichever is higher).

Can it be purchased at a significant discount to its value?
Once you have a value for the company using the DCF, you consider how the company is currently valued by the market and see if there is a sufficient margin of safety in which to buy.

Hagstrom sums it up as such:

  • The business tenets help keep you focused on companies that are relatively predictable.
  • The management tenets help keep you focused on companies that are well run.
  • These combined give you a good idea of the company’s future earnings potential.
  • The financial tenets reveal the numbers you need to make a determination of the intrinsic value.
  • The value tenets help you calculate intrinsic value and determine if this is a good buy.

In the next part, I will review Buffett’s approach to portfolio management and the psychology of money!

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