The Warren Buffett Way vs. traditional valuation methods

As a student and participant of the investment community I’ve learned that they are many approaches when choosing how to invest money. Many investors trust their money to investment bankers because they lack the financial astuteness and/or time to devote toward managing their money. Others have made a comfortable living by investing in companies in the stock market, real estate and other investment vehicles. Warren Buffett, on the other hand, the world’s most prominent value investor as well as one of the richest invests through a methodical formula which is simple to comprehend but can difficult to emulate. In the second edition of “The Warren Buffett Way”, the author Robert Hagstrom presents Buffett’s investment philosophy through four major tenets. The major tenets are business, management, financial and value. Many investment formulas are not as diligent about describing how to understand the business and management aspects of the companies in which we invest our money. It truly takes a significant about of time to understand the companies in which we invest our money and as previously mentioned, many investors would rather entrust an investment banker rather than manage a portfolio on their own.

Mimicking Buffett’s investment style with the changing times can seem difficult, but Hagstrom describes a foundation for beginning the journey through the four major tenets.

Business Tenets
Whether you have one dollar or one billion dollars to invest in a business, your first task should be to understand the business and/or opportunity. Buffett suggests investing in companies within your own circle of competence. If you can understand the business and it is simple to you on how the business operates then it resides in your circle of competence. Every investor should focus on understanding the inner-workings of the business such as revenues, expenses, cash flows, labor relations, pricing flexibility and capital allocation. The key is to avoid big mistakes by making informed decisions within your circle of competency.

After focusing only on companies which you understand, the next step is identifying those companies that have a consistent operating history. The business should not be planning any major changes in strategy and have minimal hurdles to overcome if the company is not running smoothly. Businesses with consistent operating histories will typically have high returns on invested capital and will have a likelihood of continued success. An investor should identify the strategic competitive advantage of the business that allows for greater product/service pricing flexibility.

Management Tenets
Over the past 10 years we have seen an influx of management accounting scandals from companies across various industries. The Enron scandal was one of the largest during that time and it along with other high profile cases such as Global Crossing, Adelphia, Tyco and others has brought about the Sarbanes-Oxley Act of 2002. It has never been more appropriate for the investing community to pay more attention to the Board of Directors as well as the management of the companies in which we invest. We should look at the decisions of management for clues on whether they have the best interest of the company and shareholders in mind. Buffett likes to look at how managers allocate capital when there is excess cash in the business as well as how much those managers actively buy stock in the company. Allocating capital in other investments should be done only if the gains will be higher than the average return on equity, otherwise the excess cash should be returned to shareholders by buying back shares or raising the dividend levels. Buffett also suggests to look for candor and transparency from executive management about their financial position as well as how failures are communicated. A strong management team will say and do what is right in light of the stock market and what analysts are projecting. Evaluating management can be much more difficult than evaluating financial performance, but the information gained can give early warning signs of potential problems. As a rule, Buffett suggests waving the red flag if the company displays weak accounting tactics such as not expensing stock options, complicated financial footnotes and boasts about future growth consistently.

Financial Tenets
When evaluating the financial history of a business Buffett looks at 4-5 year moving averages. This view gives a better view of how the company operates over a long term. There are a few key timeless principles that the investor should focus on during the financial analysis. Pay attention to Return-On-Equity (ROE) and not Earnings-Per-Share. Return on Equity is the ratio of operating earnings to shareholders’ equity. During the evaluation of ROE assure that all capital gains/loss and extraordinary items are excluded. In addition all marketable securities should be valued at cost and the company should have little to no debt. Debt can give the ROE a higher ratio and should be evaluated. In addition investors should look to calculate owner’s equity, high profit margins and for every dollar retained the company should have created at least a dollar of market value. The ultimate goal for the investor is to be able to tell the difference between real and made up numbers.

Value Tenets
The ultimate decision is whether to buy into the business or pass. This decision should be made based on two factors: is the business a good value and is the price favorable. The valuation methods used by Buffett are very simple in comparison to other methods. The formula assumes that you have applied all the other business, management and financial strategies for determining a company for valuation. If you can not determine a consistent pattern in earnings power, you don’t understand the business and are clueless on how management is running the company; don’t value the company. The two areas where Buffett’s methods differ from a traditional maximum dividend valuation method lie in a few adjustments and the chosen discount rate. For earnings Buffett uses owners earnings the total of net cash flows adjusted for capital expenditures. Buffett uses a constant growth rate for the short term and the long-term bond rate as the discount rate. When interest rates are low, the discount rate is adjusted upward by 3 points or so and vice-versa when the interest rates are high.

Buffett’s valuation method is so simply because there is so much weight on the other aspects of the formula such as the circle of competence and understanding executive management decisions. Once you’ve gotten intimate with the business itself, valuing the company should be straight forward; just as Hagstrom presents it.