Buffett’s “Discounted Cash Flow Model”

This is Part 6 of a Series. Go to Part 5: Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.

And then he took all the historical data, quarter-by-quarter, for every single plant; he got this similar information as best he could from every competitor they had and he filled pages with little hand scratches of all this information and he studied that information and then he made a yes/no decision. He looked at it: they were getting 36% margins, they were growing over 70% a year on a million of sales. So that's where he looked at the historic numbers in great detail, just like a horse handicapper studying the tip sheet. And then he said to himself: I want a 15% rate of return on 2 million of sales. And then he said: Yeah I can get that.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.

And it's a very simple thing, there's nothing fancy about it. And I think that's another important lesson because he's a very simple guy. He doesn't do any discounted cash flow models or anything like that for decades. He just says: I want a 15% day one return on my investment and I want it to grow from there. And the 2 million dollars of sales was pretty simple too. It had a million, it was growing 70%. There was a great margin of safety built into these numbers. It had a 36% profit margin. He said: I'll take half of that. Continue to Part 7: Phil Fisher-Type Growth Company at a Ben Graham-Like Price