Where to begin...

[DesertCat]

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Hoovers.com premuim service has an outside option built in for a lot of US companies called ValuEngine analysis. You can subscribe to the site and get reports and stuff. This is what it said about H&R block around the time Buffett bought it...


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This isn't really a fundamentally based analysis engine. It's trying to predict interest rates, and uses price action (momentum, beta) to help predict future price action. Really just a mess of different approaches sold as a "proprietary" algorithm.

As for it's call about H&R block, a stopped clock is right twice a day. Note how many times the chart recommended to buy H&R Block, then shortly later sell it, at either the same or lower prices.

[SlowHabit]

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I just feel like I'm on a random path going nowhere because I don't know where to start.

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One Up on Wall Street by Peter Lynch

You Can Be a Stock Market Genius by Joel Greenblatt

[ItalianFX]

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I just feel like I'm on a random path going nowhere because I don't know where to start.

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One Up on Wall Street by Peter Lynch

You Can Be a Stock Market Genius by Joel Greenblatt

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I think I read Beating the Street by Peter Lynch

Right now I have been reading the Buffett Letters, i'm on 1980. haha

I've read so many books about stocks.

[leto333]

One question:

DesertCat posted Buffet's letter which noted 4 points they use to determine if a business was a viable candidate for purchase.

(1) one that we can understand,
(2) with favorable long-term prospects,
(3) operated by honest and competent people, and
(4) available at a very attractive price.

My question is, what did Buffet do to determine #3.

[DesertCat]

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My question is, what did Buffet do to determine #3.

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It's harder to do as a small individual investor than as Warren, he has a lot more personal contact with CEOs and their peers than we will.

So I start by thinking most management is honest and competent so I just look for red flags they aren't. Bad compensation packages, personal history, lawsuits, business disputes (honest companies don't try to screw their partners), executive turnover, etc. When they say they'll do something, do they do it?

One thing you can do as an individual investor is to call them on the phone and see how you are treated. Even if you can't talk to the CEO/CFO, how investor relations is handled is probably indicative of the CEO/CFO's attitudes towards their investors.

[yellowbastard]

For #4, do investors simply use growing perpetuity models to price common stocks or is it more complicated than that?

Also, how is the required rate of return determined? Is the capital asset pricing model used here or are there other ways?

[DesertCat]

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For #4, do investors simply use growing perpetuity models to price common stocks or is it more complicated than that?

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Nothing grows in perpetuity (or at least faster than our GNP), so it's more complicated than that. One approach is to use DCF to estimate the value of cash flows for a growth period (say 5-10 years), then assume a slower growth rate afterwards. It depends upon the business.

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Also, how is the required rate of return determined? Is the capital asset pricing model used here or are there other ways?

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The CAPM is often used, and it's flawed since many variants of CAPM rely on Beta to define risk.

I don't think Buffett has ever done a real DCF analysis (except maybe in college). He definitely has a good understanding of what cash flow is worth at various discount rates over long periods of time. He intelligently estimates the risk of each company continuing to maintain it's growth (and for how long) based on competitive and industry factors, and uses that to come up with decent guess of the risk adjusted rate of return he's being offered.

He's said it's better to be approximately right than precisely wrong. He doesn't use a computer. If he thinks a specific return opportunity is likely over 20% per year, he doesn't care if it's 20.1% or 23.72%. He just wants to be sure it's not less than 15% a year, which I believe is his current hurdle rate. Obviously back in the Buffett Partnership days, his hurdle rate for a good idea was much higher, probably over 30% a year.

After reading about Buffett's approach, I stopped building DCF models and now I just rely on rules of thumb. Ben Graham had one where he felt a reasonable valueation was Normal Earnings * (8.5 + (2 * growth rate)). This assumes using the ave. growth rate for the next 7-10 years, and normalized earnings, not a one year spike in either. I compared it to some DCF calculations and it was a pretty decent match most of the time.

The problem with all these DCF calculations is with the right assumptions, you can get any value. Ben warned to be wary of high PE ratios (I think over 25). It's too easy to use rosy assumptions to tell you that GOOG is worth a 108 PE. It may be if nothing bad ever happens to it's business. But if there are real business risks, you have to heavily discount for that.

I have one stock that has grown earnings at 30% a year for ten years, but trades at an 11 PE. I don't need any DCF analysis or formula to tell me it's very, very cheap, as long as it can continue to grow at 15%+ a year for the next decade. The key is, will it?

[yellowbastard]

I was refering to the Gordon growth model when I mentioned "growing perpetuity."

So you're saying that mainly the future cash flows are individually estimated, then discounted at an estimated req. rate of return over the investor's time horizon?

Also, are there any specific examples you could post from the shareholder letters where a company is valued using the "Buffett approach?"

[DesertCat]

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I was refering to the Gordon growth model when I mentioned "growing perpetuity."

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I realize that, but I don't think that model is useful because growth is never perpetual. DCF can give you really outrageous results over very long periods depending upon your assumptions.

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So you're saying that mainly the future cash flows are individually estimated, then discounted at an estimated req. rate of return over the investor's time horizon?


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Something like that. You need to incorporate business risk in some way (discount the earnings or increase the discount rate proportionately), and your required rate of return will depend on what returns other investments are offering you. What's the risk that Coke will continue to be in business and grow earnings vs. Delta Airlines?

CAPM usually uses beta, but beta is a measure of volatility, not risk. So it's saying you should require a higher return from a more volatile stock price, and less from a less volatile stock price, neither of which makes sense. Real investment risks are business related.

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Also, are there any specific examples you could post from the shareholder letters where a company is valued using the "Buffett approach?"

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Not sure. Mostly I've pieced this together from various books and the shareholder letters and comments by his partner Charlie Munger. Warren repeatedly says a business is valued based on the stream of cash flows it generates. But Charlie has been with Warren since 1960 and has never seen Warren do a DCF analysis. Warren clearly knows the value of future cash flows growing at various rates. I believe he's done DCF analysis at one time and just memorized various scenarios.