Warren Buffett's obscure valuation method

What is the true value of a business? While this question has plagued many generations of investors, if one man has cracked the code, it's Warren Buffett, arguably the greatest value investor.

Unsurprisingly, Buffett has amassed a fan following invested in uncovering how the man thinks. In one such attempt, Yefei Lu tries to decipher Buffett's unique valuation technique in his book "Inside the Investments of Warren Buffett."

What most value investors do
In the book, Yefei gives the example of See's Candies, a candy manufacturer, to explain Buffett's valuation approach.

As the handbook of value investing says (every investing handbook should say this), the first step is to determine the fair value of a business and apply a margin of safety.

See's Candies made a profit of $2.1 million in 1972. In his book, Yefei considered a fair price multiple (P/E) of 10 to arrive at the fair value for See's Candies.

Thus, fair value = $2.1 million x 10= $21 million.

Now, let's assume we want a margin of safety of 30 per cent.
That means, the amount we are willing to pay = $21 x (100 - 30 per cent) = $14.7 million

But here's the conundrum. What if you have the opportunity to purchase the business at $21 million, its fair value? Will you let go of this opportunity or forego your margin of safety?

Neither, if you are Warren Buffett.

How Warren Buffet does it
According to Yefei, instead of applying the margin of safety on the fair value, Buffett would first enquire if the company can deliver a growth rate that can push its fair value to $21 million while satisfying a 30 per cent margin of safety.

Thus, if the amount we are willing to pay after accounting for a 30 per cent margin of safety = $ 21 million
then,
the new fair value = $21 million x 100/(100-30)= $30 million.

From here, we can estimate the growth rate required to justify this new fair value. To do that, Yefei uses the following simple perpetuity formula in his book:

New intrinsic value = Current earnings / (discount rate - growth rate)

So, in the case of See's Candies, we have

$30 million = $2.1 million / (10 per cent - growth rate)
growth rate = 3 per cent

Note: A discount rate of 10 per cent is used to represent the interest rate in 1972.

Thus, if See's Candies' earnings grow by 3 per cent each year, one can pay $21 million and still have a 30 per cent margin of safety.

The drawbacks
Buffett's method is highly effective if you have an in-depth understanding of a company's business model and are willing to take the risk that it will grow at the required rate.

However, investors should note this method is not without its limitations.

First, Buffett studied the See's Candies business and, based on his expert judgement, concluded that it could deliver growth of 3 per cent. But sustaining a 3 per cent growth rate every year is no child's play.

Second, growth requires additional capital. Yefei notes that See's would have burned up one-quarter of their 3 per cent earnings growth to finance the growth itself. Thus, it would actually need a 4 per cent growth per annum.

In addition, this method doesn't account for the fact that a company's capital requirement might change (increase or decrease) in the future, impacting growth.

Who should use it
If you wish to use this method for your analysis, we recommend that you first develop a good understanding of the business you are analysing. Buffett's method heavily relies on an in-depth understanding of the company's prospects and capabilities. Playing around with numbers just to arrive at a growth rate might burn your returns.

Suggested read: Six parameters to look for in a company before investing