Why Warren Buffett never calculates a DCF

And how you can stop doing them too

Any value investor will tell you that the actual value of any investment is its future cash flows discounted for time. It’s basically our religion, and it has led to a whole cult of precisely calculating values of stocks using discounted cash flows (DCFs).

But this leads us to a conundrum. The greatest value investor of all time, Warren Buffett, doesn’t calculate the discounted value of cash flows. His partner Charlie Munger has never seen him do a DCF in the 60+ years that Munger has known him.

Charlie Munger: Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.

Warren Buffett: It’s true. If [the value of a company] doesn’t just scream out at you, it’s too close.

So why doesn’t Buffett use DCFs?

Calculating a DCF is not straightforward, there are more than a few choices to be made and it can be very complex.

You need to answer quite a few questions that it is difficult to have accurate answers for. How long will earnings grow? How fast will they grow? When will its earnings end? What is the risk free rate of return? What is the companies weighted average cost of capital?

But Warren isn’t skipping DCFs because they are work, he’s skipping them because they have a false level of precision.

Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.

Buffett: The priesthood has to look like they know more than “a bird in the hand.” You won’t get tenure if you say “a bird in the hand.” False precision is totally crazy. The markets saw it in the Long-Term Capital Management [hedge fund] in 1998. It only happens to people with high IQs.

One of the biggest problems with a DCF calculation is that the output can vary wildly based on fairly subtle changes in the input assumptions. Using a simple DCF calculator as an example¹, and:

1. Starting with a business earning $10 a share, growing 15% a year for the next 5 years, 5% after that and with the expected market return set to 11%, the calculation yields a value of: $264.56.

2. Now change the growth period to 10 years and the value changes to: $371.46

3. Finally reduce expected market return to 9% and the value changes to: $584.45

The art of value investing is primarily in never trying to fool the person you can most easily fool, yourself. If you fall in love with a business, a DCF calculation gives you an infinity of levers to produce the valuation needed to justify buying it.

So how does Warren Buffett produce Intrinsic Value estimates?

He’s never been too specific about what he does. But if you read Buffett’s writings and watch the Q & A from his annual meetings, he almost always starts by thinking about earnings yield. This means he looks at how much a business earns² and what that would yield him given the current stock price. For example a $100 stock earning $10 a share after tax is yielding 10%.

Then he estimates a reasonable future growth rate for those earnings. He'll accept a lower yield for earnings growing faster, but is always open to a higher yield on something growing slower.

Example: in 2016 he started buying AAPL at around a split adjusted $24 when the previous year had $2.32 in GAAP earnings (a 10 PE). Thats about an 9.7% yield, very good but not nearly as high as the returns he’s looking for (probably 15-20% annualized). So he needed AAPL to grow EPS to reach his return target and historically it done so. Over the previous five years EPS had grown 18% annualized.

If Warren thought he was getting a future growth of 15% annualized growth in Apple EPS, he knew even if Apple’s PE remained low, he'll still make 15% a year. .

But none of this would matter

1. If he didn't think Apple had a strong moat, which would mean its future growth in earnings would be at risk from competitors or consumer preference changes.

2. If he thought management managed capital poorly. Warren clearly understood he could trust Tim Cook to buyback stock and pay dividends appropriately.³

3. If he thought the earnings were overstated, the financials misleading, etc.

Most importantly he knew his upside was that if Apple’s PE increased to a more deserving ratio for it’s growth, he’d earn significantly more than 15% annualized returns. And that’s what happened. Right now Apple is trading around a 21 PE, giving Buffett returns roughly double the seven year 15% annualized EPS growth.

Warren teaches us that the key skills in value investing aren’t in producing complex Excel spreadsheet models to model future cash flows. Far more important is time spent researching each business to determining why its worth owning and what it’s most concerning risks are.

1. Note that this calculator uses market benchmark rates instead of a risk free discount rate, why I’m not sure. So while the values it generates are questionable, the changes in the those values are still illustrative of how wildly DCF output valuations change from relatively minor input changes.

2. Its important to note that Buffett doesn’t use GAAP earnings. He uses “owner earnings” where he makes adjustments to calculate the earnings that he could put into your pocket if you owned the company outright. Maybe the companies depreciation schedules are too aggressive, so he would actually need to reinvest more over time. Or cash flow is overreported because the company gives out large numbers of stock options to employees.

3. Besides Tim Cook’s strong record of dividending out earnings and buying back stock, Analysts have historically pushed Apple to make speculative large acquisitions such as Tesla, TMobile and Netflix, and Tim Cook has always declined.