People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.
It really doesn’t work that way.
“A bird in hand is worth two in the bush” – Aesop
Aesop was onto something but he didn’t finish it. There are a couple of other questions that go along: “When are you going to get the two in the bush?”, “How certain is it to get the two in the bush?”, “What’s the interest rate?”
If you know interest rate and the timetable, you know investing. You would trade a bird in hand.
You lay out cash today to get more cash in the future.
It’s an investing decision. You have to decide how many birds are in the bush, when they are going to get out, and when you are going to acquire them.
If the interest rate is 5% and you will get the two birds in five years, two birds in the bush is much better than one bird in hand. That’s roughly 15% compounded annually. If the interest rate is 20%, you would decline to take two birds in the bush five years from now.
With growth, people associate with a lot more birds in the bush. You still have to decide when you are going to get them. You have to measure that against interest rates. You have to measure that against other bushes.
It’s a value decision: what it is worth, how many birds are in that bush, when you are going to get them, and what interest rate is.
Every year you wait to take a bird out of the bush, you have to take out more birds. If a company doesn’t pay you a dividend this year or next year, it has to be able to pay you more in perpetuity the year after.
If you buy a company for $500 billion and purchase 10% of that company and want to get a 10 percent return, $50 billion of cash has to come out of that company year after year. If they delay one year of dividend, $55 billion of cash has to come out. To do that, they have to make $80 billion pretax. There are not many companies that earn $80 billion pretax. So it requires a rather extraordinary change in profitability to give you enough birds out of that particular bush to make it worthwhile to give up the one you have in your hand.
People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.
It really doesn’t work that way. What you do is to look at all cash a business will produce between now and judgement day and discount it back at a rate that’s appropriate (intrinsic value), and then buy it a lot cheaper than that (margin of safety). You really want to look for things you can understand and where you can see out for a good many years as to the cash that can be generated from the business. If you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is.
The intrinsic value calculation should already factor in the fact that certain businesses are going to earn less in the future than now. It’s that their intrinsic value goes down.
Intrinsic value is very important and very fuzzy. We do our best to work with the kind of businesses where we think we have the highest possibilities where our predictions are of a fairly highly probable nature. That leaves out all kind of companies. It’s something like the natural gas pipeline. The chance of big surprises in a pipeline should be relatively small. It doesn’t mean they are zero but they are relatively small.
Let’s assume that you have a pipeline which either the supply of gas is going to run down or there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years and you will have to cut the price. Two years from now when you have to cut the price, the intrinsic value hasn’t gone down from today if you properly calculate it today and build in the fact that profit margins in the future will be lower than today.
You build in the prediction of decline in the future operating years. You don’t want to wait till you get there to anticipate it. That’s part of predicting in business. Lots of businesses’ earning go down. They are going to go down. You have to analyze businesses and some businesses are going to be subjected to enormous competitive pressures that are not extant today.
We made a mistake with Dexter Shoes which was earning $40 million pretax. We assumed the future would look as good as the past. That’s part of the game to figure out what those future cash flows are likely to be. When you can’t come up with reasonable estimates, you move onto the next one.
About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.
You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.
The Samurai Coach 