Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.
For many businesses, it is difficult to calculate this with a level of precision that has much utility.
Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.
Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.
The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.
In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.
A no-growth business also earning $1 million would be worth about 10 times earnings.
Business 1: $1 million / (10%-6%) = $25 million
Business 2: $ 1 million / (10%) = $10 million
As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.
Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.
You should carefully think about each of these and add them to your checklists for evaluating a business.
I’ve put Gurley’s characteristics in the form of a question.
1. Does the business have a sustainable competitive advantage (Buffett’s moat)?
2. Does the business benefit from any network effects?
3. Are the business’s revenue and earnings visible and predictable?
4. Are customers locked in? Are there high switching costs?
5. Are gross margins high?
6. Is marginal profitability expected to increase or decline?
7. Is a material part of sales concentrated in a few powerful customers?
8. Is the business dependent on one or more major partners?
9. Is the business growing organically or is heavy marketing spending required for growth?
10. How fast and how much is the business expected to grow?