How does Warren Buffet Estimate Risk Free Cash Flow?

Lot’s of investors follow Warren Buffet. His approach to evaluating companies is to estimate what he calls “the risk-free cash flow” for a company and then simply discount those earnings at the 10 Y Treasury rate. Any thoughts?

Whatever Buffet does, it’s probably not that much different from what the rest of us do. There’s a little (no, a lot of) alchemy in all of this.

How can anyone accurately predict what the future risk free cash flow is for anything, even a treasury bill? You can make an estimate, but it’s entirely that: an estimate, subject to different probabilities. In the case of a company, any company, such a prediction is approaching reading tea leaves. Sure, you can take the past, you can project it into the future, you can lay out various scenarios and apply a probability to each, then model the cash flow and reach a probability weighted projected cash flow +/- one standard deviation. Great, you know how to do analysis and apply simple statistical methods. It proves nothing.

Repeat: the future is not the past. Things are changing, and the rate of change is changing, not constant. Economies are more interconnected and more unstable than they were. The hope of economists that an interconnected world would be a more stable world is clearly not playing out according to plan. Add to that the unpredictable climate change influence, politicians and policy wonks, central banks run by bureaucrats and wow, what a mess you have. Now, mix in some terrorist wackos, cultural triggers, and a few black swans swimming around and you have a mess of a stew. Try and project risk free cash flow in that environment! Oh, and did I mention that the unit of measurement is subject to radical shifts in fundamental value? Yea, you got it: the equivalent of trying to measure a squirming 3 year old for a suit when the measuring tape is elastic.

Now that we are all wringing our hands in desperation and despair, let me conclude by saying that doing all of the analysis work we talked about is going to give you a rough ballpark answer that probably is useful in context, as a general guide. But relying on it is still a bet. We just hope the odds are OK, that we have gotten our future scenarios and variables defined OK, and that our rose colored glasses aren’t tinted too much.

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