Aesop’s Investment primer, by Warren Buffett

Aesop’s Investment primer

Every time we want to analyze the value of a business and decide if it is worth investing in, we can refer to a classic lecture given by Warren Buffet during one of Berkshire Hathaway’s annual meetings.

Buffett states that once we know a business’s cash flow between now and judgment day, we have a precise figure of what it is worth today. For him, it is a value decision based on the expected growth of the business.

To clarify the concept, he quotes Aesop’s investment primer in 600 B.C.:

“a bird in the hand is worth 2 in the bush”.

It is indeed an investment equation. It implies that what we hold today should be valued more in the future. However, Aesop’s investment primer failed to account for two additional factors:
• When are we going to get the two birds?
• What is the current (risk-free) interest rate

If we are ready to trade one bird in the hand (our cash), as an investment decision, we need to evaluate how many birds are in the bush and when and if we can realistically acquire them. In doing that, we will also look at other birds and bushes.

Buffett highlights two examples:
a) If the interest rate is 5% and we are going to get two birds in 5 years (vs. one now), two birds are a better deal (14% compound annually).
b) On the other hand, if the interest rates are 20%, and we will still get two birds in 5 years, we should decline the deal because keeping our bird in hand would already have an annual interest rate of 20%. Compounded annually, it will become more than two birds in the bush in 5 years.

The more we have to wait to take the bird out of the bush, the more birds we should be able to take to justify the equation. The equation outlined by Aesop is immutable: it can be applied today for evaluating any asset, from stock to bonds, from farms to businesses. Buffett suggests working out what cashflows we – as investors – will receive from the asset we own and/or plan to buy. As investors, we need to get the implicit math right whenever we invest, clarify when we expect the return to arrive, make conservative forecasts, and use an appropriate interest rate to compare the returns against other alternatives.

Source:

2000 Berkshire Hathaway annual meeting. You can watch Buffet’s full analysis here.