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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Buffett tip: First figure firm’s value

BILLIONAIRE investor Warren Buffett is frequently recognized for his ability to clearly explain highly complicated matters.

The so-called Oracle of Omaha lived up to that reputation during a rare interview last week on the new Fox Business News channel.

Buffett discussed a number of topics with interviewer Liz Claman–the American economy, possible successors at Berkshire Hathaway and more. His comments on stock selection were what jumped out.

Claman asked Buffett about his investment in PetroChina, a Chinese oil company that is now one of the biggest in the world. Buffett said Berkshire invested about $500 million in PetroChina in 2003 and recently sold the last of its shares, making roughly $3.5 billion in four years.

He read the PetroChina annual report before looking at the stock price. “I look at the business first and try to figure out what it’s worth,” he explained. “If I look at the price first, I’ll get influenced by that.”

He valued the entire company at $100 billion at the time. The stock market was valuing the company at about a third that price. Viewing that as a sufficient margin of safety, Buffett pounced. He sold when he believed PetroChina reached its fair value this year.

It sounds like such a simple method, but few people use it. Instead, people spend time on complex formulas intended to show whether the stock is undervalued compared with others.

The problem with that approach, Buffett illustrates in his comments, is that people are thinking too much about the price of the stock and not enough about the underlying business. Over time, stocks will do only as well as their companies.

When Buffett analyzes companies, he looks for firms that are easy to understand and have durable competitive advantages (which he calls moats). Buffett then decides what the entire company would sell for and divides that price by the total shares outstanding to calculate a fair value for the stock price.

If the number you come up with is far below, perhaps 30 percent or more, the price quoted on Wall Street, you could have an investment opportunity.

The main idea that Buffett gives us is that it’s more important to consider business value than stock prices. It might take a while, but stock prices will eventually move in line with earnings.

To carry out Buffett’s methods, an investor has to be able to calculate business value. That’s based on quantitative figures found in annual reports but also qualitative factors including brand names and future prospects.

Of course Buffett didn’t reveal all the tricks of his trade. After all, he has more than $40 billion worth of cash to deploy at Berkshire. When Claman asked him how he puts a value on a business, Buffett grinned.

“Well, that’s the trick,” he said, adding no more.