In part 1, part 2 and part 3 of this series of articles discussing the methods investment guru Warren Buffet uses to analyse investment opportunities we covered the Business, Management and Financial Tenets which are essential to determining the prospects of a company.
Here in the final instalment, we turn our attention to two Value Tenets which are critical steps in the investment process, and which often give investors' headaches.
1) What is the value of the company?
After determining whether a company has desirable 'quality' aspects, it is time to determine whether the company represents good value at current prices or not. To do this requires a determination of value.
There are many ways that investors determine value with the price-to-earnings ratio being particularly common, however a more considered approach to valuation requires the use of a discounted cash flow (DCF) model. A DCF valuation requires an investor to consider the free cash flow that will be available to them over the life of the business. This cash flow is then discounted back to a present day value, which gives investors an estimation of what Buffett refers to as intrinsic value.
This process explains why Buffett doesn't generally invest in start-ups or technology stocks. While he may be able to see the potential of these firms, he doesn't believe it is within his 'circle of competence' to accurately forecast the future cash flows of these types of firms. For this reason, Buffett is drawn to companies that have predictable cash flows, like Coca-Cola Amatil (ASX: CCL) or Woolworths (ASX: WOW).
2) Can it be purchased at a significant discount to intrinsic value?
While determining the intrinsic value of a company is vitally important, so too is acknowledging the pitfalls of investing. These pitfalls come in many forms, including inaccurate forecasts, human error, and unexpected or unlucky occurrences which damage the value of a company.
To allow for the unexpected and also to maximise the potential to profit from an investment, Buffett counsels to always demand a 'margin of safety', or in other words only buy at a significant discount to intrinsic value.
It is the demand for a 'margin of safety' that ultimately means many quality businesses never get purchased by Buffett. In the context of Australian-listed companies, stocks such as Seek (ASX: SEK) and Ramsay Health Care (ASX: RHC) might be great businesses, but the premium prices which they trade at arguably would preclude Buffett from purchasing them.
Foolish takeaway
The 12 Tenets that Roger Hagstrom identified in his book The Warren Buffett Way provide investors with a succinct checklist to use before they consider a potential investment.
