Saturday, March 30, 2013

Warren Buffett's Secret Formula and Valuation Analysis


Buffett Stock Value Formula: Free Cash Flow / Risk Free Rate

Warren Buffett's formula was never published; however, from our research and Warren Buffett's hints over the years, this formula seems to be the most likely candidate. WikiWealth actually uses this formula in all our research reports in conjunction with Buffett's qualitative assessments of value. The numerator for this equation is found on the DCF valuation for each individual stock. It's NOPAT + Depreciation - CapEx - Net Working Capital Change. The risk free rate is the US treasury rate, a standard risk free measurement.

What we know about Warren Buffett’s approach:

1. His formula is simple. He can compute it within 5 seconds, in his head.
2. He uses both quantitative (formulaic) and qualitative (management incentives and ethics).

Why does Buffett use the risk free rate?

The risk free rate best matches Buffett’s perceived investment risk. The risk free rate incorporates inflation and a small premium to entice people to own a government investment versus just owning cash. The risk free rate naturally excludes the risk of default. The US treasury bill is considered risk free, because the US government is perceived as very strong and unlikely to default, contrary to popular political beliefs.

Risk free rate vs. the WACC?

The WACC (weighted average cost of capital) is important for businesses with many different risk factors. Buffett does not invest in these types of companies, because risks are difficult to quantify. To illustrate, Warren Buffett made a mistake investing in the banking sector before the great recession. The risk he did not anticipate was the global collapse of the financial sector due to a drop in housing prices and the securitization market. This was a black swam event, so it was unanticipated. Usually, he only invests in companies with zero (or low) risk factors, according to his statements to that affect.

Why does Buffett use the free cash flow of the business?

Free cash flow is the most important part of this analysis. The more cash a business generates, the higher the value of the business. Earnings would be a great measure if they were a reliable estimate of a businesses cash flow. Unfortunately, earnings are a very corrupt measurement. How often do actual earnings per share beat estimated earnings per share every quarter like clockwork? Manipulation. Cash flow is much harder to manipulate.

Why is his formula superior to complicated valuation models?

In essence, the fewer assumptions an investor makes, the fewer the mistakes. Buffett can afford to make fewer assumptions, because he only chooses certain companies, which pass his qualitative test of value. WikiWealth’s model imitates Buffett's qualitative test and uses his simple formula to find great investments. WikiWealth's discounted cash flow models use thousands of assumptions. The benefit for a complicated valuation model is they are far more robust, which means they can determine the value or a wider range of investments.

Buffett’s Critique of Beta?

Traditional finance says that quick movements in a stock's price increase risk and decrease the value of that investment. Higher risks decrease stock prices; this is well known and understood, but what is risk? For example, if a stock quickly drops in price, the riskiness of that investment greatly increases. Warren Buffett says that if an investment decreases in price, it automatically becomes less risky and inversely more valuable. WikiWealth agrees with this conclusion.

Buffett’s Critique of Stock Splits?

Stock splits are mostly irrelevant in terms of a stock's value. The only benefit of a stock split is for individual investors who can not purchase a whole share of a stock, like Berkshire Hathaway. A split makes individual shares cheaper, but has no influence on the company value. Some of the disadvantages of stock splits include expenses related to the voting and distribution of those shares. Any additional work, with no additional value is an expense. Splits should be avoided.

Why does Wikiwealth modify the formula?

The short answer is to include interest expense in the equation. We aren’t sure of the actual Buffett equation, but we understand the idea of simplification that Buffett’s formula achieves. Our formula includes free cash flow to the firm (free cash flow to equity shareholders, plus interest expenses), because interest expenses are volatile and hard to predict with accuracy over the long term. We adjust for this and escape another difficult assumption related to the market value of debt. We assume that the book value and market value of debt equal, therefore, we escape the difficult task of predicting either one with accuracy. By including interest to free cash flow, we eliminate two difficult assumptions.

Explain the significance of the scoring system:

Buffett Score: Wikiwealth uses Warren Buffett’s current stock portfolio as a benchmark to see whether new investments belong in that portfolio. The grade is simply a quantitative way to look at the data.

Valuation Analysis: Criteria & Score

Consistency?

This stands for the consistency of past financial results. The easiest way to predict future results is by looking at past results. If revenue grew by 4% each of the last 5 years, there’s a good chance it will grow at 4% next year. Consistent financial results demonstrate a stable operating environment for the business. Maybe the business is in the mature stage of growth.
What does a lack of consistency mean? Usually the opposite of what is mentioned above, but the lack of consistency can show additional problems like big acquisition, which dilute share value and disrupt operations and management focus. Acquisitions are a common part of business development, but large acquisition almost overwhelmingly destroys shareholder value, so avoid these scenarios.

CapEx % < Buffett Portfolio?

A low CapEx indicates that the business is probably mature and doesn’t require much investment to continue to grow. As indicated by Buffett’s portfolio, a low CapEx is favorable.

WC Investment % < Buffett Portfolio?

WC means working capital and this is the amount of additional short-term capital needed to run the business. A low, negative, or decreasing WC indicates that the company is run efficiently. The lower the better in most cases, but a company often needs more working capital as revenues grow, because they are dealing with more assets and liabilities on a day-to-day basis. The second threshold means, that if the WC is not below the average for Buffett’s portfolio, then the investment has a chance to score if the investment growth rate is below that of the revenue growth rate.

Free Cash Flow…Lots of cash is great.

Cash is the key to this valuation. They more cash a generates, the better. Most companies reinvests cash in their businesses in an effort to generate even more cash in the future. Invest a dollar today and get two dollars tomorrow.

Importance:

The overall importance of value is broken down into two main areas.
1. Consistency: 50% of the score relates to the consistency of the individual financial operations of the company.
2. Cash Flow: 50% of the score comes directly from the financial results that affect cash flow: capital expenditures, working capital, depreciation & amortization, and free cash flow.

Valuation Analysis: Score

The higher the better. A company gets points for exceeding the score of his current holdings.

Qualitative Analysis: Other Questions an Investor Must Ask

1) Is the business simple and understandable?
3) Does the business have favorable long term prospects?
2) Does the business have a consistent operating history?
4) Is management rational?
5) Is management candid with its shareholders?
A good investor must do their homework before making any investment.


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