Buffett determines the value of a company by projecting its future cash flows and discounting them back to the present with the rate of long-term U.S. government bonds. I’m sure that sounds about as much fun as extracting termites from your home with chopsticks, but that’s how he calculates a company’s value and I felt compelled to share it with you.
After determining a company’s value, Buffett then looks at its stock price. It’s one of the few times he pays attention to stock price. He compares the value to the price and determines the margin of safety. In other words, if the stock is selling for just under what the company is worth, there is a small margin of safety and he doesn’t buy.
If it sells for well under the company’s worth, there is a large margin of safety and he buys. The reasoning is simple. If he made a small error in determining the value of the company, then the true value might prove to be below the stock price. But if the stock price is well below what he estimates the company to be worth, the chances of falling below it are less. It’s a straightforward use of Graham’s margin of safety.
Now, a few caveats and adjustments. Describing Buffett’s way of determining a bargain price in two steps and characterÂizing it as simple is a bit misleading. It’s accurate, but it’s not easy to copy. I can also describe Tiger Woods’s way of hitting a long drive in two steps: Keep legs loosely in place, swing club swiftly toward ball. There, now do you suppose you can golf like he does? Of course you can’t, and it’s no different with Buffett’s determination of a bargain price.
Arriving at an accurate assessment using Buffett’s method requires an accurate forecast of future cash flow. Buffett’s good at it; most of us aren’t. Even within your circle of competence, you probably don’t feel comfortable culling the factors of a comÂpany’s success, estimating their future success, and translating it into today’s dollars.
