Warren Buffett's way 3

John Burr Williams

Williams's theory, known today as the dividend discount model, or DCF analysis, provides a way to put a value on a stock or a bond. it can be reduced to very simple precept: to konw what a security is worth today, estimate all the cash it will earn over its lifetime and then discount that total back to a present value. it is the underlying methodology that Buffett uses to evaluate stocks and companies.

Buffett condensed Williams's theory as: the value of a business is determined by the net cash flow expected to occure over the life of the business discounted at an apporopriate interest rate. Williams described it this way: A cow for her milk, a hen for her eggs and a stock, by heck, for her dividends.

As for discount rate, Buffett's measuring stick is very straightforward: he uses either the interest rate for long-term US bonds, or when itnerest rates are very low, he uses the average cumulative rate of return of the overall stock market. becuase he limits his purchases to those with Ben Graham's margin of safety, Buffett ensures that using a risk-free rate for discounting is appropriate.

Charles Munger

financial knowledge, background in law and appreciation of lessons from other disciplines produced in Munger a somewhat different investment philosophy from that of Buffett. whereas Buffett was still seraching for opportunities at bargin prices, Munger believed in paying a fair price for quality companies. Convinced by Munger, Buffett said: it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

one reason that Buffett and Munger fit so well is that both men possess an uncompromising attitude toward commonsense business principles. Like Buffett, who endured poor returns in the insurance industry and for a time refused to write policies, Munger, as CEO of Wesco, refused to make loans when confronted with an unruly savings and loan industry. Both exhibit managerial qualities necessary to run high-quality business.