Determining Fair Value

 

Warren Buffett often determines the attractiveness of a company’s stock price by comparing it with his estimate of the company’s per share value. He determines value in two ways: by calculating the “earnings yield” of the company and by using the discounted cash-flow method of valuation.

 

The “earnings yield” of an investment is merely the inverse of the price/earnings ratio. If a company’s price is $100 and its annual earnings are $10, then it is trading at a price of 10 times earnings, or a price/earnings ratio of 10. Inversely, if you divide the earnings of $10 by the price of $100, the “earnings yield” would be 10%. This makes it relatively simple to compare the yield of a stock to that of a bond.

 

The discounted cash-flow method requires that you estimate the future cash flows of the company and calculate the present value of that stream using an appropriate interest rate. Discounting is necessary because the current value of $1,000 received in 2 or 10 years is less than $1,000 received today. We value those future cash flows using an interest rate you could expect to receive on a risk-free investment over the applicable period.

 

The most difficult part of these calculations is not the math; it is accurately estimating those future cash flows. This is an area where Buffett has been particularly competent, and where we have found it important to focus our efforts. We believe that identifying companies with sustainable competitive advantages in industries we know and understand helps us improve the accuracy of our cash flow estimates and helps us avoid the big mistakes that can devastate a portfolio.

 

“If a business does well, the stock usually follows.” -- Warren Buffett

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Dave Crouch and not necessarily of Raymond James. Raymond James is not affiliated with and does not endorse the opinions or services of Warren Buffett or Charlie Munger. This is not a solicitation to buy or sell Berkshire Hathaway stock or any other security. Investing involves risk, and you may incur a profit or loss regardless of strategy selected. Past performance may not be indicative of future results.

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