Here’s a good step-by-step process to the Buffett Style of Investing. I should be clear – the Buffett Style of Investing is not the ONLY style. It’s one that I like to follow because I know it has worked and because it jives with common sense. You are free to evaluate businesses and stocks using any method (valuation is not a science) but if you’re in search for a method, this is a good place to start.
The following list of articles will get the ball rolling. They can be accessed from here or via the Educational Portal page where they are shown chronologically (from most recent first). Here, I’ve arranged them in the order I think you’ll find useful.
A Primer on Intelligent Investing
- What is Intelligent Investing?
- How Buffett Analyzes a Business
- The Buffett Valuation Method
- 10 things Buffett does differently
- The Buylyst on Risk
- School of Investing: Growth
- The Specometer
Links to each of these are on the right under the section "Related Worldviews".
Long story short: Obsess over cash flows. Obsess over getting those cash flow numbers right. Don’t worry about cost of capital too much. Don’t worry about projections. Think about “sustainability” of numbers. Enjoy the process. It’s mostly subjective.
The Cash Flow Waterfall
There are 4 broad steps to this method:
- What is the Free Cash Flow over the last 12 months?
- What are some reasonable Revenue growth expectations?
- What is a Sustainable Free Cash Flow over the long-term?
- What is a reasonable “hurdle rate” for your company?
I went through Question 1 in some detail in “A Comfortable Price”. So, I won’t repeat it here. I’ll briefly discuss Questions 2, 3 and 4.
I keep growth expectations simple. I only worry about Revenue. I break down Revenue into Price and Volume. And usually, I assume some level of Volume Growth. My expectations of Volume Growth are rooted in my Worldview – my analysis about the industry or sport that the company plays. If I can make some assumptions about Pricing Power, I do. But it’s really down to Price and Volume.
About the only other variable I “project” is EBITDA Margin. Instead of forecasting each cost line item, I make a reasonable assumption about EBITDA Margin (EBITDA divided by Revenue). Usually, I assume the same level as the last 12 months unless I expect significant cost improvements because of some specific actions taken by Management.
That’s it – make reasonable assumptions about:
- EBITDA Margin
Given no other salient data points, assume the same number for every other variable in the cash flow waterfall. You get to what I call a “sustainable” Free Cash Flow number. This is the crux.
Then we get to the “discount rate” question. I use 5%. I’ve discussed this in detail here. But the gist is that this is my assumption regarding any of these:
- Inflation + a margin of safety.
- A sure-shot investment – say a mutual fund of corporate bonds that yields about 5%. That’s a reasonable assumption over the long term.
- A 10% hurdle rate for my opportunity cost of other equity investments. But then I attach a 50% probability to the outcome. The Expected Return is roughly 5%.
- Buffett usually uses the long-term 30-year US Treasury rate. He adjusts that number up or down depending on his choices of investments at the time. He keeps it very simple.
On discount rate, you’re free to use whatever number you prefer. But the message is this: the greatest investor in the world keeps things simple. I would recommend that you do too.
The end-result is this: Apply a 15X to 20X multiple to your Sustainable Free Cash Flow number. If that valuation is significantly higher than the current Market Capitalization of the business, you’re on to something. If that’s the case, combined with your assessment that the business has a Competitive Advantage that’s Durable, with an effective Management Team…Lollapaloozza!