Strategy Review: Robert Hagstrom’s The Warren Buffett Way

September 17, 2007 by Joe Ponzio

Back on August 4, 2007, I promised Michael that I would look at the Quicken site and revisit Robert Hagstrom’s investment strategies outlined in The Warren Buffett Way. Then, I completely forgot to do so. Sorry Michael-better late than never, right?

If you are not familiar with Hagstrom, he is the portfolio manager of the Legg Mason Growth Trust mutual fund and author of several books: The Warren Buffett Way, The Essential Buffett, and The Warren Buffett Portfolio, among others. The Warren Buffett Way presents a myriad of strategies for valuing companies…and that is precisely this book’s weakness.

Determine The Value

Hagstrom picks apart some of Buffett’s larger, more permanent holdings and presents certain valuations and rationale for buying. The problem is that there is no consistency in the valuation methods. Now I admit: There’s more than one way to skin a cat (or value a business), but it all comes down to one simple tenet-the value of a business is the discounted value of the cash that can be taken out of a business during its remaining life.

Owner Earnings = Net Income?

When analyzing Buffett’s purchase of The Washington Post Company, Hagstrom calculates owner earnings as net income-Wall Street earnings. Though Buffett does tell us that, over time, depreciation and amortization will equal capital expenditures, the two can vary widely for long periods of time.

Consider this: A company spends $10,000 on a piece of equipment that it will use for ten years. The IRS allows the company to depreciate that equipment for ten years. In that case, the company will have ten years of depreciation at $1,000-or $10,000 total.

Sure, depreciation and amortization will equal capital expenditures, but our company still had to shell out $10,000 today. If it continued to add $10,000 equipment every year, our depreciation would increase…but we’re still spending gobs of money on equipment.

The long and short of it: Owner Earnings do not equal Net Income.

The Post

Hagstrom then goes on to say that Buffett calculated the value of Washington Post to be Net Income divided by the rate of the U.S. Treasury-6.81% at the time-giving the company a value of $150 million. But Buffett himself said most people would value the company between $400 and $500 million. Time to fudge the numbers to make the formula work.

A couple of quick assumptions about profit margins and growth rates, and Hagstrom’s method shows the company to be worth $485 million. Of course, we have to make assumptions about the future to find the value in a company; still, the problem here is the method.

Dividing Net Income By The Treasury Rate

I was messing around in Excel, trying to figure out the logic of valuing a business by dividing owner earnings (or Net Income in this case) by a discount rate to value an investment. Here’s what I found when simplifying the numbers:

Let’s say I offered you a stream of income-$1,000 a year for 100 years. Let’s further say that you wanted to earn 8% on your money. How much is that income stream worth today? Roughly $1,000 divided by 8%-or $12,500.

Translating That To Businesses

If your company generated $1,000 in owner earnings, and you knew that you could rely on that $1,000 for the next 100 years, you could essentially divide $1,000 by your discount rate to find the value of the business. How practical is that?

Well, not practical at all. First, there is no way to know if your company will be around in 100 years. Second, there is no way to predict, with any degree of certainty, what owner earnings will be in 100 years. Third, if your business closes before 100 years have passed, you will have overpaid.

Strategy Changes

The above valuation is not the only method Hagstrom uses. Throughout the book, he presents three of four varying methods using different assumptions. Why? I can only guess that he presents a method for which the numbers work. That is, he looked at the purchase price and worked back from there.

Final Opinion: The Warren Buffett Way

In the end, the book is a good review of the businesses Buffett bought if you ignore the valuations that Hagstrom derived. Does it need to be on your shelf? It wouldn’t hurt. Still, if you are only going to buy a few investment books in your life, I think you can pass on this one.

Final Opinion: Quicken Stock Analyzer

Using Hagstrom’s method, Quicken shows that Buffett would have no interest in Johnson & Johnson. That may comes as a surprise to Buffett and his $3 billion investment.

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