2009: Does Buffett do 10-year DCFs or simply normalize free cash flow?

AUDIENCE MEMBER: Yeah, thank you, Mr. Buffett and Mr. Munger. My name’s Rick Franklin (PH). I’m from St. Louis, Missouri. I’d like to follow up on the microphone 1′s question on financial literacy. And my own question from two years ago on your discount rate.

But before I do that, I hope you’ll indulge me. Torstol’s (PH) wife, Rosemary Coons (PH), if you could come to section 222. I found your husband. (Laughter)

You can come to microphone 2, if that’s easier.

WARREN BUFFETT: You get a little of everything here. (Laughter)

AUDIENCE MEMBER: So my question is, free cash flow: sell-side analysts like to do a 10-year discounted cash flow analysis with a terminal value.

Even some of the books written about your style — “The Warren Buffett Way”, “Buffettology” — imply that you go through that exercise.

But I know you’re famous for not using computers or calculators. I’m wondering if those type of exercises fall into the “too hard” file, and you just do a simple free cash flow — normalized free cash flow — over a discount rate?

And if you care to augment the answer with your numerical analysis of Coke, I’d appreciate that. (Laughter)

WARREN BUFFETT: Well, the answer is that investing — all investing is, is laying out cash now to get more cash back at a later date. Now, the question is how much do you get back, how sure are you of getting it, when do you get it? It goes back to Aesop’s fables. You know, “A bird in the hand is worth two in the bush.”

Now, that was said by Aesop in 600 B.C. He was a very smart man. He didn’t know it was 600 B.C. But I mean, he couldn’t know everything. (Laughter)

But the — but that’s what’s being taught in the finance — you got a Ph.D. now and you do it more complicated, and you don’t say, “A bird in the hand is worth two in the bush,” because you can’t really impress the laity with that sort of thing.

But the real question is, how many birds are in the bush? You know you’re laying out a bird today, the dollar. And then how many birds are in the bush? How sure are you they’re in the bush? How many birds are in other bushes? What’s the discount rate?

In other words, if interest rates are 20 percent, you got to get those two birds faster than if interest rates are 5 percent and so on.

That’s what we do. I mean, we are looking at putting out cash now to get back more cash later on.

You mentioned that I don’t use a computer or a calculator. If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.

I mean, it should be so obvious that you don’t have to carry it out to tenths of a percent or hundredths of the percent. It should scream at you.

So if you really need a calculator to figure out that it’s — the discount rate is 9.6 percent instead of 9.8 percent — forget about the whole exercise. Just go onto something that shouts at you. And essentially, we look at every business that way.

But you’re right, we do not make — we do not sit down with spreadsheets and do all that sort of thing. We just see something that obviously is better than anything else around, that we understand. And then we act.

And Charlie, do you want to add to that?

CHARLIE MUNGER: Well, I’d go further. I’d say some of the worst business decisions I’ve ever seen are those that are done with a lot of formal projections and discounts back.

Shell Oil Company did that when they bought the Belridge Oil Company. And they had all these engineers make all these elaborate figures.

And the trouble is you get to believe the figures. And it seems that the higher mathematics, with more false precision, should help you. But it doesn’t.

The effects, averaged out, are negative when you try and formalize it to the degree you’re talking about. They do that in business schools because, well, they got to do something. (Laughter and applause)

WARREN BUFFETT: There’s a lot of truth to that. I mean, if you stand up in front of a class and you say, “A bird in the hand is worth two in the bush,” you know, you’re not going to get tenure. (Laughter)

It’s very important if you’re in the priesthood to look, at least, like you know a whole more lot more than the people you’re preaching to.

And if you come down and just — if you’re a priest, and you just hand down the 10 Commandments and you say, “This is it,” and we’ll all go home, you know, it just isn’t the way to progress in the world.

So, the false precision that goes into saying that this is a two standard deviation event or this is a three standard deviation event, and therefore we can afford to take this much risk and all that, it’s totally crazy.

I mean, you saw it with Long-Term Capital Management in 1998. You’ve seen it time and time and time again.

And it only happens to people with high IQs. You know, those of you who are — have 120 IQs are all safe. (Laughter)

But if you have a very high IQ, and you’ve learned all this stuff, you know, you feel you have to use it. And the markets are not that way.

The markets of mid-September last year, when people who ran huge institutions were wondering how they were going to get funding the next week, you know, that doesn’t appear on a — you can’t calculate the standard deviation with — that that arises at.

It’s going to arise much more often than people think, in markets that are made by people that get scared and get greedy. And they don’t observe the laws of flipping coins, it’s — in terms of the distribution of results.

And it’s a terrible mistake to think that mathematics will take you a long place in investing. You have to understand certain aspects of mathematics. But you don’t have to understand higher mathematics.

And higher mathematics may actually be dangerous and it will lead you down pathways that are better left untrod.