Forum members,

I have been reading a book "The Warren Buffet Way" by Robert Hagstrom on Buffet's investment principles. In this he analyses all of Buffets major purchaces and has described (what the author interprets) as Buffet's way of valuing a company.

[Note Buffet has never disclosed any thing himself. The author is a friend of Buffets and conveys his interpretation]

In the next post I will put in the details of his purchase of Coca Cola so that we can have a discussion on his method and debate its applicability in the current Indian market scenario.

[Note to avoid copyright violation I will not put anything verbatim put try to put things in my own words]

Hoping for a fruitful discussion ...

Regards,
Sudhanshu

Buffet bought Coca Cola in 1988-1989.

In 1988 Coca Cola's Net profit was $828 million. [Actually this is the Owner Earning that the author calculated. This is slightly different from the Net Profit but for this discussion let us assume that this is the net profit. The net difference between the two values is very small in this case].

Up to 1988 Cocal Cola grew by more than 15% per annum. Buffet assumes that the company will grow by 15% in the next ten years. Beyond 10 years Buffet is unable to correctly guess the growth rate and assumes a conservative 5% thereafter.

The calculations that the author presents are:


Buffet calculates the net profit for future years assuming the 15% growth rate. But he does not take the values as is. He calculates the Net Present Value of these future profits assuming a discount rate of 9%. [8.25% is the maximum risk free return he could get on long term government bonds. To be conservative he uses 9%.]

Row 8 applies 15% over the previous Years assumed profit. Row 9 applies the discount factor to calculate the NPV at 9% discount rate. I am not aware of how the Row 9 numbers were calulated but they come from a standard formula for NPV.

Row 10 is the Net Present Value of the profit for the year after applying the discount factor.

Row 12 is the Sum of Row 10 and indicates the Net Present value of future profits over the next 10 years.

Till this point we have done calculations for the first block of 10 years at 15% growth rate. Beyond that he assumes 5% growth rate.

Row 13 is the caluclated profit for Y10 (from Cell L8).
Assuming 5% growth, Y11 profit is on Row 15.

To calculate Market Capitalization of the company he aplies a rate of 4% [= 9% discount rate - 5% growth rate]
[Of all the calculations and assumtions, this is the one I don't understand. Why apply the factor of 4%? What is the basis? the Assumed PE ratio is 25 and appears too high to me.]

Row 17 gives calculated Market cap for Y11. C17 = C15/0.04.

Then he calculates the Net present value of this capitalization using the factor for Y10. (=D20).

So the intrinsic value of the company that he considers for the present is the present value of the future market cap at Y11 + Net Present Value of future earning for 10 years = D12 + D20. giving approximately 48.39 billion dollars.

So assuming 15% growth rate for 10 years and 5% thereafter using a 9% discount rate to calculate NPV, he arrives at a value of $48.39 Billion.

[Note: if Buffet assumes a growth rate less than the discount rate, then he assumes the intrinsic value of teh company to simply be [Current Net Profit / (9% - Growth rate)]

So if he assumes 5% growth rate, instead of the complicated caluclations he uses 828 Million / (9%-5%) = approx 20.7 Billion.

When he bought, the market cap of Coca Cola was 15.1 Billion. This was much less than the intrinsic value he claculated (both for 5% growth rate and 15 %). Therefore he bought the stock as a long term investment.

The author also notes that at that time, the market actually considered Coca Cola was over prized!!!

Regards,
Sudhanshu

[You must read my previous post on Coca Cola to understand this post]

I now attempt to apply Buffet's valuation principle to Oil Country Tubular Ltd.



I make the following changes:
1. Instead of forecasting for 10 years, I do it only for 3 years
2. I assume a growth rate of 10% for the next 3 years and 5% thereafter.
3. As noted in my earlier post, I am not comfortable with the 4% capitalization rate applied to calculate the Market capitalization. Here I assume a PE ratio of 8 which appears safe for OCTL

[Note EPS * PE = share price therefore Net Profit * PE = Market Cap]

At the end I divide by the total shares outstanding to calculate the intrinsic value per share. This comes out to around Rs 171. CMP of OCTL is around 130.

Please comment !!

Regards,
Sudhanshu

To be clear, that's not "the buffet way" to estimate stock prices.
Pick up any book on fundamental analysis and you will find it is ONE of the many ways to value assets.
The 4% (9-5) comes from the sum of the infinite series (geometric series) from the nth year onwards: 1/(d-g); d being the discount rate and g being the growth rate from nth year on.

Correct, that I why I wrote in my intro: Nobody should get the idea that this is THE way of valuing companies.


Regards,
Sudhanshu

Again, note that the calculation does not work if g > d. It gives a negative value.

NPV calculations can justify anything if you already know what you want to prove.

In all probability the author knew the value Buffet assigned to the particular asset and tweaked his discount and growth rates to arrive at the value he needed the NPV to arrive at. Try changing the values of d and g only a bit and you will find you can justify any value you want to. The calculations are extremely sensitive to terminal value. Why 5% growth rate? I say 6, and you can say 4. The NPV varies wildly between these values.

In conclusion NPV is a fantastic tool to analyze what has already happened Much like the analysts / talking heads we hear on CNBC (or UTV / NDTV, take ur pick).

That's a good point.

As there is compounding involved in such models, a slight variation in any of the rates, can lead to totally different valuation.

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I have just read one book about Buffet....

"Buffettology" by Mary Buffet.

In my opinion, the secret of Buffet's success doesn't just lie in mathematical models.

The secret also lies in his ability to identify businesses that have exceptionally strong positions in their respective industries and geographies.

The biggest advantage of choosing such businesses, is that the investor can afford to go wrong on growth projections.

Coca Cola is no different.

You can make a better tasting product, but it is very difficult to create a brand like Coca Cola.

Not all of Buffet's picks are mega-brands, but most of them have strong positions in their respective industries.

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Sorry, Folks, There's No Way You Can "Invest Like Warren Buffett"

Link

Value investing may not work the way Buffet did anymore.

However, the past 12-18 months showed that markets can still take things to good value levels for investors to buy.

May be these opportunites are few and far between, and when they come they only come en masse. Tide lifting all boats and such ..

The 'tide' definitely is FII's as far as I can see. Our markets are not deep/big enough to withstand consistent FII activity in either directions for 4-5 days straight.

"Value Investing" will work if one has the same patience that Buffet has.

Today, many so-called investors are nothing but medium-term traders and can't think beyond 3-6 months.

First, they don't have the patience to wait for the right stock to reach the right valuations.

They are addicted to buying and selling stocks.

They have to buy and sell some stock every week.

and even if they are lucky to get the right stock at the right price, they exit as soon as they see 25% or 30% profit.

Buffet bought Coca Cola in 1988 and still holds the stock.

How many investors have such patience and such confidence in their stocks?

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Well said! Very true...

A successful investor buys the right company at the right price.

So once Buffet decided that Coca Cola is a super duper investment, how did he decide at what price to buy? He must be using some model even if the one described in "The Warren Buffet Way" may not be appropriate.

Buffet bought Coca Cola in 1988 and still holds it. But he dosen't buy it now. So now even though Coca Cola is the "right company" (hence he still holds it), it is not at the "right price" (if it was, he would be buying). So some model must be implied by his decisions.

Charlie Rose - An Hour with Warren Buffett - YouTube.

Golden words Alchemist, I am having same difficulty in deciding should I become trader or investor!

I know both models and there is a tug of war between how to employ the capital I have!

Do whatever you are good at and do that only, nothing else.

People can make money both by investing and trading.

However, it is best that an individual is either an investor or a trader, but not both.

A trader can make money in any kind of market, provided he can short in cash and derivatives market.

An investor can't make money unless the tide is on his side.

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In a growing economy like India, it is easier to make money by investing.

People just have to "buy and hold" and their stocks will appreciate over the long term - provided the stocks are of quality companies.

When an economy isn't growing or shrinking, making money by investing isn't that easy.

The US markets are a classic example.

10 years back the main US index, Dow Jones Industrial was at 10400 and today it is at 10800. On an average, American investors have not made any money in stocks in the last 10 years.

Buffet's Berkshire Hathaway has given above-average return, but that's only 4% CAGR over the last 10 years. That's not really great when one looks at the return given by US government bonds in the last decade.

Exactly 10 years back (22nd August 2001), the yield on 10 year bonds of US government was 4.91%.

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At the same time, I think young people should try their hand at everything - value investing, growth investing, short-term trading, medium-term trading, long-term trading, day trading, scalping, futures trading, options trading, trading on news, trading on tips, arbitrage and any other way that they can think of to make money in stock markets.

(This should be done with one's own money and money that's not borrowed).

There is a great probability that any individual who tries out the above mentioned methods will lose money in most of the them.

However, that's an essential part of learning - learning that it isn't easy to make money in the stock markets.

After trying out everything, the individual will either find a way by which he make money in the markets or realize that he isn't good enough and should quit the stock markets.

The sooner this learning process is completed in one's career, the better.

People over 50 should think, not twice or thrice, but 10 times before trying out any new strategy or method in stock markets.

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Try 50-50

and take a call after a couple of years.

A gem of an advice.

I completed my harsh lesson in the fall of 2008 and the subsequent rise.

That was fast.

I think you need a revision.

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I was fully "invested" during the 2006 fall and subsequent rise too.

I guess two crashes are enough for me to know what kind of returns/losses I can digest and I should expect.

Warren Buffet's Annual Letter to Shareholders 2011.

Article by one of my favourite writer summing up Buffet psychology and the Big B of Indian fields.

What Ramdev, Biyani, Mallya and Govt can learn from Buffett | Firstpost