Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a 'great company at a fair price than a fair company at a great price'.

This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.

Patience

The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.

There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

What Warren Buffett says about diversification

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

'Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.'

No real difference between Benjamin Graham and Warren Buffett

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

Berkshire Hathaway holdings

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

• Manufacturing and distribution – underwear, children's clothing, farm equipment, shoes, razor blades, soft drinks;
• Retail – furniture, kitchenware
• Insurance
• Financial and accounting products and services
• Flight operations
• Gas pipelines
• Real estate brokerage
• Construction related industries
• Media

Intrinsic value

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it. That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

Defining intrinsic value

Buffett's concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:

'The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.' – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

Discounted Cash Flow (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

What Warren Buffett says about predicting future cash flows

In 1992, Warren Buffett said that:

'Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.'

It is well worth reading Buffet's analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. There are formulas for working out discounted cash flows and they can be complex but they give a result.

Explanations of DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.

A good online explanation is available here.

How Warren Buffet determines a fair price

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.

Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves.

Posted by toughiee on Sunday, November 20, 2005 at 10:21 PM | Permalink