John Burr Williams
John Burr Williams graduated from Harvard University in 1923 and went on to Harvard Business School, where he got his first taste of economic forecasting and security analysis. After Harvard, he worked as a security analyst at two well-known Wall Street firms. He was there
through the heady days of the 1920s and the disastrous crash of 1929 and its aftermath. That experience convinced him that to be a good investor, one also needs to be a good economist.9
So, in 1932 at the age of 30 and already a good investor, he enrolled in Harvard's Graduate School of Arts and Sciences. Working from a firm belief that what happened in the economy could affect the value of stocks, he had decided to earn an advanced degree in economics.
When it came time to choose a topic for his doctoral dissertation, Williams asked advice from Joseph Schumpeter, the noted Austrian economist best known for his theory of creative destruction, who was then a member of the economics faculty. Schumpeter suggested that Williams look at the "intrinsic value of a common stock," saying it would fit Williams's background and experience. Williams later commented that perhaps Schumpeter had a more cynical motive: The topic would keep Williams from "running afoul" of the rest of the faculty, "none of whom would want to challenge my own ideas on in-vestments."10 Nonetheless, Schumpeter's suggestion was the impetus for Williams's famous doctoral dissertation, which, as The Theory of Investment Value, has influenced financial analysts and investors ever since.
Williams finished writing his dissertation in 1937. Even though he had not yet defended it—and to the great indignation of several professors—he submitted the work to Macmillan for publication. Macmillan declined. So did McGraw-Hill. Both decided that the book had too many algebraic symbols. Finally, in 1938, Williams found a publisher in Harvard University Press, but only after he agreed to pay part of the printing cost. Two years later, Williams took his oral exam and, after some intense arguments over the causes of the Great Depression, passed.
The Theory of Investment Value is a genuine classic. For sixty years, it has served as the foundation on which many famous economists—Eugene Fama, Harry Markowitz, and Franco Modigliani, to name a few—have based their own work. Warren Buffett calls it one of the most important investment books ever written.
Williams's theory, known today as the dividend discount model, or discounted net cash-flow analysis, provides a way to put a value on a stock or a bond. Like many important ideas, it can be reduced to a very simple precept: To know what a security is worth today, estimate all the cash it will earn over its lifetime and then discount that total back to a present value. It is the underlying methodology that Warren Buffett uses to evaluate stocks and companies.
Buffett condensed Williams's theory as: "The value of a business is determined by the net cash flows expected to occur over the life of the business discounted at an appropriate interest rate." Williams described it this way: "A cow for her milk; a hen for her eggs; and a stock, by heck, for her dividends."11
Williams's model is a two-step process. First it measures cash flows to determine a company's current and future worth. How to estimate cash flows? One quick measure is dividends paid to shareholders. For companies that do not distribute dividends, Williams believed that in theory all retained earnings should eventually turn into dividends. Once a company reaches its mature stage, it would not need to reinvest its earnings for growth so the management could start distributing the earnings in the form of dividends. Williams wrote, "If earnings not paid out in dividends are all successfully reinvested, then these earnings should produce dividends later; if not, then they are money lost. In short, a stock is worth only what you can get out of it."12
The second step is to discount those estimated cash flows, to allow for some uncertainty. We can never be exactly sure what a company will do, how its products will sell, or what management will do or not do to improve the business. There is always an element of risk, particularly for stocks, even though Williams's theory applies equally well to bonds.
What, then, should we use as a discount rate? Williams himself is not explicit on this point, apparently believing his readers could determine for themselves what would be appropriate. Buffett's measuring stick is very straightforward: He uses either the interest rate for long-term (meaning ten-year) U.S. bonds, or when interest rates are very low, he uses the average cumulative rate of return of the overall stock market.
By using what amounts to a risk-free rate, Buffett has modified Williams's original thesis. Because he limits his purchases to those with Ben Graham's margin of safety, Buffett ensures that the risk is covered in the transaction itself, and therefore he believes that using a risk-free rate for discounting is appropriate.
Peter Bernstein, in his book Capital Ideas, writes that Graham's system is a set of rules, whereas Williams's dividend discount model is a theory; but "both approaches end up recommending the same kinds of stocks for purchase."13
Warren Buffett has used both, with stellar success.
Post a comment