Why Buffett Is So Optimistic

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Includes: AAPL, KO
by: Wayne Hylarides

Summary

Buffett uses discount cash flow analysis into perpetuity to value a business.

He uses a consistent discount rate (treasury bond) and penalizes cash flows based on risk.

Telling a good story is more important than calculations.

Book values only indirectly factor into valuation through its effect to cash flow risk.

Cash flow is king in Buffett's mind.

Why is Buffett is so optimistic?

Before I answer that question I think we need to first really understand how Buffett values businesses. If you look at the articles I produce it's clear that I use a DCF analysis to identify intrinsic value. I recently had a long conversation over email with a reader about valuing a recent business I wrote about. We started to compare valuations and got into discussions about terminal value, discount rates, etc. Although I continue to evolve the way I value a business, I believe that I'm getting pretty close to applying the Buffett approach. There are many sources you can pull from to try to get inside Buffett's head, but I think the best source is from buffettfaq.com. There you will find great references to keep your fundamentals in check. In this article, I summarize the fundamentals Buffett applies in his analysis, develop a simple valuation process, and use it to compare Coke (NYSE:KO) to Apple (NASDAQ:AAPL). (all quotes are sourced from buffettfaq.com):

Buffett uses DCF analysis of the free cash flows into perpetuity to value a business:

To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate.

If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value.

It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years.

Businesses have coupons too, the only problem is that they're not printed on the instrument and it's up to the investor to try to estimate what those coupons are going to be over time.

He calculates cash flow growth conservatively for a short period of time, followed by low growth into perpetuity:

Some managements think this [that the value of their company is infinite]. It gets very dangerous to assume high growth rates to infinity - that's where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very rarified. Charlie and I are rarely willing to project high growth rates. Maybe we're wrong sometimes and that costs us, but we like to be conservative.

He uses the same discount rate, such as the government treasury bond rate, to discount his cash flows. This allows him to compare all businesses against the price of a risk-free business with the same cash flows:

We don't formally have discount rates... We just try to buy things that we'll earn more from than a government bond - the question is, how much higher? If government bonds are at 2%, we're not going to buy a business that will return 4%. I don't call Charlie every day and ask him, "What's our hurdle rate?" We've never used the term.

Munger: The trouble isn't that we don't have one [a hurdle rate] - we sort of do - but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I'd reject it instantly.

He uses a consistent discount rate across all securities (i.e. treasury rate or some other metric) and adjusts cash flow based on the business cash flow risk, not the risks generated from share price history, volatility, or the correlation to the market. In other words, he does not use the Capital Asset Pricing Model to calculate a discount rate. The discount is already factored into his risk probabilities of future cash flow:

We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.

Look at the asset, not the beta. I don't really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price.

In fact he sees complicated valuation formulas as not pragmatic. The cash flow story is much more important than detailed spreadsheets:

No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That's what drives the academics crazy. They can compute standard deviations and betas, but they can't understand moats. Maybe I'm being too hard on the academics.

The book value isn't directly used for valuation unless you are investing in cigar butts. Balance sheet figures are only important for calculating cash flow risks:

Book value is virtually not a consideration in investment decision-making at Berkshire. The book value approach could work well with small sums of money, like Graham had managed, and that the approach had worked well for Graham-type practitioners.

Really wonderful businesses need no book value. Book value is not a great proxy for intrinsic value and it is not a substitute. Berkshire was not worth book value in 1965, intrinsic value was below book value, now the business is worth a great deal more than book value.

Book value is not a bad starting point for Berkshire when trying to calculate intrinsic value. We generally do not look at book value when evaluating a stock.

Summary

Buffett sees a business' value strictly through the lens of its cash flow. He only cares about the probability of generating cash flow indefinitely. It's that simple. All other information, internal or external, helps him decide what that cash flow will look like indefinitely. For example, the stock market and prices don't affect cash flow in the direct sense, therefore you shouldn't price a business based on the market price risks (i.e. CAPM). Buffett doesn't pay attention to the academic process of calculating cost of equity.

Here is the Buffett valuation process summary:

  1. Verify the historic free cash flows of a business and the growth rates. Don't use earnings since they are calculated based on old capital that is depreciated. We care about the current state of the business. Therefore, look at free cash flow since these are the cash flows you could theoretically take out of the business if you had 100% control.

  2. Estimate the moat of the business. Essentially you are evaluating all cash flow risks such as competitions, increasing costs, interest rate hikes, chance of defaulting on debt, consumer preferences, etc. What is the ability of the business to continue to generate or grow these cash flows in the future? This often requires specific knowledge of the industry, business models, and industry factors.

  3. Based on these risks, create a reasonable FCF story for the business for the next 100 years. Are there some years where cash flows rise? Drop? Will there be negative cash flow years? The level of safety in the story should match the safety of your discount rate. If you use a treasury bill rate, your forecasted cash flows must be risk-free or 99.999% guaranteed. As long as you are consistent across all stocks and are confident that you matched the cash flow risk with a reasonable discount rate your valuation should be more reflective of true NPV. Remember most businesses don't grow at 10% for 30 years straight. To get to a high enough level of confidence, you might have to have negative growth or negative earnings for some years.

  4. Calculate the NPV of the cash flows using the discount rate that matches the cash flow level of confidence/risk. If you see the cash flows as trailing off to the growth of the economy (i.e. mature firm) or some other growth metric, then you can capture the present value of the perpetuity through a terminal value calculation.

  5. Compare the NPV with the current stock price. Depending on your level of optimism, your NPV may be heavily overpriced or underpriced. This doesn't really matter. Consistency is what matters.

  6. Perform this analysis on all opportunities and pick the stocks with the largest % discount to NPV.

Application

Let's have a look at some well known businesses and try to value them very quickly, then compare them to see where to park our capital. Note these valuations were calculated for demonstration purposes only and are not intended to be my official valuation. I would do much more analysis to come up with a more confident valuation.

Let's look at Coke

Step 1: Review FCF history

2013

2014

2015

2016

FCF

$6.5B

$8B

$8.2B

$8B

Step 2: Moat

Coke has a very strong moat:

  • Its product and brand are sticky.

  • It has a AA- bond rating and is not in risk of defaulting.

  • Management can effectively control their pricing against competition

  • Competitors can't replicate the brand and perceived taste

Step 3: FCF Story

Coke is a mature firm and I assume Coke will have a 99.99% chance of at least a 0% growth rate for the next 100 years. There is a good chance it will grow, but my risk-free bet is 0% growth. Since the US treasury rate is 3% for 30 years, for 100 years I'll use a risk-free rate of 5%. I'll take the average FCF for the past 4 years to base the future FCFs on: $7.7B.

Step 4: NPV

The formula for the NPV of a perpetuity with zero growth is C/d, where C is the cash flow and d is the discount rate. Remember, I match my cash flow confidence level to my discount rate:

$7.7B/0.05 = $154B

Step 5: Compare to the Market Price

Coke's market cap is $180B. Therefore investing in Coke offers a 14.4% premium.

Next, Apple

Step 1: Review FCF history

2013

2014

2015

2016

FCF

$52.3B

$69.8B

$49.9B

$44.6B

Step 2: Moat

Apple has a very strong moat:

  • Its product and brand are very sticky and fashionable.

  • It has a Aa1 bond rating and is not in risk of defaulting.

  • Management can effectively control their pricing against competition

  • Competitors can't replicate the brand and perceived value easily

Risks:

  • I'm cautious about the future of Apple

  • Will apple get into another industry with poor margins outside of management competence?

  • Will some capital get eroded over the decades to come.

  • Will revenues stagnate over time?

  • Does Apple need a new Steve Jobs to grow again?

Step 3: FCF Story

Apple has become a mature firm. It can still grow, however it is limited by size. It needs to create new products to cannibalize existing product lines to maintain its size. Apple may enter some new consumer product segments however it may be tempted to entering a difficult business (auto industry?). Therefore, I see a 99.99% chance of at least a -1% growth rate for the next 100 years. This is the worst case risk I see in the business. Since the US treasury rate is 3% for 30 years, for 100 years I'll use a risk-free rate of 5%. I'll base my FCF growth start at $52.3B.

Step 4: NPV

The formula for the NPV of a constant growth business C(1+g)/(d-g), where C is the cash flow, g is the growth rate, and d is the discount rate. This formula works for negative growth rates as well. Most businesses should have negative risk-free growth rate. Remember, I match my cash flow confidence level to my discount rate. Here is the valuation:

$52.3B(1 + (-0.01))/(0.5 - (-0.01)) = $1294.4B

Step 5: Compare to the Market Price

Apple's market cap is $719B. Therefore investing in Apple offers a 44% discount.

Summary

Assuming this analysis is 100% representative (it's not - only for illustrative purposes), I think it's obvious that Apple is the better investment. Note - to do a proper analysis I would customize the cash flow analysis for the next 10 years and assume a perpetual growth thereafter. Also, I would adjust my growth rates by more detailed analysis.

So why is Warren Buffett so optimistic?

It's because he values a business based on cash flow fundamentals using discount rates based on cash flow risk and not market risk. If you do this enough, you start to see a trend. Many businesses seem undervalued. When I analyze businesses using my lens, I often see over 20% discounts (i.e. Hanesbrands). However, as a value investor I'm looking for much higher discounts. Investing is about opportunity costs. It's about picking the best opportunity. For that, you need to have a consistent approach to value cash flows. I'll leave you with one last quote from Charlie Munger:

Munger: You should find something to invest in and then compare everything else against that. That's your opportunity cost. That's what you learn in freshman economics, even if it hasn't made it into modern portfolio theory. That's why modern portfolio theory is so asinine… opportunity cost is a huge filter in life. If you've got two suitors who are eager to have you, but one is way better than the other, you're going to choose that one rather than the other. That's the way we filter stock buying opportunities. Our ideas are so simple. People keep asking us for mysteries, but all we have are the most elementary ideas.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.