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Collection: Warren Buffett - #95 Investing 'Avoid Frozen Corporation'



Good afternoon, gentlemen. My name is George Donner from Fort Wayne, Indiana. My question has to do with estimating the intrinsic value of a company, in particular the capital intensive companies like you were mentioning. I’m thinking of things like McDonald’s and Walgreens, but there are lots of others where you have a very healthy and growing operating cash flow, but it’s marginally or completely offset by heavy expenditures on putting up new stores or restaurants, or building a new plant. And so my question is, what do you do for your estimate of future free cash flow? And with Treasury around — long Treasury around 6 percent — at what rate do you discount those cash flows? WARREN BUFFETT 01:07

Well, we discount at the long rate just to have a standard of measurement across all businesses. But we would take the company that is spending the money as it comes in, and they don’t get credit for gross cash flow, they get credit for whatever net cash is left every year. But of course, if they’re spending the money wisely, even though you have to discount it for more years, the growth in cash development should offset that or they weren’t investing it wisely. The best business is one that gives you more and more money every year without putting up anything to get it, or very little. And we’ve got some businesses like that. The second-best business is a business that also gives you more and more money. It takes more money, but the rate at which you invest — reinvest — the money to get that growth is a very satisfactory rate. The worst business of all is the one that grows a lot, and where you’re forced — forced, in effect — forced to grow to stay in the game at all, and where you’re reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing about it. But in terms of discounting, in terms of calculating intrinsic value, you look at the cash that is expected to be generated and you discount back at — in our case, we use the long-term Treasury rate. That doesn’t mean that you pay the amount that present value calculation leads to, but it means that you use that as a common yardstick, that Treasury rate. And that means that if somebody is reinvesting all their cash flow the next five years, they’d better have some very big figures coming in down the road. Because at some day, a financial asset has to give you back cash to justify you laying out cash for it now. Investing is the art, essentially, laying out cash now to get a whole lot more cash later on, and something at some point better deliver cash. Ben Graham in his class, we used to talk about what he called the Frozen Corporation. And the Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold and —


Sort of like a Hollywood producer. WARREN BUFFETT 03:30

Yeah. (Laughter) And the question was, what was such an enterprise worth? Well, that’s sort of a theoretical question, but it forces you to think about the realities of what business is all about. And business is all about putting out money today to get back more money later on. Charlie? CHARLIE MUNGER 03:52

I do think there is an interesting problem that you raise, because I think there is a class of businesses where the eventual cash back part of the equation tends to be an illusion. I think there are businesses where you just keep pouring it in and pouring it in, and then all of a sudden it doesn’t work, and no cash comes back. And what makes our life interesting is trying to avoid those and get in the alternative kind that drowns you in cash. WARREN BUFFETT 04:27

The one figure we regard as utter nonsense is the so-called EBITDA. I mean, the idea of looking at a figure before the cash requirements and merely staying in the same place — and there usually are — any business with significant fixed assets almost always has with it a concomitant requirement that major cash be reinvested in order simply to stay in the same place competitively and in terms of unit sales — to look at some figure that is before — that is stated before those cash requirements, is absolute folly and it’s been misused by lots of people to sell lots of merchandise in recent years. CHARLIE MUNGER 05:12

It’s not to the credit of the investment banking fraternity that it has learned to speak in terms of EBITDA. I mean, the idea of using a measure that you know is nonsense, and then piling additional reasoning on that false assumption, it’s not creditable intellectual performance. And once everybody is talking in terms of nonsense, why, it gets to be standard. (Laughter) WARREN BUFFETT 05:47

Zone 7, please.


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