## Like a Bond – Redux

I had left my discussion of “How Buffett Analyzes Businesses” with the notion that he evaluates stocks in very bond-like fashion. This is mind-blowing to a lot of people. Students (including me) have been taught about the stark differences between stocks and bonds, using fancy statistics and intellectual frameworks like the Modern Portfolio Theory. Yes, stocks and bonds are different, obviously. A bond pays a fixed coupon, usually every 6 months, all through the end of a fixed term, at which point you get your full Principal paid back in full. Generally, pretty safe – that’s why they call it “Fixed Income”. Equities are inherently unsafe, because there is no “fixed income” (other than dividends, but they’re not contractual), and your Principal is tied directly to the fate of the company.

You can imagine, then, the valuing a Bond is a lot easier than valuing at Stock – mathematically, at least. Wouldn’t it be nice to be able to value a stock like a bond? Well, that’s what every Discounted Cash Flow (DCF) Equity Valuation model attempts to do. The difference is that stocks have many more randomly moving parts. No fixed terms. No fixed coupons. No money-back guarantee.

In bonds, we know these quantities:

- The Coupon
- The Term - the lifespan of the Bond.
- The Purchase Price
- The Principal we get back.

We punch these into a calculator and get a Yield-to-Maturity (or Yield, for the sake of simplicity). This is the “annualized” rate of return we would get we hold the bond though the end of its term. Now, the Yield could be more or less than the Coupon rate. If we buy a bond at less than 100 cents on the dollar (the dollar representing the Principal), then Yield > Coupon Rate. If we buy a bond at more than 100 cents on the dollar, Yield < Coupon Rate. If we buy at exactly 100 cents on the dollar, Yield = Coupon Rate.

That’s Bond Math 101 for you. In Equity Valuation, there are literally no known entities except the Purchase Price. That’s the only irrefutable numbers. And, of course, if there is a dividend (but that’s not contractual, and a lot less certain than coupons). Here are the variables:

- Purchase Price – the only given quantity.
- Free Cash Flow – assumption.
- The Term – usually assumed to indefinite.
- Discounting Factor – big assumption!

#4 is where Buffett and most of the investment community have a difference of opinion. We’ll get into that later. But here’s a key point between Bond and Equity Valuation:

Mathematically, Bond Yield = Equity Valuation Discounting Factor. The difference is that in a Bond Yield is a calculation. In an Equity DCF model, it’s an input. There are some fancy formulas used to calculate this input. But it is an assumption. So, you wouldn’t be wrong is suspecting that there is some sort of circular loop going on here.

Here’s a dirty truth about Equity DCF models: You can change any input to justify an output that you desperately want to be true. The numerator and denominator are subjective assumptions disguised as scientific calculations. You can change the numerator (Free Cash Flow) or the denominator (Discounting Factor) to justify the desired output (Intrinsic Value). Needless to say, Equity Valuation can be gamed, which means it requires tremendous self-control. This is the real, quantitative representation of “take your emotions out of the equation…”.

Long story short: you can obsess over the Free Cash Flow or the Discounting Factor or both. Buffett likes to obsess over Free Cash Flow – the numerator. His approach on the denominator is surprisingly simple – he doesn’t do any calculations there.