In his annual letter to shareholders for the year 2000, Buffet wrote that the principle for valuing an asset for financial gain was established by Aesop in 600 BC and it remains largely unchanged since then. The fableâ€™s moral â€“ a bird in hand is better than two in the bush.
You have to go through Buffetâ€™s explanation several times before it starts making sense but once it does it hits you that the thing is absurdly simple and insightful. Â
A bird in hand is the risk free rate of interest that you would get if you bought government securities. So the returns that you are expecting from your investments should be much more lucrative than the risk free rate of interest that you can earn. And to find out whether it is lucrative enough or not you have to look in the bush and answer these three questions:
- Are there any birds are in the bush?
- When will the birds emerge and how many would there be?
Put simply would the business ever generate positive cash flows?
When it does generate positive cash flows, would the discounted cash flows be greater than what has been spent in the initial years to be profitable and lucrative?
Buffet stresses upon the fact that ultimately it is the cash generation ability of a business that will decide its true worth. Other factors like P/E Multiple, book value, dividend yield etc. are at best just clues as to how much the business is worth.
I find this particularly interesting because I use P/E multiple quite a bit in deciding whether a stock is selling at a reasonable price or not. However the fallacy is quite obvious, a company which is struggling will have a comparatively lower p/e but that does not make it lucrative. On the other hand a company which has performed sturdily over the years and promises to do the same in the future would have a higher p/e but that doesnâ€™t make it expensive either.
Projecting cash flows for a business isnâ€™t an easy thing to do however it is not a very difficult thing to do either. What an investor needs according to Buffet is a general understanding of business economics and a sense of independent thinking which can help the investor to reach a â€˜well founded positive conclusionâ€™.
The projected cash flows should be a range rather than a fixed number so that you get an estimate of the most pessimistic view to the most optimistic. This would help in ironing out any errors in forecasts that may have been made. In industries where technology changes rapidly or in the case of new businesses even getting a range of estimates become difficult and hence Buffetâ€™s advise of investing in businesses that an investor understands.
The concepts that Buffet discusses are quite simple and insightful and though it takes some time to digest and go through them, the simplicity and thoughtfulness really makes sense in the end.