Yesterday, I wrote a blog post that described Tom Gayner’s approach to valuing Berkshire Hathaway. Gayner is a great investor with deep knowledge of Berkshire, in particular, and the insurance business, in general. In the post, I used Gayner’s framework to calculate a range of intrinsic value for Berkshire.
The blog post was also published on GuruFocus.com, where it received some criticism for the range of intrinsic value being too wide, and, buy extension, not particularly useful.
Admittedly, the range produced (for the B shares) is a wide: $55 to $208. Arguably, an analyst could pin that range down by narrowing the range of assumptions and/or tweaking the model.
On the otherhand, such a wide range may be useful to an investor if the stock is trading near, or below, the low of that range.
Because the wider the range, the greater the probability that the value is actually within that range.
Put more precisely, the greater the range, the greater the probability that the ACTUAL future free cash flows discounted by the ACTUAL future prevailing interest rates will be within that range.
If you can buy a security at a discount to this range you may have found a winner and, equally important, you’re unlikely to loose your capital.
When you insist on a margin of safety when buying a stock – for example, requiring at least a 30% discount to your estimate of intrinsic value – you are implicitly making allowance for the fact that your estimate of value may be materially higher than the business’s actual intrinsic value. This is really just another way of looking at intrinsic value as a range.
Here’s what Graham had to say on the matter in Security Analysis.
“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.”
Here’s what Seth Klarman had to say on the matter in Margin of Safety.
Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. Projected results are less precise still. You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?
Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investorsat any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal. Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. [emphasis added]
Although I stress that the valuation range for Berkshire is based on my assumptions using Gayner’s framework, Gayner’s approach exhibits wisdom when viewed through the lense of Graham and Klarman.