Models of Reality

Models of Reality

Educated men are as superior to uneducated men as the living are to the dead.

-Aristotle

Learn, understand and use the big ideas and general principles that explain a lot about how the world works. When Charles Munger was asked what would be the best question he should ask himself, he said:

If you ask not about investment matters, but about your personal lives, I think the best question is, "Is there anything I can do to make my whole life and my whole mental process work better?"

And I would say that developing the habit of mastering the multiple models which underlie reality is the best thing you can do.. .It's just so much fun - and it works so well.

A model is an idea that helps us better understand how the world works. Models illustrate consequences and answer questions like "why" and "how". Take the model of social proof as an example. What happens? When people are uncertain they often automatically do what others do without thinking about the correct thing to do. This idea helps explain "why" and predict "how" people are likely to behave in certain situations.

Models help us avoid problems. Assume that we are told that the earth consists of infinite resources. By knowing the idea about limits, we know the statement is false. Someone gives us an investment proposal about a project that contradicts the laws of physics. How much misery can be avoided by staying away from whatever doesn't make scientific sense?

What characterizes a useful model?

A useful model fits the evidence and makes reliable predictions within a stated range of conditions. Agreement with one observation does not establish that a model is true. One idea from biology that agrees with reality is that "people on average act out of self-interest." But not the idea that "people's personalities can be evaluated by using the Rorschach ink-blot test." A claim of that kind needs evidence that the test predicts the particular traits or outcomes being assessed. Ask: What is the underlying big idea? Do I understand its application in practical life? Does it help me understand the world? How does it work? Why does it work? Under what conditions does it work? How reliable is it? What are its limitations? How does it relate to other models?

Charles Munger gives an example of a useful idea from chemistry - autocatalysis:

If you get a certain kind of process going in chemistry, it speeds up on its own. So you get this marvelous boost in what you're trying to do that runs on and on. Now, the laws of physics are such that it doesn't run on forever. But it runs on for a goodly while. So you get a huge boost. You accomplish A- and, all of a sudden, you're getting A+ B + C for awhile.

He continues telling us how this idea can be applied:

Disney is an amazing example of autocatalysis ... They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the videocassette was invented, Disney didn't have to invent anything or do anything except take the thing out of the can and stick it on the cassette.

Which models are most reliable? Charles Munger answers:

The models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control - at least the guts of it that matters to you and me and people who are not professional engineers - is very much based on the elementary mathematics of Fermat and Pascal: It costs so much and you get so much less likelihood of it breaking if you spend this much ...

And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints—that's a very powerful model, too. The notion of a critical mass - that comes out of physics - is a very powerful model.

A valuable model produces meaningful explanations and predictions of likely future consequences where the cost of being wrong is high.

A model should be easy to use. If it is complicated, we don't use it.

It is useful on a nearly daily basis. If it is not used, we forget it. And what use is knowledge if we don't use it?

Use More Than One Model

Those who love wisdom must be inquirers into many things indeed.

• Heraclitus

What can help us see the big picture? How can we consider many aspects of an issue? Use knowledge and insights from many disciplines. Most problems need to be studied from a variety of perspectives. Charles Munger says, "In most messy human problems, you have to be able to use all the big ideas and not just a few of them."

The world is multidisciplinary. Physics doesn't explain everything; neither does biology or economics. For example, in a business it is useful to know how scale changes behavior, how systems may break, how supply influences prices, and how incentives cause behavior.

Since no single discipline has all the answers, we need to understand and use the big ideas from all the important disciplines - mathematics, physics, chemistry, engineering, biology, psychology, and rank and use them in order of their reliability. Charles Munger illustrates the importance of this:

Suppose you want to be good at declarer play in contract bridge. Well, you know the contract - you know what you have to achieve. And you can count up the sure winners you have by laying down your high cards and your invincible trumps.

But if you're a trick or two short, how are you going to get the other needed tricks? Well, there are only six or so different, standard methods: You've got long-suit establishment. You've got finesses. You've got throw-in plays. You've got cross-ruffs. You've got squeezes. And you've got various ways of misleading the defense into making errors. So it's a very limited number of models. But if you only know one or two of those models, then you're going to be a horse's patoot in declarer play...

If you don't have the full repertoire, I guarantee you that you'll overutilize the limited

repertoire you have - including use of models that are inappropriate just because they're available to you in the limited stock you have in mind.

Suppose we have a problem and ask: What can explain this? How can we achieve this? How can we then use different ideas? Charles Munger tells us how to do it:

Have a full kit of tools... go through them in your mind checklist-style... you can never make any explanation that can be made in a more fundamental way in any other way than the most fundamental way. And you always take with full attribution to the most fundamental ideas that you are required to use. When you're using physics, you say you're using physics. When you're using biology, you say you're using biology.

We also need to understand how different ideas interact and combine. Charles Munger says:

You get lollapalooza effects when two, three or four forces are all operating in the same direction. And, frequently, you don't get simple addition. It's often like a critical mass in physics where you get a nuclear explosion if you get to a certain point of mass - and you don't get anything much worth seeing if you don't reach the mass.

Sometimes the forces just add like ordinary quantities and sometimes they combine on a break-point or critical-mass basis... More commonly, the forces coming out of... models are conflicting to some extent. And you get huge, miserable trade-offs ... So you [must] have the models and you [must] see the relatedness and the effects from the relatedness.

The British mathematician and philosopher Alfred North Whitehead said: "The problem of education is to make the pupil see the wood by means of the trees." We need to consider many aspects of an issue and synthesize and integrate them. We need to understand how it all fits together to form a coherent whole. The term synthesis comes from classical Greek and means literally "to put together." Below are some examples of how this can be used in problem-solving.

We can combine ideas within a discipline. We saw in Part Two how psychological tendencies can combine and give Lollapalooza effects.

We can try to find connections between ideas or derive new ideas from these connections. The modern evolutionary synthesis was a unification of several ideas within biology.

We can combine ideas from different disciplines. The ideas of scaling from mathematics, systems and constraints from physics, and competitive advantage from microeconomics often explain how business value is created or destroyed.

We can try to see relationships between phenomena, and try to find one principle that can explain them all. The British physicist James Clerk Maxwell combined in one model the laws of electricity and magnetism with the laws of behavior of light. This single model explained optical, electrical and magnetic phenomena.

We can find similarities or functional equivalents within or between disciplines. Viscosity in physics can serve as an analogy for stickiness in economics, though the mechanisms and measurements differ.

Learn a Model Well Enough to Use It

Samuel Johnson said: "He is a benefactor of mankind who contracts the great rules of life into short sentences, that may be easily impressed on the memory, and so recur habitually to the mind."

Richard Feynman answered the following question in one of his physics lectures:

If, in some cataclysm, all of scientific knowledge were to be destroyed, and only one sentence passed on to the next generations of creatures, what statement would contain the most information in the fewest words? I believe it is the atomic hypothesis (or the atomic fact, or whatever you wish to call it) that all things are made of atoms - little particles that move around in perpetual motion, attracting each other when they are a little distance apart, but repelling upon being squeezed into one another. In that one sentence, you will see, there is an enormous amount of information about the world, if just a little imagination and thinking are applied.

We can use the Feynman "one sentence explanation" when dealing with big ideas. "What sentence contains the most information in the fewest words?" An example of a one-sentence idea from psychology is: "We get what we reward for." A sentence from physics is: "Energy is neither created nor destroyed - only changed from one form into another."

Another way to understand a model is to give it a "hook." Associate the model with a dramatic real-life story, analogy, individual, or picture. For example to remember social proof, we can think about the Genovese homicide in New York City (see Part Two).

A Chinese proverb says, "I forget what I hear; I remember what I see; I know what I do." Since the best way to learn something is by doing it, we must apply models routinely to different situations. Like any skill, this takes both practice and discipline.

Search for Explanations

What happens and why does it happen?

One way of forcing us to learn models to better deal with reality is to open our eyes and look at the things we see around us and ask "why" things are happening (or why things are not happening). Take some simple examples as "why do apples fall downward?" or "why do we fall down when we slip?" or "why don't we fall off the earth?" The English mathematician and physicist Sir Isaac Newton's law of gravitation can explain this.

Newton's 1st law tells us that an object in motion tends to continue in motion at a steady speed in a straight line, and an object at rest tends to stay at rest, unless the object is acted upon by an outside force.

This means that there are only 3 ways to change an object: an object at rest can start to move, an object in motion at a steady speed can go up or down in speed, and an object in motion in a straight line can change direction. And what is needed to change an object's motion? A force.

All change in motion happens in response to the action of force(s). By forces, we mean a push or a pull that acts on an object. When we open a door or throw a baseball, we are using forces (muscular effort). Almost everything we do involves forces.

Newton's 2nd law relates net force to the product of mass and acceleration. Acceleration is any change in speed and/or direction. It depends on the mass (measures an object’s resistance to changes in motion) of an object and the magnitude and direction of the force acting on it. The more force we use at a given mass, the greater the acceleration. But the more mass, the more an object resists acceleration. For example, the more force we use to throw a baseball, the greater the acceleration of the ball. If we increase mass, we have to add more force to produce the same rate of acceleration.

Newton's 3rd law is that forces work in pairs. One object exerts a force on a second object, but the second object also exerts a force equal and opposite in direction to the force acting on it - the first object. As Newton said in Philosophiae Naturalis Principia Mathematica: "If you press a stone with your finger, the finger is also pressed by the stone." If we throw a baseball, the ball also "throws" us or pushes back on our hand with the same force.

Now we come to the force of gravity. Influenced by Johannes Kepler's work on planetary motion and Galileo Galilei's work on freely falling objects, Newton found out that there was a force that attracts two objects to each other. Two factors influence the degree of attraction. Mass and distance. The greater the mass of two objects or the closer the distance between them, the greater the attraction between them. This also means that the greater the distance between the objects, the weaker the force of gravity. If we for example double the distance, the force is one-fourth as strong.

Newton's gravitational force is the product of the two masses divided by the square of their separation, multiplied by the universal gravitational constant, G. This is different from the local gravitational acceleration, g (about 9.8 meters per second each second, or 9.8 m/s²), near the Earth's surface.

It is the force of gravity that makes an apple fall toward the Earth.

The Earth attracts the apple with a force that is proportional to its mass and inversely proportional to the square of the distance between them. But Newton's third law says that the apple also exerts an equal and opposite force on the Earth. The force of attraction on the apple by the Earth is the same as the force of attraction on the Earth by the apple. So even if it looks to us like the apple falls to the Earth, both the Earth and apple fall toward each other. The force is the same but as we see from Newton's second law, not the acceleration. Their masses differ. The Earth's mass is so large compared to the apple that we see the apple "falling." Apples fall, starting at rest, to the Earth since they have less mass than the Earth, meaning they accelerate (change speed) more toward the Earth than the Earth does toward the apple. The Earth's great mass also explains why we fall toward the Earth when we slip.

The same force draws the Moon to the Earth. But what keeps the Moon in orbit around the Earth instead of crashing into the Earth?

Newton knew that there must be some force pulling the Moon toward the Earth. Otherwise according to the 1st law the Moon would continue in motion in a straight line at a steady speed instead of its more elliptical motion. Some force must continuously pull the Moon out of its straight-line motion and change its direction. Approximating the Moon's orbit as circular, the force points toward the Earth's center. Why? Newton knew that a centripetal force (any force directed toward a fixed center) controls objects going in a circle around a fixed point.

That force is gravity. It accelerates the Moon toward the Earth, continually changing its velocity. In the circular approximation, this changes the direction rather than the magnitude of the Moon's speed. As the Moon moves horizontally in a direction tangent (the straight line that touches a curve) to the Earth, at each point along its path, gravity pulls it inward toward the center of the Earth and the result is a Moon in circular orbit.

The Moon's speed is great enough to ensure that its falling distance matches the Earth's curvature. In this approximation, the Moon stays at the same distance because the Earth curves away as the Moon "falls." By the time the Moon has fallen a certain distance toward Earth, it has moved sideways about the same distance. If its speed were much lower, the pull of gravity would gradually force the Moon

closer to the Earth until they crash into each other. If its speed were high enough,

the Moon could escape its bound orbit, though gravity would still act on it.

The Moon doesn't accelerate as much as the apple, because of its distance to Earth (the force of gravity is weaker). The Moon in its orbit is about sixty times as far away from the Earth's center as the apple is.

Newton's law of gravitation isn't enough to describe the motion of objects whose speed is near the speed of light. Why? Relativity changes the relationship between energy, momentum, and velocity at high speeds. An object's rest mass remains constant; its energy and momentum grow as its speed approaches the speed of light. Newton's theories and the theory of relativity also differ when gravitational fields are much larger than those found on Earth. Under most conditions, though, Newton's laws and his theory of gravitation are adequate.

The relative influence of gravity varies with size and scale.

Why can an insect often survive a fall from a high tree?

In Two New Sciences, Galileo Galilei wrote: "Who does not know that a horse falling from a height of three or four cubits will break his bones, while a dog falling from the same height or a cat from a height of eight or ten cubits will suffer no injury?"

Imagine if a mouse, a horse and a human were to be thrown out of an airplane from 1,000 yards. What happens? The biologist J.B.S. Haldane said in On Being the Right Size (reprinted in The World of Mathematics): "You can drop a mouse

down a thousand-yard mine shaft; and, on arriving at the bottom, it gets a slight shock and walks away, provided that the ground is fairly soft. A rat is killed, a man is broken, a horse splashes."

Physical forces act on animals differently. Gravity has a more powerful effect on bigger things, than on smaller things. Gravity is a major influence on us, but is of minor significance to smaller animals. The important comparison is surface area relative to mass. Small animals can experience much more air resistance relative to their weight than large animals do. Haldane says: "Divide an animal's length, breadth, and height each by ten; its weight is reduced to a thousandth, but its surface only to a hundredth. So the resistance to falling in the case of the small animal is relatively ten times greater than the driving force [of gravity]."

"Weight affects speed when air resistance is present.

On smaller scales, gravity becomes less and less important compared with air resistance. Throw a mouse off the plane and it floats down until air resistance balances its weight.

A falling object falls faster and faster, until the force of air drag acting in the opposite direction (arising from air resistance) equals its weight. Air drag depends on the surface area (the amount of air the falling object must plow through as it falls) and the speed of the falling object. Since a mouse has so much surface area compared to its small weight, it doesn't have to fall very fast before the upward acting air drag builds up to its downward-acting weight. The net force on the mouse is then zero and the mouse stops accelerating.

The force of air resistance against the falling horse is much greater than the force against the mouse. This happens because the horse plows through more air than the mouse does. The heavier horse falls faster through the air, increasing air resistance even more. The horse falls faster than the human before the air drag equals its weight and will therefore reach the ground first.

The horse has a greater surface area than the mouse, but the mouse has a greater surface area for its volume than the horse has. A mouse obeys the same law of gravitation as a human, and also the same law of air-resistance. But gravitation is key for humans, while air-resistance is all-important for the mouse. On the other hand, due to surface tension, the mouse will have problems when climbing from a pool of water. Haldane tells us a wet mouse has to carry its own weight of water. Imagine how hard it would be to get out of the bathtub if we

carried on our body a weight of water equal to our weight.

These examples show how we can better deal with reality by observing and asking "why" things happen. So look around, ask questions and remember the words of inventor and engineer Charles Proteus Steinmetz: "There are no foolish questions and no man becomes a fool until he has stopped asking questions."

Assume that the big ideas are true until learning otherwise. All knowledge is subject to change as new evidence arrives. This means we have to continuously learn and re-learn.

Keeping knowledge alive and adding knowledge over time comes with an extra benefit. "Just as iron rusts from disuse, and stagnant water putrefies, or when cold turns to ice, so our intellect wastes unless it is kept in use," wrote Leonardo da Vinci. Research by Integrative Biology Professor Marian Cleeves Diamond at the University of California, Berkeley, reveals that a stimulating environment, curiosity and education are nourishment to the brain and therefore healthy. Her work supports the value of an engaging environment; it does not show that more stimulation is always better or that activity prevents every kind of cognitive decline. In Psychology Today (1984) she says, "I looked for people who were extremely active after 88 years of age. I found that the people who use their brains don't lose them. It was that simple."

Remember, knowing a definition or memorizing an idea is useless if we don't understand its meaning. Alfred North Whitehead said in The Aims of Education: "Education should be useful, whatever your aim in life."

Meaning

Bad terminology is the enemy of good thinking.

• Warren Buffett

Words, definitions, propositions, statements, or goals don't tell us anything. We need to understand what they mean. It is the same with knowledge. Knowledge is only valuable if it's useful and something is only useful if we understand what it means.

Richard Feynman's father, Melville, taught his son the difference between knowing the name of something and knowing what goes on:

See that bird? It's a brown-throated thrush, but in Germany it's called a halzenfugel and in Chinese they call it a chung ling and even if you know all those names for it, you still know nothing about the bird. You only know something about people; what they call the bird.

Now that thrush sings, and teaches its young to fly, and flies so many miles away during the summer across the country, and nobody knows how it finds its way.

Doesn't this tell us something in the sense of learning? Words or names don't constitute knowledge. Knowing the name of something doesn't help us understand it. Since understanding implies action and accomplishment, one way of understanding is to see what happens. Feynman illustrates:

There is a picture of a dog, a windable toy dog, and a hand comes to the winder, and then the dog is able to move. Under the last picture, it says "What makes it move?" ... the answer I was trying to learn is that "energy makes it move." ...

It would be equally well to say that "God makes it move," or "spirit makes it move," or "movability makes it move." (In fact one could equally well say "energy makes it stop.")

Look at it this way: That's only the definition of energy. It should be reversed. We might say when something can move that it has energy in it, but not "what makes it move is energy."...

If you ask a child what makes the toy dog move, you should think about what an ordinary human being would answer. The answer is that you wound up the spring; it tries to unwind and pushes the gear around. What a good way to begin a science course. Take apart the toy; see how it works...

I think, for lesson number one, to learn a mystic formula for answering questions is very bad.

Feynman gives another example of an empty definition: "the soles of your shoes wear out because of friction." Real knowledge is: "Shoe leather wears out because it rubs against the sidewalk and the little notches and bumps on the sidewalk grab pieces and pull them off."

Feynman provides a test we can do to check our understanding:

Without using the new word which you have just learned, try to rephrase what you have just learned in your own language. Without using the word "energy," tell me what you know now about the dog's motion.

Understanding "meaning" requires that we observe and ask basic questions.

Examples of some questions are:

• Meaning of words: What do the words mean? What do they imply? Do they mean anything? Can we translate words, ideas or statements into an ordinary situation that tells us something? An expression is always relative. We have to judge and measure it against something.
• Meaning of an event: What effect is produced? What is really happening using ordinary words? What is it doing? What is accomplished? Under what conditions does it happen? What else does it mean?
• Causes: What is happening here and why? Is this working? Why or why not? Why did that happen? Why does it work here but not there? How can it happen? What are the mechanisms behind? What makes it happen?
• Implications: What is the consequence of this observation, event, or experience? What does that imply?
• Purpose: Why should we do that? Why do I want this to happen?
• Reason: Why is this better than that?
• Usefulness: What is the applicability of this? Does it mean anything in relation to what I want to achieve?

Danish physicist Niels Bohr said: "Never express yourself more clearly, than you are able to think." When describing something, tell it as it is and use words that people understand, and in terms of ideas with which they are familiar. Albert Einstein said: "If you can't explain it simply, you don't understand it well enough." Get to the point. Ask: What do I want to say? One reason for miscommunication can be that the words mean one thing to you and something else to the person you're talking to.

Ask "What happens?"

Why have Warren Buffett and Charles Munger successfully compounded the book value of Berkshire Hathaway 3700 times over the 42 years described in this account? Why do many people lose money investing?

The reason we invest in an economic asset like a business, apartment building, farm, or bond is to make money. But what does that mean? What is making money? What happens when we make money?

Follow the cash. "How much cash do I get and when do I get it?"

What happens when we make money is that we get more money back in the future than we invest today. For example, we invest $100 and get back $150.

What determines our return from investing in an economic asset? The price we pay, how much money we get back, and when we get it back. It makes a huge difference if we get $150 back in 2 years or 10 years. The difference in yearly return is 22% versus 4%. Our return can be measured against the expected returns from other available investment opportunities. This means that the value of an economic asset is influenced by interest rates. If interest changes, value changes. The higher the rates, the less the value.

If we knew for certain we would get $10 in cash every year for 5 years and we use a risk-free government bond rate of 6% as the discount rate, then the asset has a value of about $42. This means that if we pay $42, we get about a 6% annualized return, assuming the payments arrive at each year-end. If we pay $30, the annualized return rises to about 20%. The larger the difference between an economic asset's value (e.g. $42) and the price we pay, the higher our yearly return becomes.

Warren Buffett says, "We use the risk-free rate merely to equate one item to another. In other words, we're looking for whatever is the most attractive. In order to estimate the present value of anything, we're going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate... to simply compare all kinds of investment opportunities across the spectrum: oil wells, farms, whatever it may be."

Don't pay more than what you get back in value.

Benjamin Franklin said: "I conceive that great part of the miseries of mankind are brought upon them by the false estimates they have made of the value of things, and by their giving too much for their whistles." One of Francois Due de la Rochefoucauld's maxims was: "The height of ability consists in a thorough knowledge of the true value of things."

The key question we should ask when investing money in economic assets is: What is the expected future cash we can take out and when does it appear? How else can we know what an asset may be worth and what kind of return we can expect at a given price? Warren Buffett says: "In the end, what you have to decide is whether you're going to value a business at $400 million, $600 million or $800 million - and then compare that with the price."

John wants to buy an ice cream store (it doesn't matter if it is a small ice cream store or 100 shares in a billion dollar business, the relevant reasoning is the same).

Is this a good deal? It depends on the price John pays, and the discounted value of the cash that can be taken out of the ice cream store during its remaining life. How much cash can John take out? When can he take it out? This depends on the amount and timing of the free cash flow that is generated by the store or how much cash he can take out (and when) without hurting the store's present position against competition.

Warren Buffett says of the "cash flow" numbers that are often set forth in Wall Street reports:

These numbers routinely include (a) [reported earnings] plus (b) [depreciation, depletion, amortization, and certain other non-cash charges] - but do not subtract (c) [the average annual amount of capitalized expenditures for plant and equipment, etc.] Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished.

Some cash is always needed for reinvestment in capital expenditures for plant and equipment and working capital merely to enable a business to stay in business or maintain its unit volume and long-term competitive position. A classic example is a retail store that needs to install air-conditioning because other stores have made the investment. It doesn't generate any extra business, but without it, the store may lose customers to competition.

Buffett also says that we have to watch out for certain figures: "When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed."

He continues:

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

But isn't it earnings that matter for stockholders? John Burr Williams wrote in his 1938 book, The Theory of Investment Value:

If earnings not paid out in dividends are all successfully reinvested at compound interest for the benefit of the stockholder ... then these earnings should produce dividends later; if not, then they are money lost.... Earnings are only a means to an end, and the means should not be mistaken for the end. Therefore we must say that a stock derives its value from its dividends, not its earnings, In short, a stock is worth only what you can get out of it... for we are discussing permanent investment, not speculative trading, and dividends for years to come, not income for the moment only.

Warren Buffett adds, "If somebody's reinvesting all their cash flow, they better have some very big figures coming in down the road because a financial asset has to give you back a lot more cash one day in order to justify your laying out cash for it now."

Is value a precise figure?

Warren Buffett says:

Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover - and this would apply even to Charlie and me - will almost inevitably come up with at least slightly different intrinsic value figures.

Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Is there a difference between how we value different businesses?

No matter whether a company makes telecom equipment, cars, or candy, it's still the same question: How much cash do we get and when? The name attached to the cash doesn't matter. Warren Buffett says:

What you're trying to do is to look at all the cash a business will produce between now and judgment day and discount it back to the present using an appropriate discount rate and buy a lot cheaper than that. Whether the money comes from a bank, an Internet company, a brick company...the money all spends the same. Why pay more for a telecom business than a brick business? Money doesn't know where it comes from. There's no sense in paying more for a glamorous business if you're getting the same amount of money, but paying more for it. It's the same money that you can get from a brick company at a lower cost. The question is what are the economic characteristics of the bank, the Internet company or the brick company. That's going to tell you how much cash they generate over long periods in the future.

What if John needs to invest more cash in the store?

We have to consider the amount and timing of both cash into and from the store. As many investors in "growth" companies are well aware of, some businesses seem to need a never-ending supply of new cash. Warren Buffett says, "Growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years... Growth is simply a component- usually a plus, sometimes a minus - in the value equation."

But isn't it easy going wrong in estimating the amount and timing of future cash flows in and out of a business?

At Berkshire, they deal with this problem in two ways. Warren Buffett says:

First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

Warren Buffett also says that, "we try... to keep our estimates conservative." He continues:

... take all of the variables and calculate 'em reasonably conservatively... don't focus too much on extreme conservatism on each variable in terms of the discount rate and the growth rate and so on; but try to be as realistic as you can on these numbers, with any errors being on the conservative side. And then when you get all through, you apply the margin of safety.

It's the same thing Berkshire does in insurance. Buffett gives an example:

If we're trying to figure out what we should charge for, say, the chances of a 6.0 earthquake in California, we know that in the last century I think there've been 26 or so earthquakes in California that registered 6.0 or greater. And let's forget about whether they occur in remote areas. Let's just say we were writing a policy that paid off on a 6.0 or greater quake in California, regardless of whether it occurred in a desert and did no damage. Well, we would look at the history and we'd say, "Well, there've been 26 in the last century."

And we would probably assume a little higher number in the next century. That'd just be our nature. However, we wouldn't assume 50 - because if we did, we wouldn't write any business. But we might assume a little higher. If I were pricing it myself, I'd probably say, well, I'll assume that there are going to be 30 - or maybe 32 or something like that.

And then when I'm all through, I'll want to put a premium on it that incorporates a margin of safety. In other words, if I were to figure that the proper rate for 32 was $1 million, I would probably want to charge something more than $1 million to build in that margin of safety. But I want to be conservative at all the levels - and then I want to have that significant margin of safety at the end.

What can John reasonably expect the store to be worth?

How much should John pay for the store? What future free cash flow can rationally be expected? How much cash can John take out and when?

Warren Buffett says, "You'd try to figure out what you were laying out currently and what you're likely to get back over time, how certain you felt about getting it and how it compared to other alternatives." He continues: "For our discount rate, we basically think in terms of the long-term government rate... But in times of what seem like very low rates, we might use a little higher rate." Buffett also says, "And that discount rate doesn't pay you as high a rate as it needs to."

In 2003, Warren Buffett said, "We love owning common stocks - if they can be purchased at attractive prices... Unless, however, we see a very high probability of at least 10% pre-tax returns, we will sit on the sidelines."

Let's assume based on the store's history and expecting the same conditions in the future, John estimates that he can take out $300,000 in cash every year. Knowing he can always buy a risk-free government bond, John uses a bond rate of 6% as the discount rate. He also knows he can reinvest whatever cash he can take out from the store at 6%. The value of the store is then $5 million ($300,000/0.06).

Whatever he can pay below this figure increases his expected return. But since cash from a business can't be as certain as cash from a government bond, why should John pay $5 million? Why should John take time and effort investing in something that gives him the same return as doing nothing? And since John can't know for certain whether expected cash flows will turn out as he expects, he should buy the store at a price that gives him a huge margin of safety.

If John's required rate of return is 10%, the value of the store is $3 million.

Each person should use his own required rate of return. But whatever discount rate we use, we should always require a substantial discount from the estimated value in order to justify making the investment.

We shouldn't engage in false precision. Warren Buffett says, "We believe that if you can pinpoint it, you're kidding yourself. Therefore, we think that when we make a decision there ought to be such a margin of safety - it ought to be so attractive - that you don't have to carry it out three decimal places." He continues: "We are very inexact ... How certain we are is the most important part... You'd be amazed at how inexact we are." Charles Munger says, "We never sit down, run the numbers out and discount them back to net present value... The decision should be obvious."

We can use whatever discount rate we require and we can always compare investment opportunities with the long-term Treasury rate. But there is no point in calculating the value of the unpredictable. We need some certainty. Ask: How much confidence do I have in the numbers?

We can't compensate what we can't predict with a higher discount rate. Warren Buffett says:

When we look at the future of businesses, we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don't know what's going to happen in the future, that doesn't mean it's risky for everyone. It means we don't know - that it's risky for

us. It may not be risky for someone else who understands the business.

However, in that case, we just give up. We don't try to predict those things. We don't say, "Well, we don't know what's going to happen. Therefore, we'll discount some cash flows that we don't even know at 9% instead of7%." That is not our way to approach it. Once it passes a threshold test of being something about which we feel quite certain, we tend to apply the same discount factor to everything. And we try to only buy businesses

about which we're quite certain.

Should John always take out whatever cash he can?

That depends on if the return for keeping the cash in the business is higher than the return John gets if he takes it out and invests somewhere else. Why should John want to take it out if he could reinvest the cash in the business at a higher return than 6%? And why should he not take the cash out if he can't reinvest it in the business at a higher return than 6%?

Here is a big difference between a company controlled by John and a public company where John only owns a part of the business. He doesn't control when to take the cash out in a public company. Both in private and public companies, cash may be reinvested at a mediocre return or into ideas that don't work. History has shown that many times reinvested cash has been wasted money and that a pay-out would have been better.

How much cash flow the store will generate is mainly determined by three variables: (1) Sales - how many units of ice cream will be sold at what price? (2) Operating costs - how much does it cost to make the ice cream and conduct the business? (3) Invested capital - how much capital is needed to conduct the business? To what degree is this capital financed with debt rather than equity and at what cost?

These variables determine what return the business earns on the capital that is invested in the store. Sales, costs, and capital need are largely determined by demand, competition from similar or substituting products, advantages against competition and their sustainability, cost and capital efficiency, and operational effectiveness in execution. What does this mean? Let's translate it into a simple question: Does the ice cream store have something people need or want now and in the future (demand), that no one else has (competitive advantage) or can copy or get now and in the future (sustainable) and can these advantages be translated into business value?

For example, why do customers choose to buy ice cream from this store rather than from somewhere else? Is it location, assortment, taste, service, price? What do they associate the store and its products with? What is important to customers? Why do they come back? Have their motivations changed over the years or are they likely to change over the next 10 years? What incentives can cause customers to switch to or away from the store? What threats are there?

Warren Buffett illustrates his thinking:

If you and I were looking at the chewing gum business (and we own no Wrigley's, so I use it fairly often in class), you'd pick a figure that you would expect unit volumes of chewing gum to grow in the next 10-20 years and you'd give me your expectations about how much pricing flexibility Wrigley's has and how much danger there is that Wrigley's market share might be dramatically reduced-you'd go through all of that... We're evaluating the moat, the price elasticity that interacts with the moat in certain ways, the likelihood of unit demand changing in the future or management being either very bright with the cash that they develop or very stupid with it...

I would say you can almost measure the strength of a business over time by the agony its managers go through in determining whether a price increase can be sustained ... You can learn a lot about the durability of the economics of a business by observing the price behavior.

Can competitors make the store's product obsolete or copy its advantages?

If someone puts a store next to John's and customers don't see any difference between the two stores’ products and services, then customers are likely to buy the ice cream in the store with the lowest prices.

Could John still make money having the lowest price? Yes, if demand exceeds supply or if John can produce and sell his ice cream at a lower cost than competition assuming of course competition doesn't want to run its business at a loss. John must run the store with extreme cost and capital efficiency relative to the competition. Lower costs and better use of capital allows him to keep the lowest price and still make money.

How important is store management?

How much cash and when John gets it is also a function of the ability and integrity of management. Management can influence owners' return by influencing the return of the business. It can influence where capital is being employed, and under what conditions money is to be reinvested.

When it comes to integrity, Warren Buffett says it best:

One friend of mine said that in hiring they look for three things: intelligence, energy, and character. If they don't have the last one, the first two will kill you because, it's true, if you are going to hire somebody that doesn't have character, you had really better hope they are dumb and lazy, because, if they are smart and energetic, they'll get you in all kinds of trouble.

A business may look to have a huge margin of safety in price but without an able and honest management this margin may end up as an illusion. History is filled with stories about great businesses that were destroyed by poor management. Ask: Is the company equipped with a competent and honest management that focuses on value? Will they use free cash flow for the benefit of the owners?

But in some businesses, not even brilliant management helps. Warren Buffett shares his experiences:

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: "When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

Let's take another example of "what happens". This time we describe a model from chemistry and give an example of a misused word - entropy.

At 3.54 a.m. the city of Los Angeles woke up to a 6.5 earthquake.

Why does an earthquake crush so many structures and cause so many deaths? Why doesn't hot coffee stay hot? The answer to these questions gets to the heart of every spontaneous (means in chemistry "by itself, without energy input") physical or chemical event in our lives. The warmth in a hot beverage is due to fast moving molecules. They collide with slower moving molecules in the (relatively colder) environment and cause the slower ones to speed up. Energy is spread out from the hot liquid to the cup, the air, and by the currents of the air, to distant places. That is the nature of energy.

The instant we drop a ball on the floor its energy becomes kinetic energy or energy due to movement. But the term isn't important. What happens is. All energy tends to spread, to become dispersed, if it is not hindered from doing so. That explains why iron rusts, why there are hurricanes, why objects break, etc. Why does a speeding truck running into a brick wall cause enormous destruction? Its kinetic energy not only tends to spread out; it spreads out catastrophically.

The same with the earthquake. Stress in the earth caused by the movement of tectonic plates over the mantle suddenly spreads. Its potential energy is instantly changed to kinetic energy as the earth moves. When such gigantic energy spreads, it shakes everything for miles around an epicenter. Because of that energy dispersal, not only buildings collapse, but lives are cut short.

Our lives are based on energy dispersal. Each second, chemicals in our body (converted within us from the food we eat and oxygen we breathe) keep our hearts beating. Our lungs pump oxygen into us and carbon dioxide out. We are energy processing machines. We must keep spreading out energy so that we are warm and keep making chemicals so our hearts beat and muscles work and our lungs function. If these processes are seriously interrupted - as they are in any major accident like an earthquake - we die.

What does it mean (what happens) when we hear it was a magnitude 6.5 earthquake? The Richter scale is a logarithmic scale developed by the geophysicist Charles F. Richter and measures the amplitude (size) of an earthquake from the recording of earthquake waves made on a seismograph. Each unit increase in the scale corresponds to a 10-fold increase in the measured wave amplitude at a comparable distance. A magnitude 7.5 earthquake therefore has a recorded amplitude 10 times that of a magnitude 6.5 earthquake under comparable measurement conditions. But since energy causes the damage, the important difference lies in the energy release. For every unit increase, energy release increases by a factor of about 32. A 7.5 earthquake releases about 32 times more energy than a 6.5.

Since 1900, the biggest earthquake in the U.S. occurred in Alaska in 1964. It had a magnitude of 9.2. What is the difference in strength or energy between a magnitude 9.2 earthquake and a 6.5 earthquake? About 11,220 times. This means that it would take 11,220 earthquakes of magnitude 6.5 to equal the energy released by a 9.2 earthquake. This explains the destructive power of big quakes.

"Follow the energy. "

Energy dispersal is one useful way to explain entropy. More precisely, entropy is a thermodynamic state quantity; heat transferred reversibly, divided by absolute temperature, gives the associated entropy change. Entropy is a misused word, often used to explain all kinds of "disorder." Disorder is certainly characteristic of many of our situations in life - failed relationships, social problems, messy desks, disorderly bedrooms, etc. However, entropy has no relevance to these things. The thermodynamic concept should not be treated as a literal explanation of social or household disorganization.

A room doesn't have a tendency to get messy by itself. Some outside energy is needed. It is the energy concentrated in our muscles that is being spread and causes our desks to be messed up. There is no energy being spread out in the papers themselves. As Chemistry Professor Frank Lambert says, "There isn't any 'tendency of objects to become disorganized' in nature any more than bank tellers have a 'tendency to give money to robbers' without a gun."

That energy tends to spread explains why metal rusts, why things break and wear down. Energy can disperse through processes that damage materials, but the direction of a particular process depends on the system and its surroundings. Thermodynamic favorability also does not tell us how quickly a process occurs. The repetition of time and energy must be considered. A small push (or activation energy) is needed to start a reaction. Gasoline needs a spark or flame to react with oxygen. We need a match to light a fire. For example, it took a single spark to initiate the reaction between hydrogen gas and oxygen, causing the airship Hindenburg to burn. It takes movements of wind and warm moisture from a tropical ocean to form a hurricane. It takes oxygen and moisture to make iron rust. It takes energy to make wood rot. And this process can be delayed. This happens if we for example paint iron to prevent rusting. Painting keeps oxygen away from the iron so a reaction can't happen.

These examples show how by observing "what happens" we can better understand reality.