The Buffett Method, in Plain Words

The method asks three questions about a business:

• How much cash can this business truly hand to its owners, year after year, after paying for the upkeep the business needs to stay as strong as it is? That cash figure has a name: owner earnings.
• What is all of that future cash worth in today's dollars? That total has a name too: intrinsic value.
• Is the price being asked comfortably below that value, with room left over for being wrong? That cushion is an older idea called the margin of safety.

That is the whole shape of it. The rest of this page takes each part slowly.

A business reports a profit figure each year. Buffett's point in 1986 was that the reported figure, by itself, does not tell you how much cash the owners could actually take out. So he set out a different figure and gave it a name: owner earnings.

Here is his definition, in his own words:

“Owner earnings represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges … less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”

— Warren Buffett, appendix to the 1986 Berkshire Hathaway shareholder letter

In plain words, it has three parts:

• (a)

  Start with the reported earnings — the profit the business says it made.

• (b)

  Add back non-cash charges — items like depreciation that lowered the reported profit on paper but did not take cash out of the business that year.

• (c)

  Then subtract the upkeep — the average amount the business must spend each year on its plant, equipment, and the like, just to hold its position and keep doing the same amount of business. If the business also needs extra working capital to hold that position, that belongs in this part too.

Why part (c) is the heart of it

Many people quote a simpler “cash flow” figure: part (a) plus part (b), with nothing subtracted. Buffett called that an absurdity, because it pretends the upkeep costs nothing. A business that must keep spending to stand still does not hand all of that cash to its owners. Part (c) is what makes owner earnings honest.

His own warnings about this figure

• Part (c) “must be a guess — and one sometimes very difficult to make.” (1986 letter.)
• Owner earnings do not give exact, tidy numbers. Buffett warned against figures that look “deceptively precise.”
• Even so, he said owner earnings — not the standard reported figure — are “the relevant item for valuation purposes.” In plain words: if you want to judge what a business is worth, this is the cash figure to start from.

Once you have an honest cash figure, the next question is what the business is worth. Buffett's answer rests on a simple thought: a dollar you will receive years from now is worth less than a dollar in your hand today. So you take all the cash the business can hand out over the rest of its life, and you shrink each future amount back into today's dollars. That shrinking-back is called discounting.

His definition, in his own words:

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

— Berkshire Hathaway 1992 annual report, restated in the 1994 shareholder letter

His own warnings about this figure

• Intrinsic value “is an estimate rather than a precise figure.”
• Two careful people, looking at the exact same facts, “will almost inevitably come up with at least slightly different intrinsic value figures.”
• That is one reason Berkshire Hathaway never publishes its own intrinsic value estimates. Its annual reports give readers the facts instead, and let each reader do their own estimating.

Both figures above are estimates, and part of them is an honest guess. A careful reader therefore does not treat the estimate as exact.

The older idea behind this caution is the margin of safety. Buffett learned it from his teacher, Benjamin Graham. In plain words, it means this: the method only finds a price comfortable when that price sits well below the estimated value, so there is room left over if the guess turns out to be too hopeful.

No cushion, no comfort. That is the idea — a habit of leaving room for error, not a promise about what will happen next.

• It names no company as a good or bad choice, and it points to nothing for anyone to act on.
• It gives no prices, no returns, and no claims about how any approach has performed.
• It does not say that following these ideas leads to profits. Buffett's own letters stress that key parts of the method are guesses and estimates — two honest people can land on different numbers from the same facts.
• It is a reading lesson about two published definitions, nothing more. For decisions about your own money, the letters themselves — and a qualified adviser who knows your situation — are the place to go.

Sources: Warren Buffett's letter to Berkshire Hathaway shareholders for 1986, appendix on owner earnings; Berkshire Hathaway annual report for 1992, on intrinsic value (restated in the 1994 letter). Berkshire Hathaway publishes the letters at berkshirehathaway.com. Short quotations above are Buffett's words, kept brief and labeled with their year.