Some time ago, I came across an interesting article that lays out an email exchange between investor Dan Ferris and Staley Cates, the president of Southeastern Asset Management, Inc. which manages the highly successful Longleaf family of funds. In the article, Cates explains how Longleaf does discounted cash flows. There are several important takeaways from the article:
- According to Buffett, the single best way to value a business is to determine how much free cash it will generate over its lifetime and discount it back to its present value.
- One of the challenges of this approach is that it depends so much on things that won’t happen for many years into the future. To compensate, Cates is conservative and assumes no growth after year 8.
- Cates uses a 9% discount rate for all businesses to keep things simple. Like Buffett, he appears sceptical of the notion that you can compensate for risk by using a higher discount rate. For Buffett, it’s binary: you either know what you’re doing, in which case you can make a reasonable projection of future long-term earnings, or you don’t, in which case you should “take a pass”.
- Cates takes seriously Graham’s concept of “Margin of Safety”. They will not invest unless they can purchase shares at a 40% discount to their conservative estimate of the business’ value, as derived from their discounted cash flow analysis.
Here is the article:
“…The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for…”
“[The intrinsic value of a business] is the discounted value of the cash that can be taken out of a business during its remaining life.”
Cash Flow Analysis: Listening to Warren Buffet
If that statement merely appeared in a textbook, I might yawn and disregard it. But I didn’t get it from a textbook. I got it from Warren Buffett’s Owner’s Manual, available online at www.berkshirehathaway.com. Since Buffett is the richest investor alive, I believe knowing how to figure out “the discounted value of the cash that can be taken out of business during its remaining life” must be just about the most important skill you could ever possess, if your goal is getting rich by investing in stocks.
The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for.
Lacking an informal, or formal, or any other type of relationship with the Sage of Omaha, I asked Staley Cates, co-manager of Longleaf Partners Fund, to enlighten me on the scintillating subject of cash flow analysis. (You’ll recall that Longleaf has been in the Extreme Value Model Portfolio since February 2004.)
Cash Flow Analysis: The Lesson
During our conversation, Cates told me exactly what I needed to know. [Continue reading]