Warren Buffett revealed his magical "Two-Column Valuation Method" investment process publicly on page 6 of his Berkshire Hathaway's (BRK.A, BRK.B) 2010 Annual Report. (Buffett later republished his "Two-Column Method" on page 99 of his 2011 Annual Report, and on page 104 of his 2012 Annual Report).
I will now quickly summarize page 6 of Berkshire Hathaway's 2010 annual report describing Buffett's "Two-Column Valuation Method":
BERKSHIRE HATHAWAY INC. INTRINSIC VALUE - TODAY AND TOMORROW *
Though Berkshire's intrinsic value cannot be precisely calculated, two of its three key pillars can be measured. Charlie and I rely heavily on these measurements when we make our own estimates of Berkshire's value.
COLUMN #1: The first component of value is our investments: stocks, bonds and cash equivalents. At yearend these totaled $158 billion at market value.
Per Share Investments
Compounded Annual Increase in Per-Share Investments
COLUMN #2: Berkshire's second component of value is earnings that come from sources other than investments and insurance underwriting.
Per Share Pre-Tax Earnings
Compounded Annual Increase in Per-Share Pre-Tax Earnings
Market price and intrinsic value often follow very different paths - sometimes for extended periods - but eventually they meet.
There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. Some businesses will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a business's intrinsic value. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
*Reproduced from Berkshire Hathaway Inc. 2010 Annual Report.
OK. So how does Warren Buffett's "Two-Column Valuation Method" work?
EXAMPLE #1: I will explain, and the answer is simpler than you may think. First, determine the "Per-Share Investments" amount for the most recent year. In Buffett's 2010 Annual Report, let's use $94,730. Next, determine the "Per-Share Pre-Tax Earnings" for the most recent year. In Buffett's Annual Report, let's use $5,926.04. Next, determine which multiple to apply to the "Per-Share Pre-Tax Earnings." Choose a multiple to apply this other similar businesses show within the same sector/ industry.
Pre-Tax Earnings can also be referred to as Operating Earnings, which are found on the Income Statement.
Pre-Tax Earnings are also referred to as EBIT, or Earnings Before Interest and Taxes.
If other businesses stock prices are currently trading at a multiple of Pre-Tax Earnings of 10; then, for this example let's use 10 as our multiple we'll apply to Pre-Tax Earnings.
Therefore, if Pre-Tax Earnings are $5,926.04, and we multiple this amount by our multiple of 10, then this equals $59,260.40.
$5,926.04 x 10 = $59,260.40
Next, we add the business's Per-Share Investments to this amount. Therefore,
$94,730 + $59,260.40 = $153,990.40
EXAMPLE #2: Similarly, if we were to apply a different multiple to Berkshire Hathaway's 2010 Pre-Tax Earnings of $5,926.04, we would arrive at a different estimated intrinsic value. For instance, if we were to use a multiple of 12 (instead of 10), then…
$5,926.04 x 12 = $71,112.48
Next, if we were to add the Berkshire's 2010 Per-Share Investments of $94,730 to $71,112.48, Berkshire Hathaway's estimated intrinsic value at the end of 2010 would be $165,842.48.
$94,730 + $71,112.48 = $165,842.48
Therefore, using Warren Buffett's "Two-Column Method," the intrinsic value of Berkshire Hathaway at the end of 2010 could be estimated to be somewhere between $153,990.40 and $165,842.48. Comparatively, Berkshire Hathaway's stock price on December 31, 2010 closed at $120,450, well below it is underlying intrinsic value.
"Market price and intrinsic value often follow very different paths - sometimes for extended periods - but eventually they meet." Warren Buffett
"Wall Street is more concerned with correlation than valuation." Scott Thompson
"It's better to be approximately right, than precisely wrong." Warren Buffett
Obviously, the key to mastering Buffett's "Two-Column Method" is correctly calculating Per-Share Investments, selecting an appropriate multiple to apply to Pre-Tax Earnings, and accurately combining these two amounts together to arrive at an estimated intrinsic value.
On one occasion when I met Warren Buffett, I mentioned that John Burr Williams' valuation method of using Discounted Cash Flows (DCF) of Free Cash Flows (FCF) to calculate intrinsic value worked well for some business valuations, but not for others. We discussed many topics, including his past valuation methods such as his part Net-Net Working Capital Method, DCF Method, Four Filters Investment Process, and current "Two-Column Method." I find him to be brilliant, and yet having a warm, welcoming personality with a great sense of humor.
Warren & Charlie have developed a simple yet powerful "Four Filters investment process." Therefore, Buffett's "Two-Column Valuation Method" relates to Filter #4 (price/value) of their powerful "Four Filters investment process." It's important for you to consider all four investment filters of Buffett and Munger, and not just "Filter #4" relating to quantitative valuation.
In closing, Buffett's decision to publish his "Two Column Method" publicly in his Berkshire Hathaway annual report has gone relatively unnoticed. Value investors can benefit enormously by studying Buffett's "Two-Column Valuation Method." I'm glad to be one of the few authors to explain it.