122 THE WARREN BUFFETT WAY
Theoretically, investors make their decisions based on the differ-
ences between price and value. If the price is lower than its per share
value, a rational investor will decide to buy. If the price is higher than
value, any reasonable investor will pass.
As the company moves through its economic life cycle, a savvy in-
vestor will periodically reassess the company’s value in relation to mar-
ket price and will buy, sell, or hold shares accordingly.
In sum, then, rational investing has two components:
- Determine the value of the business.
- Buy only when the price is right—when the business is selling at
a signif icant discount to its value.
CALCULATE WHAT THE BUSINESS IS WORTH
Through the years, f inancial analysts have used many formulas for de-
termining the intrinsic value of a company. Some are fond of various
shorthand methods: low price-to-earnings ratios, low price-to-book
values, and high dividend yields. But the best system, according to Buf-
fett, was determined more than sixty years ago by John Burr Williams
(see Chapter 2). Buffett and many others use Williams’s dividend dis-
count model, presented in his book The Theory of Investment Value,
as the best way to determine the value of a security.
Paraphrasing Williams, Buffett tells us that the value of a business is
the total of the net cash f lows (owner earnings) expected to occur over
the life of the business, discounted by an appropriate interest rate. He
considers it simply the most appropriate yardstick with which to mea-
sure a basket of different investment types: government bonds, corpo-
rate bonds, common stocks, apartment buildings, oil wells, and farms.
The mathematical exercise, Buffett tells us, is similar to valuing a
bond. The bond market each day adds up the future coupons of a
bond and discounts those coupons at the prevailing interest rate; that
determines the value of the bond. To determine the value of a busi-
ness, the investor estimates the “coupons” that the business will gener-
ate for a period into the future and then discounts all these coupons
back to the present. “So valued,” Buffett says, “all businesses, from