Warren of the company. Buffett feels it is most

Warren Buffett believes that
intrinsic value can only be determined with a full and through understanding
and analysis of the company and its financial statements and the discounted cash
flow, not from what the stock price says it is worth.  Buffett gets his view of investing from Ben
Graham who is considered the father of value investing.  Value investing is where an investor looks at
the overall financial condition of a company including; statement of cash, flow
income statements, balance sheets to pull out the financial data and using the
various fundamental financial equations to determine the what the value of the
stock should, you then compare this to the current stock price and if the stock
price is below what you believe the value to be you would then buy.  While Buffett holds this philosophy of
investing he acknowledges the fact that the financial statements released by
the company are past looking and my not depict the true economic reality of the
company.  Buffett feels it is most important
to understand what he calls the economic reality. Since these statements adhere
to the generally accepted accounting principles (GAAP) certain aspects of the
company are not considered.  He believes
that all aspects of the business should be included in valuing the company,
these would the intangible assets, including patents and trademarks held by the
company, specialized managerial expertise, and what the reputation of the
business is can all affect its value.  He
judges an investment on a business by business basis, not on how the market,
the economy, or other securities are performing.  His analysis judges the simplicity of the
business, how reliable the business has operated, is the business have a long-term
appeal, the effectiveness of the management, and is the business’s capacity to
create value.  One of the most important
factors that Warren Buffett uses is the discounted future cash flows.  He believes that this is the best measure of
the intrinsic value of a company.  He defines
“intrinsic value as the discounted value of cash that can be taken out of a
business during its remaining life.” This is easier said than done, even
Buffett says that this is highly subjective and can fluctuate as estimates for
cash flow and interest rates change.  One
also must determine to either receive dividends or to reinvest the profits back
into the business.  To determine if the
investment is wise the investor must determine the rate of return of the company
and the cost of equity.  They would then
take the take the discounted cash flow and divide this by the book value if
this number is greater than one the investment creates wealth for the investor
and if the number is less than one value is destroyed and the investor would be
wise to look for a different investment choice. 
In essence Buffett believes that a gain in intrinsic value is more important
than increasing account profit.   As he said in 1992 “… Irrespective of whether
a business grows or doesn’t, displays volatility or smoothness in earnings, or
carries a high price or low in relation to its current earnings and book value,
the investment shown by the discounted-flows-of-cash calculation to be the
cheapest is the one that the investor should purchase.”  Investors and regular people look so favorably
on Warren Buffett’s perspectives because he has significantly outperformed the
market no just for short durations but for decades.  Looking at the share price of Berkshire
Hathaway Class A shares from 1977 to 2005 the price went from $102 to $85,500 an
83,723% increase or an average of 27.1% return per year, while, the Standard &
Poor’s 500 grew from 96 to 1,194 for a return of 1, 1143% or an average return
of 9.4% per year.  The alternative to
determining the intrinsic value of a company and investing in underpriced stocks
is the Efficient market hypothesis (EMH) which is where a share price will react
rapidly to publicly known information and as such the stock price is a fair
reflection of the company.  If EMH were true,
there would be no need to determine the value of stocks since there are nor
bargains and it is impossible to outperform the market.  Buffett is quoted in 1990 as saying, “It has
been helpful to me to have tens of thousands turned out of business schools
taught that it didn’t do any good to think.” 
This helps to explain Buffett’s above markets for years, when you are
the only one looking it is easy to find bargains.  However, with more and more people searching
to value investments it is harder to find one. 
Warren Buffett is also a detractor of hedge funds that charge high fees
saying that managers reap the most rewards not the clients, in 2007 he stated
that an S&P 500 index fund would produce better returns for clients than
these hedge funds, after a decade the index fund outperformed each of the hedge
funds that took up Buffett’s challenge by a significant amount.