Determining Fair Value

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Determining Fair Value

Warren Buffett determines the attractiveness of a company’s price by comparing it with his estimate of the company’s value. To determine value, he estimates the company’s future cash flows and discounts them at an appropriate rate. Discounting is necessary because $1,000 today is worth more than $1,000 received after one year. If an investor can earn 6% interest on his or her money, then $1,000 today is worth $1,060 in one year. Conversely, an expected $1,000 cash flow one year from now is worth only $943.40 today, because $943.40 earning 6% grows to $1,000 in one year.

Where it originated

This discounted cash-flow valuation method was described by John Burr Williams in his 1938 book, The Theory of Investment Value. It is used by countless investment professionals, so Buffett’s approach to valuation is not a competitive advantage. However, his ability to estimate future cash flows more accurately than other investors is an advantage.

You needn’t be a genius to succeed at investing

Another part of his edge may be due to his sharp mind, but Buffett insists that successful investing doesn’t require a high IQ; it depends more on a successful framework and having the proper temperament. Buffett succeeds largely because he focuses his efforts on companies with durable competitive advantages that fall within his circle of competence. These are key features of his investing framework.