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When judging the value of a share, a bond or a business Buffett encourages us to go back to basics as set out in John Burr Williams’ book The Theory of Investment Value (1938) and to see value being determined by estimated future cash inflows and outflows, with each forecast net cash flow for a period being discounted at an appropriate interest rate.
The logic of using discounted flows of cash applies to shares, where there is greater uncertainty over what cash will be generated in say 5 years or 10 years, as much as it does to bonds, with their defined payment amounts and dates.
Of course, the analyst has a tougher job estimating the cash attributable to shareholders than for bondholders. Equity flows are subject to significant variability due to a whole host of qualitative factors, from the morale of the workforce and the behaviour of competitors to customers changing preferences and the competence of managers.
“The quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity ‘coupons.’” (Warren Buffett’s 1992 Letter to Berkshire Hathaway shareholders)
Despite the difficulties with equity valuation it is better to think through the issues within the framework of discounted cash flow, with its forward focus and its discounting discipline, rather than lazily adopt measures such as multiplying last year’s profits or, worse, using EBITDA or, more frighteningly, “adjusted” EBITDA.
Managers and discounted cash flow
In addition to investors valuing shares using the discounted cash flow method, corporate managers should also apply it when considering growth in the company’s asset base. This will bring them to a deeper understanding that “Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (1992 Letter)
Airline growth was certainly hurting investors. Acutely so for the common stockholders, but it was also bad for preferred stockholders because operating losses were so poor that there was doubt that USAir would be able to maintain the preferred dividend, hence Buffett’s estimated 35% drop in the value of Berkshire’s holding to $232.7m.
Applying discounted cash flow logic to building a portfolio
The investment to be bought is the one that is cheapest relative to its value determined by discounted-flows-of-cash calculation, “irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.” (1992 Letter)
I’ve found to my cost the impossibility of disabusing many managers from the notion that their shareholders want the prioritisation of turnover and earnings per share growth regardless of value creation. These managers often operate in industries where any newly allocated capital
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