In 2011, Warren Buffett discussed the merits of investing in the entire world’s gold supply (picture a cube of gold weighing about 170,000 metric tons with sides 68 feet long sitting comfortably in the infield of a minor league ballpark) as opposed to investing in all U.S. cropland plus 16 Exxon Mobils (XOM). As time passes, Buffett argues, the cropland and Exxon Mobils will go on to deliver staggering amounts of output in the form of corn, wheat, cotton and trillions of dollars of dividends, while the cube of gold will be unchanged, still sitting in the baseball infield, still unable to produce anything. “You can fondle the cube, but it will not respond," he wrote in his 2011 letter to Berkshire Hathaway (BRK.B) shareholders.
Thus, Buffett would pick the productive assets of pile B, the cropland and Exxon Mobils, over the cube of gold. Productive assets, he tells us, can be in the form of a business whether through stock purchases or outright ownership, farms and real estate. “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM) and our own See’s Candy meet that double-barreled test," he wrote in the letter.
These assets can be turned into economic equivalents using the correct valuation techniques. A price tag can be established and a rate of return can be determined. Ultimately, by being in the right forest (productive assets) and by correctly evaluating these assets, investors can achieve higher rates of return.
Measuring Productivity Through Traditional Valuation Methods
Berkshire and Buffett prefer to buy businesses outright, but when they can’t, they will buy sizeable chunks of businesses through stock purchases in companies such as IBM, American Express (AXP) and Coca-Cola. In the world of Buffett and Benjamin Graham, the father of value investing, stock investing is most intelligent when it is most business-like and the investor should treat a stock purchase as if represented the entire business.
Typical valuation gauges for the purchase of a business include book value (the value of all assets minus all debts), comparable market value (using recent sales data of equivalent businesses to establish a price, similar to the comparable market analysis performed for residential real estate) and a cap-rate valuation that takes the earnings of the business, either the most recent year or an average of a given number of preceding years, and divides them by a capitalization rate. The capitalization rate is based on risk and expected return. For example, if a barber shop has averaged earnings of $20,000 over the past five years and it is determined that the capitalization rate should be 20%, then the value of the business will be $20,000 /0.20, or $100,000.
Cash Flow for Rental Property
For rental property, the typical valuation metrics include a comparable market analysis (residential property is normally valued using this method, and it proves fairly useless for rental property because it doesn't account for earnings); reproduction value, or the cost to replace the building; an earnings capitalization approach (the same as the cap rate calculation for a business); a gross rent multiplier calculation and a monthly cash-flow statement analysis.
The gross rent multiplier is simply the gross annual rents of a property multiplied by a factor that represents the potential for “cash flow.” The rule of thumb is that a property will produce a cash flow at a multiple of seven; a property with gross annual rents of $20,000 will most likely yield a cash flow at a price of $140,000 ($20,000 x 7). This calculation is useful in filtering out properties for further analysis, but holistically it is very blunt, and a more detailed projected income statement is typically developed. This detailed income statement accounts for rental incomes, vacancy rates, property management fees, repairs and maintenance, yard work, miscellaneous, reserves, loan payment, insurance and property taxes. The resulting earnings, or “cash flow,” is then divided by the down payment in order to determine a cash on cash return on investment.
Two key advantages to property investing include the use of increased returns through leverage and “phantom” cash flow add-back in the form of the non-cash item of depreciation. Return on invested capital is a more useful metric when comparing rental property to stock investments.
Farmland is typically valued using a rent capitalization calculation since according to croplife.com,“more than 50% of farmland in the Midwest is currently rented.” Thus a parcel of farmland that rents for $500 an acre will be valued at $12,500 an acre if the capitalization rate is 4%. ($500 /0.04). This capitalization rate is based on long-term interest rates.
Creating Economic Equivalents Using the Discounted Cash-Flow Model
The true intrinsic value of a productive asset as detailed in Buffett’s 1992 letter to Berkshire Hathaway shareholders was set forth by John Burr Williams over 50 years ago in The Theory of Investment Value. “The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset,” Williams wrote. This intrinsic value can be calculated using the discounted cash-flow model which will result in a single dollar value that in turn can be compared with the asset’s current price to arrive at a rate of return. This rate of return turns all of our asset classes into economic equivalents.
Owner Earnings and Growth Rates
So, how does one determine all of the inflows and outflows expected to occur during the remaining life of the asset? Simple: You first determine an earnings base value (in the world of Buffett, that would be owner earnings which is net income plus depreciation and amortization minus capital expenditures) and then grow this value by a reasonable rate of growth. The growth rate is segmented into a first stage and a second stage where the first stage is the rate of growth that is expected to continue over the next five to 10 years, and the second stage is a residual rate that is expected to occur after growth tapers off to a moderate level.
For the first stage, the growth rate used can be the historic 10-year earnings growth rate for the asset in question. To determine the historic earnings growth rate of any asset, simply use the time value of money calculation for rate, or I/Y, using the earnings from 10 years ago as the present value, the most recent year’s earnings for the future value and 10 for the number of years. If you are confident that earnings will continue on this trajectory for the next five to 10 years, then use this rate for the first-stage growth rate.
For the second-stage rate, the residual rate, a common approach is to use “the long-term nominal growth rate in the general economy of the company’s home country." according to Robert Hagstrom, author of the The Warren Buffett Way. For example, the long-term economic growth rate of the United States is 5%.
Predictability is key in using the discounted cash-flow model. The asset in question must have a consistent record of earnings in order to project future earnings with any degree of confidence. Additionally, the variables in the model are like knobs on the Hubble space telescope: adjust them but a little and you are looking at an entirely different universe.
The Discount Rate
The discount rate is the rate used to discount all future earnings back to a present value. Think of it as the opportunity cost of investing in the asset at hand; instead of purchasing farmland, you could buy a Treasury bill. The value that Buffett uses is the risk-free rate, which is the 30-year T-bill rate, now at 3%. Others add to this rate an equity risk premium which accounts for risk. This value can be found on the website of Aswath Damodaran, professor of finance at New York University The rate now stands at 6.12%. Thus, the total discount rate will be 9.12%.
Calculate Intrinsic Value
The previous inputs are all entered into a discounted cash-flow model, and the net present value of all of the future cash flows is calculated. This net present value is the intrinsic value of the asset, and it can be compared to its selling price—whether it is the stock price, price tag of the business, price tag on the building or the price per acre—in order to determine a margin of safety.
Margin of Safety
As defined by Buffett’s mentor, Benjamin Graham, margin of safety is the difference between the current price of the asset and the calculated intrinsic value of the asset. Margin of safety can be thought of this way: If you need to build a bridge that will be used by trucks weighing 50,000 tons, then build a bridge that will hold trucks weighing 100,000 tons. A large margin of safety provides a safety net for errors and deviations in the intrinsic value calculation. According to Buffett, the three most important words in investing are margin of safety.
Margin of safety can be found by dividing the asset’s calculated intrinsic value by the price of the asset and subtracting 1. All else equal, an asset with a margin of safety of 75% has a much wider safety net than an asset with a margin of safety of 25%.
The Land of Economic Equivalents—Rate of Return
In order to determine the asset’s rate of return, you simply change the discount rate in the discount cash-flow model until the calculated intrinsic value is equal to the selling price of the asset. For example, if American Express’ intrinsic value is calculated to be $172.08 per share using a discount rate of 9.12% and its current price is $71.73, then adjusting the discount rate to 14.6% will result in an intrinsic value of $71.73 which is the same as the selling price. This means that based on the model built that the American Express investor can expect an annual rate of return of 14.6%. This rate of return makes for easy comparison across asset classes and facilitates the effective deployment of capital. Thus, whether the output is Coca-Cola, chocolate, living space or cotton, the discounted cash-flow model reduces disparate assets to economic equivalents.
A Bird in the Hand
According to Buffett in his 2000 annual letter to shareholders, the formula for valuing all assets that John Burr Williams laid out in The Theory of Investment Value was correctly identified by Aesop in 600 B.C—“a bird in the hand is worth two in the bush.” That axiom needs to be modified with four questions: How certain are you that the birds are in the bush, when will they emerge, how many will there be and what is the risk-free interest rate? (The yield on long-term U.S. T-bills.) All of these variables are captured in the discount cash-flow model. “If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars," Buffett wrote in the shareholder letter.
This law according to Buffett is immutable. It applies to the “outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. … Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe," Buffett wrote.
The Bottom Line
“Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce,” Buffett wrote in his 2011 shareholder letter. As it relates to the individual investor, identifying these productive assets over a cube of gold and mastering the model that transforms them into economic equivalents leads to intrinsic value. That leads to margin of safety which leads to higher rates of return.