More Praise for The Warren Buffett Way, First Edition

Washington Post
was $80 million.
Yet Buffett claims that “most security analysts, media brokers, and media
executives would have estimated WPC’s intrinsic value at $400 to $500
million.”
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How did Buffett arrive at that estimate? Let us walk through
the numbers, using Buffett’s reasoning.
We’ll start by calculating owner earnings for that year: Net income
($13.3 million) plus depreciation and amortization ($3.7 million) minus
capital expenditures ($6.6 million) yields 1973 owner earnings of $10.4
million. If we divide these earnings by the long-term U.S. government
bond yield at the time (6.81 percent), the value of the 
Washington Post
reaches $150 million, almost twice the market value of the company but
well short of Buffett’s estimate.
Buffett tells us that, over time, the capital expenditures of a news-
paper will equal depreciation and amortization charges, and therefore
net income should approximate owner earnings. Knowing this, we can
simply divide net income by the risk-free rate and thus reach a valuation
of $196 million.
If we stop here, the assumption is that the increase in owner earn-
ings will equal the rise in inf lation. But we know that newspapers have
unusual pricing power: Because most are monopolies in their commu-
nity, they can raise their prices at rates higher than inf lation. If we
make one last assumption—that the 
Washington Post
has the ability to
raise real prices by 3 percent—the value of the company is closer to
$350 million. Buffett also knew that the company’s 10 percent pretax
margins were below its 15 percent historical average margins, and he
knew that Katherine Graham was determined that the Post would once

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again achieve these margins. If pretax margins improved to 15 percent,
the present value of the company would increase by $135 million,
bringing the total intrinsic value to $485 million.
Wells Fargo
The value of a bank is the function of its net worth plus its projected
earnings as a going concern. When Berkshire Hathaway began purchas-
ing Wells Fargo in 1990, the company in the previous year had earned
$600 million. The average yield on the thirty-year U.S. government
bond that year was approximately 8.5 percent. To remain conservative,
we can discount Wells Fargo’s 1989 $600 million earnings by 9 percent
and value the bank at $6.6 billion. If the bank never earned another
dime over $600 million a year for the next thirty years, it was worth at
least $6.6 billion. When Buffett purchased Wells Fargo in 1990, he paid
$58 per share for its stock. With 52 million shares outstanding, this was
equivalent to paying $3 billion for the company—a 55 percent discount
to its value.
The debate in investment circles at the time centered on whether
Wells Fargo, after taking into consideration all its loan problems, even
had earnings power. The short sellers said it no; Buffett said yes. He
knew full well that ownership of Wells Fargo carried some risk, but he
felt conf ident in his analysis. His step-by-step thinking is a good model
for everyone weighing the risk factor of an investment.
He started with what he already knew. Carl Reichardt, then chair-
man of Wells Fargo, had run the bank since 1983, with impressive re-
sults. Under his leadership, growth in earnings and return on equity
were both above average and operating eff iciencies were among the
highest in the country. Reichardt had also built a solid loan portfolio.
Next, Buffett envisioned the events that would endanger the in-
vestment and came up with three possibilities, then tried to imagine
the likelihood that they would occur. It is, in a real sense, an exercise in
probabilities.
The f irst possible risk was a major earthquake, which would
“wreak havoc” on borrowers and in turn on their lenders. The second
risk was broader: a “systemic business contraction or f inancial panic so
severe it would endanger almost every highly leveraged institution, no

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T H E W A R R E N B U F F E T T W AY
matter how intelligently run.” Neither of those two could be ruled out
entirely, of course, but Buffett concluded, based on best evidence, that
the probability of either one was low.
The third risk, and the one getting the most attention from the
market at the time, was that real estate values in the West would tumble
because of overbuilding and “deliver huge losses to banks that have f i-
nanced the expansion.”
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How serious would that be?
Buffett reasoned that a meaningful drop in real estate values should
not cause major problems for a well-managed bank like Wells Fargo.
“Consider some mathematics,” he explained. Buffett knew that Wells
Fargo earned $1 billion pretax annually after expensing an average
$300 million for loan losses. He f igured if 10 percent of the bank’s $48
billion in loans—not just commercial real estate loans but all the bank’s
loans—were problem loans in 1991 and produced losses, including in-
terest, averaging 30 percent of the principal value of the loan, Wells
Fargo would still break even.
In Buffett’s judgment, the possibility of this occurring was low. But
even if Wells Fargo earned no money for a year, but merely broke even,
Buffett would not f linch. “A year like that—which we consider only a
low-level possibility, not a likelihood—would not distress us.”
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The attraction of Wells Fargo intensif ied when Buffett was able to
purchase shares at a 50 percent discount to their value. His bet paid off.
By the end of 1993, Wells Fargo’s share price reached $137 per share,
nearly triple what Buffett originally paid.
B U Y AT AT T R A C T I V E P R I C E S
Focusing on businesses that are understandable, with enduring eco-
nomics, run by shareholder-oriented managers—all those characteris-
tics are important, Buffett says, but by themselves will not guarantee
investment success. For that, he f irst has to buy at sensible prices, and
then the company has to perform to his business expectations. The sec-
ond is not always easy to control, but the f irst is: If the price isn’t satis-
factory, he passes.
Buffett’s basic goal is to identify businesses that earn above-average
returns, and then to purchase these businesses at prices below their 

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1 3 1
indicated value. Graham taught Buffett the importance of buying a
stock only when the difference between its price and its value represents
a margin of safety. Today, this is still his guiding principle, even though
his partner Charlie Munger has encouraged him toward occasionally
paying more for outstanding companies.
The margin-of-safety principle assists Buffett in two ways. First, it
protects him from downside price risk. If he calculates that the value of
a business is only slightly higher than its per share price, he will not buy
the stock. He reasons that if the company’s intrinsic value were to dip
even slightly, eventually the stock price would also drop, perhaps below
what he paid for it. But when the margin between price and value is
large enough, the risk of declining value is less. If Buffett is able to pur-
chase a company at 75 percent of its intrinsic value (a 25 percent dis-
count) and the value subsequently declines by 10 percent, his original
purchase price will still yield an adequate return.
The margin of safety also provides opportunities for extraordinary
stock returns. If Buffett correctly identifies a company with above-
average economic returns, the value of its stock over the long term will
steadily march upward. If a company consistently earns 15 percent on
equity, its share price will appreciate more each year than that of a com-
pany that earns 10 percent on equity. Additionally, if Buffett, by using
the margin of safety, is able to buy this outstanding business at a signifi-
cant discount to its intrinsic value, Berkshire will earn an extra bonus
when the market corrects the price of the business. “The market, like the
Lord, helps those who help themselves,” says Buffett. “But unlike the
Lord, the market does not forgive those who know not what they do.”
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