Let’s get back to the basics-Warren Buffett and his teachings. We know that every company has an intrinsic value. Calculating that value is simple-it is the discounted cash that can be taken out of the business during its remaining life. In fact, that calculation can be used to value everything-businesses, CDs, bonds, cars, real estate, the list goes on and on.
Buffett tells us,
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Just because we know the value of a business, and simply because it is on sale, doesn’t mean we should buy it. Half of the strategy is valuing a company; half is finding wonderful businesses.
Apples To Oranges
Think about this: Would you rather buy a wonderful business at a 25% discount or a mediocre business at an 80% discount? In reality, that’s a tough question. The value of a business (or anything) lies in the future.
The above is not a question of numbers; rather, it is a question of confidence. If you knew that both businesses would perform exactly as you projected, you’d be crazy to buy the wonderful business. But we don’t know exactly how the companies will perform, which is exactly why we need a margin of safety in the first place.
When comparing wonderful businesses to mediocre businesses, you are not comparing apples to apples. A wonderful business is wonderful specifically because it will grow consistently. A mediocre business is mediocre specifically because it may not.
Time Will Truly Tell
Time is the friend of the wonderful company, the enemy of the mediocre.
All we can do is attempt to predict the future. That’s not a lofty goal, is it? Still, it is easier to predict the growth of a wonderful business (read: consistent, steady, reliable) than it is to arbitrarily guess the growth of a mediocre business.
We can slap some growth rates on a company, buy it at a discount, and wait for a few years to see if we were right. Or, we can limit our analyses to those companies that lend themselves to confidence and stability-and invest with much more certainty.
Leverage The Past, But Don’t Rely On It
We analyze the past to find consistency and acceptable growth in the business. Still, the value of a company lies in its ability to generate owner earnings in the future.
If past history was all there was to the game, the richest people would be librarians.
Back in the 1980s, there was a fierce battle for market share between Beta and VHS manufacturers. In the end, VHS won the home market and Beta won the professional market. VHS ruled supreme-even as DVDs began growing popular.
Then, virtually overnight, VHS was gone-as were virtually all owner earnings derived from it.
Don’t Buy Everything-Or Even “Just Anything”
Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.”
In the end, if you limit yourself to buying truly wonderful companies, that you like, that are on sale, you’ll be just fine. Remember:
Price is what you pay. Value is what you get.
Filed under: How to Think About Investing
Once again, awesome advice. I have had some questions on the issue of recognizing great opportunities. Does a great price on a somewhat predictable business worth it? You made me second guess this. It has made me realize I might want to be as patient as possible in order to “swing the bat” on only the most Powerful and Reliable investments (considering the economic factors intrinsic value powerful moat).
Thanks alot Mr. Ponzio!
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A great price on a predictable business is perfectly acceptable. In my opinion, a “wonderful” business is, among other things, very predictable. If you have a very good idea of what the business is worth today, and you have a very good idea of what it will be worth in ten years, there is no reason you shouldn’t buy it if the price is right.
In his 1992 Letter to Shareholders of Berkshire Hathaway, Buffett said:
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – 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.
The better you are at predicting the cash flows, the “worse” the business could be. You don’t have to stick with the high profit margin, well-funded companies. Most people should because they tend to provide the most stable and predictable cash flows and make the valuation process much easier.
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Nice post. Classic advice.
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