Video Link: https://youtu.be/-rDWOyGXSdg
In this episode, Warren Buffett was asked when he assess a business and derive its intrinsic value, how does he estimate the future growth of the business and decide what margin of safety to use?
In this episode, you’ll learn:
How to use Margin of Safety?
How does Warren Buffett use Margin of Safety in the insurance business?
To check out all Collection: Warren Buffett <click here>
~ Please visit the site above for full video of Berkshire Hathaway Annual Meeting.
AUDIENCE MEMBER 00:00
Good morning. I’m Marc Rabinov from Melbourne, Australia.
Mr. Buffett and Mr. Munger, I’d like to ask you, when you assess a business and derive its intrinsic value, how do you estimate the future growth of the business, and how do you decide what margin of safety to use? Thank you.
WARREN BUFFETT 00:24
It was the future growth and what, Charlie?
CHARLIE MUNGER 00:28
Well — I have difficulty understanding that question fully. He’s talking about how do we combine our estimates of future growth with our passion for having a margin of safety. Surely, you can handle that. (Laughter)
WARREN BUFFETT 00:49
Well, I can certainly handle it as well as you can. (Laughter)
Every time he laterals them off to me, you know, he calls those audibles. (Laughter)
You calculate — I think you take all of the variables and calculate them reasonably conservatively. But you don’t try and put too much windage in at every level.
And then when you get all through, you apply the margin of safety. So I would say, don’t focus too much on taking it on each variable in terms of the discount rate and the growth rate and so on. But try to be as realistic as you can on those numbers, but with any errors being on the conservative side. And then when you get all through, you apply the margin of safety.
Ben Graham had a very simple formula he used for just the most obvious situations, which was to take working capital — net working capital — and try and buy it at a third off working capital. And overall, that worked for him. But that method sort of ran out of steam when the sub-working capital stocks disappeared.
But it’s the same thing we do in insurance. I mean, if we’re trying to figure out what we should charge for, we’ll just say, the chances of a 6.0 earthquake in California, well, we know that in the last century, I think that there have been 26 or so 6.0 or greater quakes in California.
And let’s forget about whether they occur in remote areas, let’s just say we were writing a policy that paid off on a 6.0 or greater quake in California, regardless of whether it occurred in a desert and did no damage or anything.
Well, we would look at the history and we’d say, “Well, there’ve been 26 in the last century.” And we would probably assume a little higher number in the next century, that’d just be our nature. But we wouldn’t assume 50. If we did, we wouldn’t write any business.
So we would — we might assume a little higher. I would, if I was pricing it myself, I’d probably say, “Well, I’ll assume there are going to be 30, or maybe 32, or something like that.”
Then when I get all through, I’ll want to price the — I’ll want to put a premium on it that now puts in a margin of safety. In other words, if I figured the proper rate for 32 is a million dollars, I would probably want to charge something more than a million dollars to build in that margin of safety.
But I don’t want to hit it at — I want to be conservative at all the levels and then I want to have that significant margin of safety at the end.
And I guess that, as I understand the question, that’d be my answer. And Charlie, do you want to add to that?
CHARLIE MUNGER 03:29
Yeah, that book, “Deep Simplicity,” that I recommended to you says that you can predict out of those 26 earthquakes how the size will be likely to be allocated.
In other words, there’s a standard power law that will tell you the likelihood of earthquakes of varying sizes. And of course the big earthquakes are way less likely than the small ones.
So you count the math and you know the applicable power law and you guess as to how much damage is going to — it’s not that difficult.
WARREN BUFFETT 04:11
It becomes more difficult if somebody said they really want protect against a 9.0 or something like that. You know, is it one in 300 years? Is it one in a thousand years? You know, when you get really off the data points.
But that is not what you’re looking at in investments. You don’t want to look at the things that are that — you don’t want to come up with the companies where you make the assumptions that get that extreme.
And you don’t have to, that’s the beauty about investments. You only have to look at the ones that you feel capable of evaluating and you skip all rest.