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Does Warren Buffett Use Discounted Cash Flow?

Discounted cash flow/DCF is a controversial topic that will divide a lot of value investors. I personally don't use DCF in most cases, for two key reasons. Firstly, DCF is largely about forecasting and assumptions (e.g. discount rates - 8% or 12% will make a world of difference). As a value investor, I want to pay for assets and current earnings power, not growth (future). Secondly, strictly speaking, DCF is only suitable for mature companies with predictable, recurring cash flows e.g. toll road businesses. Wall Street is using DCF for a majority of companies and it does not always make sense.

I like former Third Avenue Chief Investment Officer Curtis Jensen's quote on discounted cash flow below which sums up my thoughts on this particular valuation metric.

Discounted cash flow to us is sort of like the Hubble telescope - you turn it a fraction of an inch and you're in a different galaxy. There are just so many variables in this kind of analysis - that's not for us.

Charlie Munger said at the 1996 Berkshire Hathaway Annual Meeting: "Warren talks about these discounted cash flows. I've never seen him do one." ["It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."]

Alice Schroeder, author of "The Snowball: Warren Buffett and the Business of Life", who interviewed Buffett extensively for the book, spoke at the Value Investing Conference at the Darden School of Business that "This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)" Source:

Buffett: All investing is laying out cash now to get some more back in the future. The concept of "a bird in the hand" came from Aesop in about 600 BC. He knew a lot, but not that [he lived in] 600 BC. He couldn't know everything. [laughter] The question is, how many birds are in the bush? What is the discount rate? How confident are you that you'll get [the bird]? Et cetera. That's what we do. If you need to use a computer or calculator to figure it out, you shouldn't [buy the investment]. Those types of [situations] fall into the "too-hard" bucket. It should be obvious. It should shout at you, without all the spreadsheets. We see something better.

Munger: Some of the worst business decisions I've seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they've got to do something.

Buffett: The priesthood has to look like they know more than "a bird in the hand." You won't get tenure if you say "a bird in the hand." False precision is totally crazy. The markets saw it in the Long-Term Capital Management [hedge fund] in 1998. It only happens to people with high IQs. The markets of mid-September last year were [such that] you can't calculate standard deviations. People's actions don't observe laws of math. It's a terrible mistake to think higher math will take you a long way- you don't need to understand it, [and] it may lead you down the wrong path.
Source: (BRK Annual Meeting 2009 Bruni Notes)

In summary, I don't do DCF. For deep value, cheap cigar-butts, I focus on the value of assets such as cash, net current assets, net tangible book value and all forms of hidden assets like property, net operating losses, holdings in other companies etc. For wide moat high-quality businesses, I look for low EV/EBIT, EV/EBITDA and Acquirer's Multiple ratios; if I feel EBIT and EBITDA are lumpy, I will try to derive normalized EBIT, EBITDA or operating income. The closest I get to a DCF is to simply discount normalized earnings by an arbitrary discount rate of 10%, a valuation approach that Bruce Greenwald outlined in his book Value Investing: From Graham to Buffett and Beyond.