Investing Guidelines: Value Tenets 123manufacturers of buggy whips to operators of cellular telephones, be-
come economic equals.”^2
To summarize, then, calculating the current value of a business
means, f irst, estimating the total earnings that will likely occur over the
life of the business; and then discounting that total backward to today.
( Keep in mind that for “earnings” Buffett uses owner earnings—net
cash f low adjusted for capital expenditures, as described in Chapter 7.)
To estimate the total future earnings, we would apply all we had
learned about the company’s business characteristics, its f inancial
health, and the quality of its managers, using the analysis principles de-
scribed thus far. For the second part of the formula, we need only de-
cide what the discount rate should be—more on that in a moment.
Buffett is f irm on one point: He looks for companies whose future
earnings are as predictable, as certain, as the earnings of bonds. If the
company has operated with consistent earnings power andif the busi-
ness is simple and understandable, Buffett believes he can determine its
future earnings with a high degree of certainty. If he is unable to proj-
ect with conf idence what the future cash f lows of a business will be, he
will not attempt to value the company. He’ll simply pass.
This is the distinction of Buffett’s approach. Although he admits
that Microsoft is a dynamic company and he regards Bill Gates highly
as a manager, Buffett confesses he hasn’t a clue how to estimate the fu-
ture cash earnings of this company. This is what he means by “the cir-
cle of competence”; he does not know the technology industry well
To properly value a business, you should ideally take all the
f lows of money that will be distributed between now and judg-
ment day and discount them at an appropriate discount rate.
That’s what valuing businesses is all about. Part of the equation
is how conf ident you can be about those cash f lows occurring.
Some businesses are easier to predict than others. We try to
look at businesses that are predictable.^3
WARRENBUFFETT, 1988