So far we have seen Buffett's business, management, and financial tenets. This pretty much sums up how good a company is. So is that it? Can you invest right away? That's a big NO! Quoting Warren Buffett here: "Price and value aren't the same: Don't pay too much". That's because even a great company would be a bad investment at the wrong price. That's why, after ascertaining everything related to the company, the decision to buy or sell would finally be based on the following two tenets.
- Determine the value: If we have to know whether a company is worth investing in at a certain price, first we have to determine its value. But how to determine the value? Buffett does not follow valuation metrics such as P/E (price-to-earnings) or P/B (price-to-book). According to him, the value of a company is determined by net cash flows expected to occur during the life of a business discounted at an appropriate rate (a DCF calculation). Now, what is this net cash flow? It is the owners' earnings that we discussed in our previous article (See, this is why you should read the whole series). To estimate the future cash flows, which is very difficult, we must understand the company thoroughly. And about the discount rate, Buffett doesn't complicate it much. Unlike many analysts who use CAPM or capital asset pricing model (which is a whole other story that we will discuss sometime later), Buffett simply uses a long-term government bond rate. That's it, he makes it as simple as that.
- Buy at attractive prices: Now that we have found the company's value, we should compare it with the current price. The difference between the value of the company and the current price is called the margin of safety. The greater the margin of safety, the better it is because it will give us more room for errors. Buffett points out that both valuation and margin of safety aren't accurate numbers. They may change a bit but even an approximate estimate is good for decision-making.
We have now successfully covered all the major tenets of Warren Buffett. These points and articles will be of no use if we do not implement them in real life. So the next time you are looking at a company, follow the tenets.
Alternatively, if you do not have enough time to do such in-depth research, we have a service called Value Research Stock Advisor where we have not only recommended more than 50 stocks but also have two ready-made stock portfolios. One of the portfolios, All-Weather, has given 20 per cent returns per annum since we started - now that's the return we want.
Once again we would like to mention that these tenets have been taken from the book 'The Warren Buffett Way' by Robert G Hagstrom. It is a fantastic book and we recommend you read it.
Also in this series:
Buffett's business tenets
Buffett's management tenets
Buffett's financial tenets