Friday, November 7, 2008

The Warren Buffett Way: Chp 4 Part 4: Buying a Business

Market Tenets:

There are two critical market tenets that should be adhered to:

1) What is the value of the business?
2) Can the business be purchased at a significant discount to its value?

Warren references John Burr Williams in "The Theory of Investment Value" (1938), when explaining how to value a business. Buffett refers to a discounted net cash flow model as being appropriate to value a business. This approach will allow one to compare all businesses to each other from the perspective of value.

Buffett invests in companies that are simple and understandable and that have operated reliably. By investing within his circle of competence, Buffett can place a high degree of certainty on the future cash flows that a business will generate before he makes an investment. This makes the valuation process more accurate.

Buffett uses a long term U.S. government bond rate to discount the cash flows when valuing a company, however he is cautious in using this discount rate as interest rates decline. He looks for businesses with low business risk and he excludes investing in companies that have high debt, thereby limiting the financial risk. Buffett has said that since he puts a heavy weight on certainty, the whole idea of adding a risk premium to his formula doesn't make sense to him.

Buffett refers to price to earning ratios and price to book ratios as shortcut methods that fall short in determining whether a company is worth buying. Buffett has said that you can find the cheapest investment using the discounted-flows-of-cash calculation.

Tellingly, Buffet has said that if he has made a mistake with an investment it has come from either 1) the price paid, 2) the management joined or 3) the future economics of the business.

The price paid for an investment is critical because it offers protection of capital and can enhance the returns of an investment. If you purchased a company's shares for significantly less than the intrinsic value per share, it provides some margin of error with the original purchase. Likewise, if the company's shares eventually return to reflect the business value of the company, the large discounted purchase price will produce a larger return on the investment.

Buffett looks at owning shares as owning pieces of companies, not owning pieces of paper. Buffett has said that buying a stock without understanding the operating functions of a business is unconscionable. Graham wrote in his book, the Intelligent Investor, that "investing is most intelligent when it is most businesslike". Buffet feels those are the most important words ever written about investing.

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