Buffettology – A Book Report
By Lynn Ostrem
Warren is looking for excellent business economics and competent management. He buys into a business only when it is selling at a price that makes business sense, given its intrinsic value.
Intrinsic Value: He defines it as the sum of all the business’s future earnings discounted to present value, using government bonds as the appropriate discount rate.
Stable earnings may allow one to place an intrinsic value on a business, but they will not always indicate the nature of a business’s underlying economics. Stable earnings merely allow for a perceived sound base on which to perform mathematical calculations.
Warren prefers to compare rates of return against government long-term Treasury bonds (or AAA Corporate) since the government can always raise taxes to keep from defaulting. But one problem with using bonds is that their yield is quoted in pre-tax terms. So, an 8% bond yield has an after-tax return of 5.52% (based on 31% personal tax rate).
Net earnings as reported by the investment surveys like S&P and Value Line are an after-corporate tax income figure. This means they will be subject to no further taxation unless the company pays a dividend.
He believes that without some predictability of future earnings, any calculation of a future value is mere speculation. The certainty of future earnings removes the element of risk from the equation. Warren will only invest is companies whose future earnings he can reasonably predict.
Warren chooses the kind of business he would like to own, then lets the price
and rate of return determine the buy decision. His approach is to determine what
he wants to buy in advance and then wait for it to go on sale. You have to know
what you want to buy before you look at the price.
Diversification is something people do to protect themselves from their own stupidity. He holds a small number of investments that he really understands. They are easier to follow. Graham wasn’t all that concerned with the nature of the business he was buying. He couldn’t be. He was involved in too many businesses.
Warren considers the earnings his. So, if a company earns $5.00/share, and he owns 100 shares, he has just earned $500.
Selecting Excellent Businesses:
Commodity Businesses are a no-no. They sell a product where the price is the single most important motivating factor in the consumer’s buy decision. There is considerable competition. Profits are kept low because of price competition. Capital is usually spent upgrading plant and equipment to keep abreast of the competition.
Producers of raw foodstuffs, i.e. corn and rice
Gas and Oil companies
Identifying Commodity Businesses:
Low profit margins
Low return on equity (American corporation average is 12%; they are much lower)
Absence of any brand-name loyalty, patents or copyrights
Presence of multiple producers
Existence of substantial excess production capacity in the industry
Identifying Consumer Monopoly/Toll Bridge Businesses:
Large barriers to entry
Consumer awareness/name brand loyalty
Don’t rely heavily on investments in land, plant and equipment
Large cash flows
Nearly always debt free
Low-tech products which don’t require sophisticated plants or on-going improvements
Don’t be overly concerned with P/Es. For companies who almost never have to replace plant and equipment, and have the capacity to produce high rates of return on a small net tangible asset base, the stock market sees this economic trick that inflation plays and responds by giving these businesses a higher P/E.
Utilities are great businesses, but regulations keep the owners from obtaining superior results.
Warren says the real test of strength is how much damage a competitor could do even if they didn’t care about making money.
The 9 Questions to Determine an Excellent Business:
#1 Does the business have identifiable consumer monopolies? USA Today, Coca Cola, Marlboro, Disney. Or advertising/media, financial services, credit card companies. A great product is where you start.
#2 Are the earnings of the company strong and showing an upward trend? Look at the 10-year history, and the 5-year history. It’s a good sign if the latest period is growing faster than the overall period.
#3 Is the company conservatively financed? Great consumer monopolies generate a lot of cash, have little or no debt, with long-term debt of less than one times current net earnings.
#4 Does the business consistently earn a high rate of return on shareholders’ equity? Shareholders’ equity is defined as total assets less total liabilities. Since American businesses earn an average of 12%, we are looking for something higher, preferably 15% or above. This shows that management can profitably employ retained earnings.
#5 Does the business get to retain its earnings? Warren found that exceptional businesses that didn’t need to spend retained earnings on upgrading plant and equipment or on new product development, could either acquire new businesses or expand the operations of their already profitable core enterprises. We want to invest in businesses that can retain their earnings and haven’t committed themselves to paying out a high percentage of their profits in dividends.
#6 How much does the business have to spend on maintaining current operations? We want businesses that seldom need to upgrade plant and equipment, don’t need ongoing expensive research and development, have products that never go obsolete, are simple to produce, where there’s little or no competition, and essentially, products that people never want to see change.
#7 Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does management do at this? We want companies that have the capacity to take retained earnings and reinvest them in business ventures that will give them an additional high return. Therefore, we need to invest in "cash cows."
#8 Is the company free to adjust prices to inflation? An excellent business is one that is free to increase the prices of its products right along with inflation, without it experiencing a decline in demand.
#9 Will the value added by retained earnings increase the market value of the company? The market will continually ratchet up the price of a company’s stock if it can properly allocate capital and keep adding to the company’s net worth. This can occur, even if the company sports a low P/E.
Types of Excellent Businesses:
Businesses that make products that wear out fast or are used up quickly, that have brand-name appeal and that merchants have to carry; where the price competition is shifted to the merchants. (Gillette, Coca-Cola)
Communications businesses that provide a repetitive service that manufacturers use to sell their products. (Interpublic)
Businesses that provide repetitive consumer services that people are consistently in need of; where non-union workers with little or no skills can perform the services. (ServiceMaster, H&R Block, MBNA)
One of Warren’s prerequisites is that he understands what the company makes and how it’s used.
Read all the articles, investment surveys, company reports and make notes.
Assemble at least 7 years of financial history.
Determine whether it is a commodity-type business or a consumer monopoly-type business.
Run figures for the return on equity and earnings growth over the last 8-10 years. They must have strength.
Do scuttlebutt research. Talk to merchants, industry insiders, and customers.
Next Step: Learn about the company’s management. The abilities are easy
to identify in a manager who
has an owner’s perspective. They include:
Profitably allocating capital.
Keeping the return on equity as high as possible.
Paying out retained earnings or spending them on the repurchase of a company’s stock if no investment
opportunities present themselves.
Dividends – Remember to figure them less personal income tax rate + state taxes.
Short-term Capital Gains – Less than 12 months are figured at the same rate as above.
Long-term Capital Gains – Currently at 20%.
In a world with an average of 5% inflation and 31% income tax, we need an annual rate of return on our investments of at least 7.2% just to stay even. Since Warren believes that politicians will constantly try to inflate the economy and at the same time raise taxes, he has set up a minimum possible pre-tax annual compounding rate of return of 15%.
Before the Numbers:
First, you must have established the nature of the company, predictability of earnings, the benefits of a consumer monopoly, with management that is honest and competent who function in the shareholder’s best interests. You must also determine whether management can effectively allocate capital in a profitable fashion.
Working the Numbers:
Test #1 – Determine at a glance the predictability of earnings:
Compare the EPS for a number of years (adjusted for price splits).
Are they consistent?
Are they showing an upward trend?
What were the economic dynamics that created this situation?
Test #2 – Determine your initial rate of return:
Estimated EPS for the current year div. by current stock price = initial rate of return
This would be the first year’s return.
(Later, this will be used in conjunction with the annual EPS growth rate.)
Test #3 – Determine the EPS growth rate:
Figure the annual compounding rate of growth for the company’s EPS for the last 10 years and the last
5 years. This will tell you the annual compounding rate of growth of the earnings over the long and short haul. To calculate:
Using the BAII Plus calculator:
Punch (2nd - #5) (2nd – CE/C);
Punch in the first year’s EPS (i.e. 1989) as the "old" value, then hit enter;
Arrow down, punch in the latest year’s EPS (i.e. 1999) as the "new" value, then hit enter;
Arrow down twice to (#PD), punch in number of years (i.e.10), then hit enter;
Arrow up to (#CH), hit the compute key (CPT) to see your answer.
This will compute the annual compounding rate of return over the long-term.
Now do the same with the 5-year period to determine the near-term rate of return.
The two numbers will allow us to see the true long-term nature of the company, and to determine whether management’s near-term performance has been in line with the long term.
Why the change (in growth rates)?
What effect will past economies have on our ability to predict future earnings?
What were the business economics that caused this change? (Buying back stock? New business ventures?)
Stock price relative to bonds: If a company’s EPS are $5.12, and the
price traded between $42 and $58
that year, the rate of return for THAT year was between 9% and 12%. If the long-term bond is 10%,
the stock’s price relative to a government bond is $51.20. You would have to buy $51.20 in bonds yielding 10% to get the same earnings per year.
$5.12 div. by $42 = 12%
$5.12 div. by $58 = 9%
$5.12 div. by .10 = $51.20
So, would you like to own government bonds at a static rate of 10%, or a stock with a lower return whose earnings are growing annually at 9% to 12%?
Return on Equity:
Warren calls a stock an equity/bond with a variable rate of return. The EPS is the yield (or coupon). So, if a company has EPS of $2.50, and per-share equity (also known as Book Value) of $10.00, then Warren would say that the company is getting a return on equity of 25%. ($2.50 div. by $10 = 25%)
Projecting the per-share equity value of a company: Warren also likes to use share equity to project future value (no more than 5-10 years ahead). This is done by using historical trends for the return on equity, less the dividend pay out rate. (We’ll skip the dividend part for now.)
Warren figures out approximately what the equity value (whole book value) of the company will be at a future date (say 10 years). Then he multiplies the per-share equity value by the projected future rate of return on equity ten years out. This gives him the projected future EPS of the company. He is then able to project a future trading value of the company’s stock. Using the price he paid for the stock as the present value, he can calculate his estimated annual compounding rate of return. Then, he compares this projected return against other indicators (government bonds) to see if he can stay ahead of inflation.
Determine the compounding annual rate of return of per-share equity for the
last 10 years.
Using the calculator, punch in the current per-share equity as present value, then hit (PV);
Punch in the rate of equity growth, then hit (I/Y);
Punch in the number of years, then hit (N);
Hit the compute key (CPT), then future value (FV) to get what should be the future per-share value of equity. How much are you willing to pay for that equity? Well, how much are you looking for? 15% like Warren?
Clear the calculator;
Punch in the future per-share equity value you just calculated, as future value, then hit (FV);
Punch in a 15% desired rate of return, then hit (I/Y);
Enter the number of years as 10, then hit (N);
Hit the compute key (CPT) and present value (PV), and the calculator will tell you the most money you
can spend per share to receive a 15% rate of return over the next 10 years.
What’s the rate of return? Let’s check it:
Clear the calculator;
Hit (2nd - #5) (2nd – CE/C);
Punch in the current price of the stock as the "old" value, hit enter;
Arrow down, punch in your estimated per-share equity in 10 years as the "new" value, hit enter;
Arrow down twice to (#PD), punch in 10 years, hit enter;
Arrow up to (#CH), hit the compute key (CPT);
This will tell you the rate of return if you purchased the stock at the current price.
The effect of dividends on determining the projected annual compounding rate
(I’ll use her example for Coca-Cola)
Current price of the stock: $5.52/share;
Current per-share equity: $1.07/share;
Current EPS: $.36/share. He figures his yield is earning him 33.6% ($.36 div. by $1.07 = 33.6%);
Current retained per-share earnings is $.21/share, or 58% of the total earnings/share (.21 div. by .36 = 58%);
That leaves the other $.15 of total EPS as a dividend (.15 div. by .36 = 42%).
If the company continues to grow it’s ROE by 33.6% and pay out 42% in dividends, we can figure the
future ROE and EPS.
To determine the growth rate of retained earnings:
The ROE is growing at 33.6%. Only 58% of that growth is retained.
So, 58% of 33.6 = 19.4%. (33.6 x .58 = 19.4%)
So for next year, if ROE/share grew from $1.07 by 19.4%, it would be $1.28/share. (1.070 x 1.194 = $1.28).
To project future ROE/share:
With the calculator, punch in the current ROE/share as present value (PV) (In this case, $1.07/share);
Punch in 19.4% as the compounding growth rate (I/Y);
Punch in 10 years (N);
Then hit the compute key (CPT) and future value key (FV) to get your projected per-share
ROE ($6.30 in this case)
Projecting EPS using ROE:
Remember our ROE growing at a compounding annual rate of 33.6%? Well, now that you have your projected per-share ROE of $6.30, simply multiply it by the growth rate of 33.6% to get your future EPS. ($6.30 x 33.6% = $2.12)!
Warren is convinced that, if the company has a consumer monopoly, a high rate of return on equity, and very strong increasing earnings, the chances are very good that accurate long-term projections of earnings are possible.
Bringing historical P/Es into the equation for projecting high and low price:
Now that we have our projected EPS, we can use P/Es to estimate our future price range. However, Mary Buffett warns us to be conservative. People using historical high P/Es can create projections that lead to disaster! She says stick with the average annual 10-year P/E, just to be safe, especially if there is a big spread between historical high and low P/Es.
So, using our example above, Coca Cola’s average annual 10-year P/E ranged
from 15 to 25;
Our projected 10-year future earnings are $2.12;
$2.12 x 15 = $33.15 (our estimated low price);
$2.12 x 25 = $53.00 (our estimated high price);
The present price per share was $5.22.
To determine the future compounding annual rate of return on our projected
Hit (2nd - #5), hit (2nd - CE/C);
Punch in the current price as the "old" value, hit enter. (in this case $5.22);
Arrow down, punch in the "new" value, hit enter. ($33.15 for one calculation and $53.00 for 2nd calculation);
Arrow down twice to (#PD), punch in 10 for the number of years, hit enter;
Arrow up to (#CH), and hit they compute key (CPT) to see your future rate of return.
In this case, the rate of return at the low P/E price is 20.3%
In this case, the rate of return at the high P/E price is 26%
So, we can figure our 10-year rate of return will be between 20.3% and 26%.
Adjusting our projected rate of return for taxes and dividends:
The projected share price minus the cost per share = total profit ($33.15 – $5.22 = $27.93);
Subtract corporate taxes (whatever!) of 35%. (This leaves us with $27.93 x 65% = $18.15);
If you chart out the dividend payments from our example, you would have $4.70 per share paid in total dividends over the 10 years. Since dividends are taxed at our personal tax rate (don’t forget state taxes!), a 31% tax rate would reduce the total dividends paid to $3.24 per share ($4.70 x 69% = $3.24);
So, add back the after-tax dividends paid to our net stock price ($18.15 +
$3.24 = $21.39);
Now, add back in our purchase price of $5.22 ($21.39 + $5.22 = $26.61);
FINALLY…With a cost basis of $5.22 per share, and an after-tax profit of $26.61 per share, the compounding annual rate of return would be 17.7% (And this is on the low average P/E of 15. Now do it for the high P/E price of $53.00).
EASIER METHOD: Using the EPS annual compounding rate of growth to project future pre-tax stock price:
To figure the 10-year compounding EPS growth rate:
Hit (2nd - #5), then hit (2nd - CE/C);
Punch in 10-year-old EPS as "old" value, hit enter;
Arrow down, punch in current EPS as "new" value, hit enter;
Arrow down twice to (#PD), punch in 10 for the number of years, hit enter;
Arrow up to (#CH) and hit the compute key (CPT) to get your compounding annual rate of return.
To figure the future EPS:
Hit (2nd - CLR TVM);
Punch in your current EPS as present value and hit (PV);
Punch in 10 for the number of years and hit (N);
Punch in your historical rate of EPS growth and hit interest key (I/Y);
Hit the compute key (CPT), and the future value key (FV), to get your projected EPS.
Review the P/E ratios for the last 10 years. Note the average annual high and low P/Es. Using both (separately), multiply the projected EPS by each P/E to get the estimated high and low projected prices.
Then calculate the compounding annual rate of return for the future prices,
based on today’s price:
Hit (2nd - #5), then hit (2nd - CE/C);
Punch in the current price as the "old" value, hit Enter;
Arrow down, punch in your estimated future price as the "new" value, hit Enter;
Arrow down twice, punch in 10 for the number of years (#PD), hit Enter;
Arrow up, hit the compute key (CPT), and you will see your compounding annual rate of return, based on today’s price. Remember that this is a pre-tax rate of return.
One way to determine the quality of management is what they do with earnings. Do they pay them out or retain them? If they retain them, do they profitably employ them?
Determining the value of share repurchases:
(Using her example of Coca Cola for 9 years of repurchases):
Over this period, shares were reduced from 3.174B to 2.604B = 570M shares retired (21%);
They spent $5.8M of shareholders’ equity on repurchases ($5.8B div. by 3.174B shares = $1.82/share;
The current year’s net income was $2.176B div. by the current 2.604B shares = $.84 in EPS.
Had they not repurchased, the current year’s net income div. by 3.174B shares = $.68 in EPS.
The $1.82 spent to repurchase shares earned the shareholders $.16 in EPS. ($.84 - $.68 = $.16);
This is a compounding rate of return of 8.7%. Doesn’t seem like much, but…
At a current P/E of 25, the $.68 in EPS would equate to a market price of $17.00 ($.68 x 25 = $17.00);
At a current P/E of 25, the $.84 in EPS would equate to a market price of $21.00 ($.84 x 25 = $21.00);
So, the $1.82 per share they spent to repurchase, earned them $4.00 more in market value.
Even though it reduced the equity base, it also reduced the shares outstanding—basically a wash. The pie remains the same size, but the pieces just got larger. Not only do the EPS increase, but so does the ROE/share. You can increase the ROE rate of return by either increasing the net earnings or decreasing the amount of equity.
How to determine if EPS are increasing because of share repurchases: Just because a company is buying back shares, doesn’t mean they are growing their business. This is an accounting trick. Actual net earnings are not affected by share repurchases. So, you need to do the following:
Compare the company’s annual compounding rate of growth of (whole dollar) net earnings against the company’s annual compounding rate of growth for EPS. If they are different, then check to see if the company increased annual earnings by true business growth or simply by manipulating the books through share buy-backs.
How to determine whether management is making good use of retained earnings: Retained earnings are used to buy back shares, enter into new business ventures, or otherwise increase the value of its core business. There should be a profitable return. We determine this by taking the per share earnings retained by the company for a certain period of time, then comparing them to any increase in EPS during this same period.
Example for a company not paying a dividend:
Cray Research earned a "total" of $31.67 in EPS from 1983 to 1993.
From 1983 to 1993 the EPS increased from $.89 to $2.33/share. This is an increase of $1.44/share.
$1.44 div. by $31.67 = 4.5%. This is the profit management earned by retaining the earnings.
Example for a company paying dividends:
Coca Cola earned a "total" of $4.44 in EPS from 1983 to 1993.
They paid out $1.89 in dividends, leaving $2.55 in retained EPS for that time period.
From 1983 to 1993 the EPS increased from $.17 to $.84/share. This is an increase of $.67/share.
$.67 div. by $2.55 = 26.2%. This is the profit management earned by retaining the earnings.
Which management is doing a better job of profitably allocating retained earnings?
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