AUDIENCE MEMBER 00:00
Mr. Buffett, Mr. Munger, [thank you again for being so generous with your time with us every year.
I’d like to follow up on the question from the gentleman from Australia and from Munich on valuation.
The gentleman from Australia asked about margin of safety, and you replied that a superior business may not require that much of a margin of safety.
And my follow-up would be, does that suggest market rate of returns going forward for superior businesses?
And then on the Munich valuation, in which you cited a farm example on discounted cash flows,] I’m very curious how you come up with your discount rate and how you might adjust that discount rate based upon various businesses.
You might want to discuss your discount rates used for Coca-Cola, J&J, or some of your past investments. Thank you.
WARREN BUFFETT 00:19
Yeah. We don’t formally have discount rates. I mean, every time I start talking about all this stuff, Charlie reminds me that I’ve never prepared a spreadsheet. But I do, you know, in effect, in my mind I do.
But we are going to want to get a significantly higher return, obviously — in terms of cash produced relative to the amount we’re outlaying now for a business — than we are from a government bond.
I mean, we — you know, we are going to — that has to be the yardstick at a base. And how much more do we want?
Well, if government bond rates were 2 percent, we’re not going to buy a business to earn 3 or 3 1/2 percent expectancy over the years. We just don’t want to commit our money that way. We’d rather sit around and wait a little while.
If they’re 4 3/4 percent, you know, what do we hope to get over time? Well, we want to get a fair amount more than that.
But I can’t tell you that we sit down every morning and I call Charlie in Los Angeles and say, “What’s our hurdle rate today?” I mean, we’ve never used the term.
You know, it’s a little bit of the — we want enough so that we feel very comfortable if they closed down on the stock market for a couple of years, if interest rates go up another hundred basis points or 200 basis points, we’re still happy with what we’ve bought.
And above that, I really — I know it sounds kind of fuzzy, but it is fuzzy.
CHARLIE MUNGER 01:52
Yeah. The concept of a hurdle rate makes nothing but sense, and yet a lot of terrible errors are made by people who are talking about hurdle rates.
Just because you can measure something and guess it, doesn’t mean that it’s the controlling variable in what you’re dealing with in a messy world.
And I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about why one is better than another and what the likely returns are from each, et cetera, et cetera.
And the trouble with the hurdle rate concept — not that we don’t have one, in a sense — is it doesn’t work as well as a system of comparing things.
In other words, if I have something available that I think will give me 8 percent for sure and I can buy all I want of it, and you’ve got a perfectly good investment that I think will earn 7, I don’t have to waste 5 minutes with you.
You’re like the mail order service offering the bride through the mail and she’s got AIDS. You know, I can go on to some different subject.
And so this — the concept of opportunity cost is — it’s so little taught in investment. They teach it in the freshman course in economics in all the major universities, but when you get to the corporate finance departments and so forth, it doesn’t lend itself with the kind of mathematics they want to use, so they ignore it.
But in the real world, your opportunity costs are what you want to make your decisions based on.
WARREN BUFFETT 03:40
Yeah. And even if you had something you were really familiar with and were very sure on the 8 percent, 8 1/2 wouldn’t tempt you if somebody came along, as a practical matter.
CHARLIE MUNGER 03:49
WARREN BUFFETT 03:51
As I mentioned, I’ve been on 19 corporate boards. I would say that of the presentations I’ve seen — and I’ve seen a lot of them — and every one of them had a calculation of internal rate of return, if they’d burned them all, the boards would have been better off.
I mean, there’s so much nonsense presented, because the presenters, essentially, know what the listeners are desirous of hearing, and what is needed in order to get through something the CEO wants to do anyway — you just get nonsense figures.
And, you know, we may get nonsense figures, too, but they’re ours, and we — (Laughs)
CHARLIE MUNGER 04:33
Let me give you an example of that. I have a young friend who sells private partnership interests to investors. And he’s in a really tough field where it’s hard to get decent returns.
And I said, “What return do you tell them you’re aiming for?” And he said, “20 percent.” And I said, “How did you pick that number?” And he said, “If I chose any lower number, they wouldn’t give me the money.” (Laughter)
WARREN BUFFETT 05:01
And there’s no one in the world we think can earn 20 percent with big money. I mean, it just — so anybody making a promise like that, basically, we’re going to write off immediately.
It’s amazing to me what — you know, in a sense, how gullible big investors are, pension funds and so on, in that they have people come around and promise them the Holy Grail.
And they want it so badly, you know, that they’re willing to believe things that just have to be nonsense.
Let’s go to number 9.
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Buy when you feel very comfortable even if the stock market closed down for a couple of years or interest rates go up causing the risk-free investment to go up in returns and you are still comfortable holding it because your investment still generates a higher return.
Your discount rate is determine by your opportunity cost.