One of the biggest problems facing investors is the calculation of intrinsic value. There has been much written about the correct way to calculate intrinsic value but one of the best explanations can be found in the book Charlie Munger: The Complete Investor, by Tren Griffin.
The book provides the essential steps of Munger’s investing strategy and is a must read for all investors. In particular is the chapter titled – Berkshire Math, which outlines the method of calculating intrinsic value used by Munger and Buffett and how it differs from the typical calculation method.
Here’s an excerpt from the book:
IN MAKING AN intrinsic value calculation, Berkshire uses the long-term (30-year) U.S. Treasury rate as the discount rate. This is not a typical approach, and many people do not fully understand why Berkshire uses this rate. Buffett explained:
We use the risk-free rate merely to equate one item to another. In other words, we’re looking for whatever is the most attractive. In order to estimate the present value of anything, we’re going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate … to simply compare all kinds of investment opportunities across the spectrum.
—WARREN BUFFET, BERKSHIRE ANNUAL MEETING, 1997
What is happening in this process is an examination of opportunity cost. Intelligent people make decisions based on opportunity costs—in other words, it’s your alternatives that matter. That’s how we make all of our decisions.
—CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003
Munger thinks about the opportunity cost of capital by considering what the alternatives are for that capital. Buffett has said, “Charlie and I don’t know our cost of capital. … We measure everything against our alternatives.”1 Why would you buy an investment that is not in your top 2 percent of opportunities? As has been explained previously, this will lead to a concentrated portfolio that is perfectly acceptable to Munger. Because he believes that risk comes from not knowing what you are doing, he has adopted a focused investing style, which will be explained below.
“How does Munger account for risk when he buys an asset?” He will only invest if he strongly believes the current earnings are nearly certain to continue. While most other investors will adjust the discount rate for what they may believe to be greater risk, Berkshire wants essentially no risk as a starting point. In other words, rather than adjust the discount rate to account for risk, Munger and Buffett use a risk-free rate to compare alternative investments.
They look for both conservatively determined fundamentals and a stable business history, which indicate to them that the current state of the business in question will continue. However, to provide a cushion against mistakes, they will not actually buy an asset without at least a 25 percent discount in intrinsic value (this discount is their margin of safety).
The theory behind Munger’s very different approach to dealing with risk is worth examining in detail. As a review, risk is the possibility of suffering a loss (not price volatility). The way Berkshire deals with risk is by buying what they feel is a conservatively valued asset with no risk at a discount price. Their focus is on having protection against mistakes that they may make during that process. What they do not do is increase the interest rate used in the computation to deal with risks inherent in the business. If there are significant risks inherent in the business itself, they put the decision in the too hard pile and move on to other potential opportunities.
The mathematical process that Munger and Buffett use at Berkshire is simple. (Please do not stop reading because I used the word mathematics.) First, Berkshire calculates the past and current “owner’s earnings” of the business. Then they insert into the formula a reasonable and conservative growth rate of the owner’s earnings. They solve for the present value of the owner’s earnings by discounting using the 30-year U.S. Treasury rate.
The focus of the investing process at Berkshire is on return on equity (ROE), not earnings per share (EPS). As an aside, Munger believes that every manager of a business should be thinking about intrinsic value when making all capital allocation decisions. Note that Berkshire does not use price to earnings multiples in calculating value. Owner’s earnings is a very specific type of earnings, and they stick to that set of figures.
In determining intrinsic value, Munger doesn’t swallow the stories of promoters who sing songs and tell tall tales about EBITDA (earnings before interest, taxes, depreciation, and amortization) and non-GAAP (generally accepted accounting principles) “earnings.” He likes genuine free cash flow. He considers “drowning in cash” to be a very good thing indeed. On the topic of non-GAAP earnings, Munger has said this:
I don’t even like to hear the word EBITDA.
—CHARLIE MUNGER, Q&A WITH SIX BUSINESS SCHOOLS, 2009
1.Warren Buffett, quoted in Tilson, Notes from the Berkshire Annual Meeting, 2003.
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