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The business of value investing – Six essential elements to buying companies like Warren Buffett- Charlie Tian 2009
https://bbs.pinggu.org/thread-695143-1-1.html (Page 116-126)
Intrinsic Value, Seeking business with a wide moat
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For the most part, however, cash flows are never guaranteed, and that’s why the intrinsic value figure is only an approximate value, not an exact amount. Yet it does provide the most accurate approximation of a business’s true worth. The better your understanding of a business, the better your calculation of intrinsic value will be. And the more data and reasoning you have, the more accurate your intrinsic value becomes.
If someone offered you $1,000 today or $1,000 three years from now, you’ll take the money now and put it in an interest - bearing account, and it will be worth more three years from now. When valuing the cash flows that a business will generate years from now, you need to discount them back to the present to see what they are worth today. When calculating intrinsic value, you want to compare the intrinsic value today with the market value today. There’s a never - ending discussion about the appropriate discount rate to use when calculating intrinsic values. Many investors and the examples in this book use 10 percent as a default discount rate. Ten percent is often cited as a good multiple because of the historical market return of 8 to 10 percent a year. And the historical market return is a function of historical corporate profit growth rates, which average in the high single digits when you combine stable slow growth businesses with younger, more rapidly growing businesses.
However, the most important consideration when thinking about applying a discount rate is the reliability of the cash flows over a period of years. More reliable cash flows can be assigned lower discount rates because the lower the discount rate, the higher the present value of the cash flows. This makes sense when you consider the safest investments on the planet, U.S. Treasuries, which are bonds that are backed by the full faith and credit of the United States government. Corporate cash flows are not as safe and secure as U.S. Treasury cash flows, so any discount rate used to determine the intrinsic value of a business should be higher than 3.75 percent. The issue then becomes what rate is appropriate: 5 percent, 10 percent, 15 percent, or something else? This is when investing becomes part art and part science. If you use too low a discount rate, then lots of not-so-great businesses will look cheap relative to the intrinsic value. Use too high a discount rate and every business looks overpriced. While many brilliant investors advocate using 10 percent as a discount rate, in no way should it be the default rate at all times. You have to account for the riskiness of the cash flows. A start - up company could easily be valued at a 25 percent discount rate while a business like Coca - Cola could be valued using something less than 10 percent. We can be comfortable knowing that the world will continue to drink Coke, and you have decades of cash flow generation to back you up. But if you’re trying to value a new restaurant chain, you have to account for the lack of operating history, future competitive threats, and so on. I wish there were a scientific formula for applying discount rates, but if there were, investing wouldn’t be investing. The other companion to the discount rate is the growth rate in the cash flows. By now we might conclude that a 10 percent discount rate for the movie - store example was too low a figure. The example was used to illustrate the significance of intrinsic value and the margin of safety. Based on the competitive landscape for movie rentals, however, 10 percent was not an appropriate discount rate, especially if we are assigning a 10 percent discount to the low - risk investment. A much higher discount rate would need to be applied in order to get a more conservative intrinsic value for the movie store. Ideally if you are investing in a business, you are doing so because you are confident that, over time, the business will be earning more profits and thus generating higher levels of cash flow. But again, projecting cash flow growth rates is also an estimate and an estimate can easily be different from the actual future results. There’s a good reason why guys like Buffett stick to simple, easy-to- understand businesses. Determining the cash flows of a stable business such as Wrigley or Coca - Cola several years out will likely prove to be more accurate than figuring out how much cash of a risky business, such as, Advanced Micro Devices will produce.
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To calculating an intrinsic value involves predicting future cash flows, you need to have some reasonable confidence in the future earnings growth of a business. For earnings to grow, a company needs to increase revenue and at least maintain costs. And for the most part, increased earnings should lead to increased cash flows in the long run. Don’t spend a lot of time looking at one - time quarterly charges and the like when you ’ re looking for increased cash flows. Instead, you might want to look at annual cash flow statements for signs of a good, healthy increase in the rate of cash flow growth. Businesses that have competitive advantages or wide moats around them usually throw off tons of cash, and they allow you to predict future cash flows with a higher degree of certainty. Once you find an attractive business that you understand, you need to determine whether the business has staying power or is under constant threat from new entrants. An investment approach that focuses on investing in wide - moat businesses and avoiding the no - moat businesses will produce satisfactory long - term results.
The definition of a great business with a wide moat is one that has at least some of these characteristics:
• Recurring revenue streams
• Ability to produce at low costs
• A monopoly or oligopoly type of market positioning
• A strong franchise or brand that gives the company insulation from most of the competition
• Ability to raise prices ahead of inflation
As an example, insurance companies take in a lot of premiums up front and pay out claims at a later date. Find an insurance business that masters the art of taking in the most and paying out the least, and you have yourself a wonderful business. Warren Buffett knew that when he found GEICO, one of the nation’s largest auto insurers. He wrote an article about the company, titled “he Security I Like Best” when he was 21- long before he bought it. Even then, Buffett saw that GEICO had a recurring revenue stream that would never go away as long as humans use cars. By insuring drivers all over the country, GEICO naturally shields itself from the risk of being geographically concentrated. It also has a history of insuring the best drivers, so its claims pay-out is low. That means GEICO can lower its premium, which it does. And that gives the company a good, wide moat. Companies that dominate their industry tend to do quite well over the long run. American Express is a wonderful example of a business operating in a monopolistic type of industry. For decades, credit cards and travellers’ checks were synonymous with American Express, and if you look at the company today, you can still find tons of cash generation, despite the current restrictive credit environment. Home Depot and Lowe’s are other great examples of businesses that own their industry.
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