Sunday, March 8, 2009

Even Buffett Isn't Perfect: Chapter 2

In this chapter, the author discusses the finance industry's tendency to label fund managers as either growth or value. Value stocks tend to have low P/E and P/B ratios, while growth stocks can be said to be in favour due to their high P/E and P/B values. But Janjigian disputes that such a distinction can be made in the case of Buffett, as although most of Buffett's purchases would fall in the value category, he will buy companies that appear expensive but exhibit tremendous growth.

To illustrate the difference between growth and value, the author takes the reader through an investment in the Washington Post versus an investment in Google. It is clear from the data that Google is the more expensive stock (higher P/E, P/CF, P/B and P/S), but the difference is explained by the appeal of Google's growth potential.

Where Buffett sees an issue with the way the finance industry treats growth is that expectations get out of hand. Investors almost always pay too much for growth, as expectations are rarely matched by the actual results over the long term. The author also discusses the fact that growth always invariably slows down, even for the best companies.

Indeed, despite the fact that Buffett would probably agree that Google is a fantastic company, he would still rather own (and does) The Washington Post than Google, as the author argues it's the price of the stock relative to the value of the firm that counts, not simply how great the firm's prospects are.

The author concludes the chapter by discussing how Buffett determines whether a company is cheap: the discounted cash flow valuation. To Buffett (and indeed most of the finance world), an investment is worth the discounted future stream of cash flows that accrue to the investor. This estimate of the value of a company can fluctuate wildly with tiny changes in assumptions. This is why Buffett prefers companies that are easy to understand, as the future cash flows can be predicted with more certainty.

3 comments:

Anonymous said...

Any idea on how many years out does Buffett or investors on average project out the cash flows?

Saj Karsan said...

Hi Anon,

I have no idea how many years Buffett uses. Many people try to use 5 or 10 and then add some terminal value, but the real key is understanding the business (circle of competence) so that you can see the risks to that cash (and account for them) and also to choose companies which have stable earnings, as this reduces uncertainty going forward (as compared to a company with wildly fluctuating earnings because of its operating environment or competitors etc)

Kevin said...

I'm not even sure if Buffet really does a calculation for something like that because no matter what the numbers he comes up with are not gonna be any more reliable than a gut feeling and a prediction from just eyeballing the companies past cash flows,revenue, and underlying growth strategies.

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