Warren Buffett & Charlie Munger: What if the growth rate is larger than the discount rate?

uh good morning gentlemen um my name is tony ado and i come from new jersey mr buffett my question is on business valuation and growth in one of your letters you mentioned the discounting formula owner earnings divided by the difference between the discount and the growth rate but if the growth rate is larger than the discount rate and if we use this formula then we get a negative number and one way around this let's call method a is to have two growth stages one with a high growth and the second stage with the low growth and the second way method b would be to estimate how much the earnings is on the third year for the company and then multiply this by the average price to earning ratio to get the price in the 10th year i don't know if you use the method a or method b but if not i would like to ask mr buffett how do you estimate how much a company is worth if the growth rate is larger than the discount rate well you put your finger on an interesting a mathematical relationship because if you're using a present value discount formula and you put in a growth rate that is higher than the discount rate as you have postulated the answer of course will be infinity and there are a lot of managements around who like to think their stocks are worth infinity but we haven't found one yet the that that precise subject was covered in a paper uh called the saint petersburg paradox by a fellow named durant probably 30 years ago uh uh and somewhere we probably have a copy at our office my guess if you go to google and you put in the name durant and you put in st petersburg you may be able to call up that article although they aren't necessarily terrific on old articles uh so if you if you'd like it we would you'll let somebody know what our office we'll we'll look around a little and we'll see if we can find that that it gets very dangerous to project out high growth rates because you get into this paradox uh if you say the growth rate of a company is going to be nine percent between now and judgment day and you use a seven percent discount rate it uh it goes off you know you get into infinity and that's where people get in a lot of trouble the the idea of projecting out extremely high growth rates for very long periods of time has caused investors to lose you know very very large sums of money there aren't many companies just take a look at the fortune 500 go back 50 years it's they're commemorating that and look at the companies there that were there and how many of uh how many have really maintained rates much above 10 it's it's it's not an easy hurdle and when you get up to 15 you know you're you're in the atmosphere in a way a rarified atmosphere so that's there's a real danger in projecting out high growth rates and charlie and i uh will very seldom well virtually never get up into into high digits you can lose a lot of money doing that you may miss an opportunity sometime but i haven't seen people who have been consistently successful doing that and you do run into this paradox you mentioned charlie well you're obviously right when you get a mathematical result that is infinity to back off and realize that can't happen and of course what people do is they project that the growth rate will will uh reduce and indeed eventually stop and then you get more realistic numbers what else could anyone do okay we're gonna

Channel: The Financial Review

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Id: IuhYRhlcxI4

Length: 4min 16sec (256 seconds)

Published: Sat Jan 22 2022