4 simple steps to Value Investing: Step 4

In the previous article, we discussed the third of the four steps to successful value investing created by none other than the legendary Warren Buffett. Let us now move on to the next and the last step in this article.

The last step pertains to valuations. It is most important of all the steps since valuations decide the action points (buy or sell) of investors.

Let us first understand what his perception of value is. Then we will have a look at how Warren Buffett calculates the intrinsic value and the tools and standards he uses.

What is value?

In order to understand value, Buffett quoted a famous saying that 'a bird in hand is worth two in the bush'. In other words, investing is knowing exactly what you are paying for today rather than speculating and over paying for you could possibly get in future. And in order to know the correct price to be paid, you need to assess the value of the underlying asset correctly. Only when the investor understands the moat the business enjoys and the risks to it, can he determine the intrinsic value and price he would be willing to pay, with adequate margin of safety.

How to estimate intrinsic value?

Determining value is a tough task. That's because it involves forecasting future cash flows which in itself is a challenge. Discounting those cash flows at an appropriate rate gives us an estimate of value. However, forecasting cash flows for a business is not easy because of the uncertainty involved with the future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you know the coupon payments of future. But that is not the case with businesses.

So, basically the mantra is to look out for businesses that resemble coupon bonds. This would make the valuation exercise easier. In other words, businesses where forecasting future cash flows is relatively easier are the ones that should be on the radar. For instance, it would be comparatively easier to predict the cash flows of a company like HUL than Bharat Heavy Electricals (BHEL) because of the kind of businesses they are in. While HUL's products have certainty of demand across economic cycles, BHEL's order book and project execution rates tend to be volatile.

Once you have the estimate of cash flows discount it with the appropriate interest rate and compare it with your purchase price. The decision then needs to be taken accordingly.

Predicting cash flows for cyclical businesses

But, say you are looking at a business where forecasting free cash flow is difficult. Say for example a capital intensive business. How to forecast cash flows then? Also, what kind of discount rate should be used here considering the riskiness in cash flows?

Buffett feels that for cyclical business the estimates for cash flows have to be conservative. Also, since he focuses on long term investing, the discount rate used is constant across securities. And that figure is arrived at by using the government bond rates. An appropriate premium over that and you are on the right track. No complicated financial models with risk premiums, sensitivity analysis, scenario framework and betas, just simple logical mathematics.

Word on relative valuation

You might have known by now that Buffett is not a big fan of relative valuation because of his focus on cash flows. Nonetheless, if used, appropriate relative multiples need to take into account the return generating capability (shareholder returns - return on equity, return on capital employed) of the business.

How to estimate growth rates?

Forecasting future cash flows involves an estimate of growth rate. The mantra here is to be conservative. If the growth rates are higher, then the estimate of intrinsic value will increase. And investment decisions are based on comparing intrinsic value with the market price. Thus, your estimate of intrinsic value has to be as accurate as possible. High growth rates make intrinsic value more susceptible to changes. Hence being conservative pays off.

Margin of safety

The concept of margin of safety is the essence of his valuation. Since the estimates of intrinsic value involve subjective judgments there is a possibility of being overly optimistic. Margin of safety provides cushion by adjusting the optimism from the forecast. Say for example your estimate of intrinsic value is Rs 100. Taking into consideration a margin of safety of 20% you adjust the value to Rs 80. This will ensure that you do not overpay for any asset.

Basically these are the methods which are used to value an asset by the legendary investor. You may notice the art of conservatism here. But it helps since valuations are subjective in nature. Being aggressive means you can be trapped by overpaying for an asset. Conservatism also helps overcome emotions and makes you wait for the right price to buy. In short, it ensures that the buying price is so low that the possibility of losing capital is virtually zero. It acts as a floor value for your investment. Any upside from there on is an icing on the cake.