Thanks to a book titled The Warren Buffett Way investors have a reference guide (according to the author Roger Hagstrom) for the methods investment guru Warren Buffet utilises to analyse investment opportunities.
So far I have covered the Business, Management and Financial tenets outlined in the book for determining the prospects of a company.
In this, the final instalment we turn our attention to two Value tenets which are critical final steps in the investment process and which often bring investors unstuck…
1. What is the value of a company?
After determining whether a company has desirable 'qualities' via the first three sets of tenets, it's time to determine whether a company represents good value at current prices or not.
To do this requires a determination of value.
There are many ways that investors approach valuation with the price-to-earnings ratio being particularly common.
A more considered approach to valuation requires the use of a discounted cash flow (DCF) model. A DCF valuation requires an investor to consider the free cash flow that will be available to shareholders over the life of the business. This cash flow is then discounted back to a present day value which provides an estimation of what Buffett refers to as intrinsic value.
This process explains why Buffett doesn't generally invest in start-ups or technology stocks. While he may be able to see the potential of these businesses, he doesn't believe it is within his 'circle of competence' to accurately forecast their future cash flows. For this reason, Buffett is instead drawn to companies with more predictable cash flows like Coca-Cola Amatil Ltd (ASX: CCL) or Wesfarmers Ltd (ASX: WES).
2. Can it be purchased at a significant discount to intrinsic value?
While determining the intrinsic value of a company is vitally important, so too is acknowledging the pitfalls of investing. These pitfalls come in many forms including inaccurate forecasts, human error and unexpected or unlucky occurrences which damage the value of a company.
To allow for the unexpected and also to maximise the potential to profit from an investment, Buffett counsels to always demand a 'margin of safety' or in other words only buy at a significant discount to intrinsic value.
It is this demand for a margin of safety which ultimately means many quality businesses never get purchased by Buffett. In the context of ASX stocks, Blackmores Limited (ASX: BKL) and Ramsay Health Care Limited (ASX: RHC) might be great businesses, but the premium prices which they trade at arguably would preclude Buffett from purchasing them.
