Warren Buffett's 3 Questions For Valuing A Stock

How Buffett values stocks differently than other investors

September 14, 2024

Read Time: 6-minutes

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Today, we're going to look at Warren Buffett's 3 questions for valuing a stock.

This topic came from a reader's question:

"Can you help me understand the process of how to gauge intrinsic value of a company?"

— P.T.

Calculating the intrinsic value of a company, or our estimate of the stock's value, is, of course, a critical exercise…

The problem is most business schools and resources teach valuation using concepts like "Beta" and "Standard Deviation"—which Buffett and Charlie Munger disagree with:

"It became very fashionable in the academic world, and then that spilled over into the financial markets, to define risk in terms of volatility, of which beta became a measure, but that is no measure of risk to us."

— Warren Buffett

"Much of what is taught in modern corporate finance courses is twaddle."

— Charlie Munger

So, let's dive in.

Worth Exploring:

How Warren Buffett Thinks About Stocks:

Buffett simplifies valuing stocks by thinking about them as similar to bonds:

A bond, as most of you know, comes with a certain maturity and with a string of little coupons. A 6% bond, for example, pays a 3% coupon every six months.

A stock, in contrast, is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect "coupons."

When you look at a bond it's very easy to tell what you get back, it says it right on the bond, it says when you get the interest payments and the principal. The cashflows are printed on the bond, the cash flows aren't printed on the stock certificate. That's the job of the analyst, to change that stock certificate, to change that into a bond.

—Warren Buffett

So, how do we turn a stock into a bond? Buffett draws on wisdom from a legendary figure…

(Note: if you're unfamiliar with the concept of the time value of money, here's a quick primer.)

Aesop’s Wisdom

In Buffett's letter to Berkshire shareholders in 2000, he gave us the foundation for how he values stocks:

"…the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions.

1. How certain are you that there are indeed birds in the bush?

2. When will they emerge and how many will there be?

3. What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?

If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars."

— Warren Buffett

Buffett’s First 2 Questions

So, Buffett’s first two questions are about our confidence in future earnings (Buffett uses Owner's Earnings1 as his measure of earnings) and their timing & amount.

Buffett continued, with 2 lessons to help answer his first 2 questions. The first lesson:

Alas, though Aesop’s proposition and the third variable — that is, interest rates — are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

— Warren Buffett

Using ranges builds in conservatism in our estimates. And as Buffett encourages:

The second lesson Buffett shared is on our expectations as we value stocks. More specifically, how frequently we’ll find our valuations useful:

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value.

…

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

— Warren Buffett

Essentially, we have to be patient and willing to look at many stocks to find good opportunities. As Peter Lynch put it:

So, what does Buffett recommend studying to be able to estimate earnings?

To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

— Warren Buffett

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The 3rd Question

While determining the risk-free interest rate is simple, as Buffett mentioned above, his approach to discount rates is quite different than what is commonly taught...

As mentioned above, most business schools teach complicated methods to come up with a discount rate. Methods Buffett has said make no sense to him.

Here's how Buffett thinks about discount rates, as he shared during Berkshire Hathaway’s annual meeting in 1996:

We basically think in terms of the long-term government rate.

And there may be times, because we don’t think we’re any good at predicting interest rates, but probably in times of…what would seem like very low rates we might use a little higher rate.

But we don’t put the risk factor in, per se, because essentially, the purity of the idea is that you’re discounting future cash. And it doesn’t make any difference whether cash comes from a risky business or a…so-called safe business.

So, the value of the cash delivered by a water company, which is going to be around for a hundred years, is not different than the value of the cash derived from some high-tech company, if any, that you might be looking at.

It may be harder for you to make the estimate. And you may, therefore, want a bigger discount when you get all through with the calculation. But up to the point where you decide what you’re willing to pay you may decide you can’t estimate it at all. That’s what happens with us with most companies.

But we believe in using a government bond-type interest rate. We believe in trying to stick with businesses where we think we can see the future reasonably well, you never see it perfectly, obviously, but where we think we have a reasonable handle on it.

And we would differentiate to some extent. We don’t want to go below a certain threshold of understanding. So, we want to stick with businesses we think we understand quite well, and not try to have the whole panoply with all different kinds of risk rates, because, frankly, we think that’d just be playing games with numbers.

…

[You're better off if you] just stick with businesses that you can understand [and] use the government bond rate. And when you can buy…something you understand well at a significant discount, then, you should start getting excited."

— Warren Buffett

In other words, rather than adjust his discount rate according to the perceived riskiness of the investment, he uses the long-term risk-free rate. And then he reduces his initial valuation estimate for more difficult-to-estimate businesses—or avoids those businesses entirely.

This is because he believes he's simply discounting the cash, and he uses the long-term government bond interest rate to generate the maximum value of the stock.

And he recommends pairing this approach with a minimum "threshold of understanding" of the business to ensure his answer to Question #1 is sufficiently high.

Conclusion:

Those are the 3 primary questions Buffett asks to value a stock. Let's recap:

Buffett’s 3 questions:

  1. How certain are you that there are indeed "birds in the bush?" (conviction in future earnings1 )

  2. When will they emerge and how many will there be? (timing and amount)

  3. What is the risk-free interest rate (which Buffett considers to be the yield on long-term U.S. bonds)?

To help determine the answers to the first two questions, Buffett recommends using ranges (rather than precise forecasts) and focusing on the economics of the business. He says to expect to look at many companies before occasionally finding one where we have high confidence in our valuation alongside a significantly undervalued stock.

Finally, Buffett uses the yield on long-term U.S. bonds to discount the cash from businesses and adjusts his initial valuation in proportion to his ability to forecast earnings. As such, he encourages us to stick to businesses we can easily understand and act boldly when undervalued stocks appear.

Well, that's it for this week.

I hope you found it valuable.

See you next Saturday.

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Footnotes:

1 — From Buffett's 1986 Berkshire Hathaway letter to shareholders: “If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charge…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”

Disclaimers

This material is not investment advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher. Additional disclaimers here.