I’m a big fan of the Warren Buffett Way actually. Each to their own though. :O)

I think if he did use a formula, it would have to be the residual income (abnormal earnings) model, simply because it emphasizes the fundamentals he looks at (ROE, book value, and growth) and is (to me at least) more intuitive than DCF (which I realize given the same numbers should give the same results since both models are (for long projections) re-arrangements of each other). Valuing a company as a premium or discount to book value greatly simplifies things, as compared to trying to figure out what growth rate and what time frame for that growth a given P/E value assumes. Plus this model shows the margin of safety plain as day (well better than any P/E ratio could). The best part is, you don’t have to forecast 100 years into the future to get a decent valuation… if you assume growth for only a 3 years into the future, you know what the value of your company is based on those 3 years and what book value is now. You can assume normal earnings from then to eternity, or assume the company liquidates. Either way, you will earn about what your RI model predicts. If nothing else, it is a good way to avoid overpaying.

Warren only likes companies to pay dividends when they cannot earn a rate of return higher than what shareholders could earn elsewhere (in his shareholder letters he always says something like “our goal as usual is to ensure that every dollar of retained earnings translates into MORE than one dollar in value”). So that would rule out the common (and useless) dividend growth model. As already demonstrated, to value a company paying all earnings out every year as dividends (just like a bond would), you need only the discount rate and the expected constant earnings. Buffett figured the Washington Post would grow, so he knew his estimate using this method would be low… he knew there was a great margin of safety then and he would earn more than the required rate.

Now, in his earlier years, he was quite successful at using Graham’s method (getting one last puff out of “cigar butt” stocks he says), and that worked quite well. Good luck finding such opportunities these days as markets have become fiercely competitive and arbitrage opportunities should be scarce. If you want to see Graham’s teachings though to get an idea of where Buffett started in the stock picking game and what formed his foundation, read Security Analysis. Fundamental analysis (and there are no secrets to it) is the first thing one should learn.

Finally, I should mention that I don’t think Warren has said much of anything about the books that have been written about his methods, but Charlie Munger did give the nod to The Warren Buffett Portfolio as one that most closely fits their investing style (focus investing of course).

Would you consider making one of your blog posts a list of must-read books about value investing and maybe a short review/opinion of them? There’s a lot of material out there and I’d like to be able to concentrate on the best books available. The only one I KNOW is a must-read is Intelligent Investor.

Thanks,

Ryan

I just finished reading Buffettology. The topics and ideas were portrayed quite clearly. Was a quick read too. Now I am about to go through it again with tooth and comb (my way of deciphering) to try and plug holes in the methods.

Would love read your thoughts on the book.

I use value line investment survey (get it for free from the Library at college) as a screen to select companies and for past data.

what are your thoughts on value line?

Giggsy : “United is Life”

Here’s the other problem I have with it: Using his “residual value” formula would give you the present value of 100 years of income. If you actually run the numbers for years 11-20, using Hagstrom’s 5% growth rate and 9% discount rate, you’d have a residual value of $38,458 (he has $87,900). The present value of that would be $10,072 (he has residual present value of $37,129).

In the end, his formula came up with a value and a margin of safety. Still, I don’t think it is practical (and I doubt that Buffett tries) to estimate the 100-year future value of a company – especially considering few companies ever hit the 100-year mark.

Make sense?

It is equal to yours?

There is more than one way to value a business. Still, I think he made some serious stretches and assumptions to make his valuations work for the book rather than find a model that works for all purchases.

Though I can’t be sure, I assume that Buffett has one simple model that he uses for all businesses. I can’t imagine that he sits at his desk and says,

Well, it didn’t work when I did it this way. Let me try another method and see if the business is undervalued.

My two cents on it.

Hagstrom uses a DCF method to evaluate a business, is that wrong?

Did you compare with your results?

Thank you

I haven’t read The New Buffettology – though I suspect (or hope) it is similar to the original. “Hope” because I am fairly certain that Buffett hasn’t really changed his investment strategy since the original Buffettology.