I wanted to ask you if you could give me an example of valuing a company with "Owner Earnings" that Buffett speaks about in his annual reports… I would like to know how do you believe he accounts for the valuation of the company if it is indeed growing?... what does he do if the company is indeed growing earnings (or free cash flow) at a 15% - 20% clip or better?
Since I’m not really going to answer the question you asked – simply because I don’t think Warren Buffett values stocks that way – I will give you a helpful rule of thumb for valuing fast growing businesses. We’ll use your example of a company growing 20% a year. Growth rates above 20% a year are hard to sustain. So there’s little point incorporating them into a valuation.
If you buy a company that will be worth 15 times earnings in 10 years’ time and will grow its earnings by 20% a year for those 10 years – here is what return you’ll get at different starting prices:
|Today’s P/E||10-Year Return|
So, if all you need is a 10% annual return and you really think you’ve found a company that will certainly grow its earnings by 20% a year for the next 10 years – you can pay up to 40 times earnings. I wouldn’t do it. But you could match the S&P 500 doing that as long as you were right about the 20% a year growth part.
Does Warren Buffett Value Growth?
I don’t think Buffett values growth. He’s offered some pretty big clues that he calculates intrinsic value differently from most people.
For example, this is from Berkshire’s latest annual report (it’s the same as last year):
Though Berkshire’s intrinsic value cannot be precisely calculated, two of its three key pillars can be measured. Charlie and I rely heavily on these measurements when we make our own estimates of Berkshire’s value. The first component of value is our investments…Berkshire’s second component of value is earnings…There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
Buffett is not just measuring the growth at someplace like IBM (IBM). This is also made clear by the fact that you can’t really come up with a formula that simply combines price and growth and get a value for IBM stock that makes it look like a great purchase at the prices Buffett paid for the stock. In fact, most comparisons of IBM’s P/E ratio to its sales growth rate would show the company to be overvalued. The P/E is 15. While sales growth per share is about 7%. That is not “growth at a reasonable price”. So, Buffett must be making some other calculation.
IBM’s return on equity has risen from about 15% a decade ago to around 50% to 100% today. The company has used its free cash flow to buy back stock. This has brought its equity down – IBM’s shareholder equity is actually lower today than it was 10 years ago. Meanwhile, margins have improved dramatically at IBM over the last 10 years. So, each dollar of total sales now delivers about 4 times more earnings per share. Remember, the same dollar of sales today is delivering 4 times more profit per share than it did 10 years ago and the company has increased its overall sales by about 2.8% a year. So, actual sales growth at the company is under 3% over the past 10 years. But earnings growth is much, much higher.
When Buffett buys IBM he is getting $13.25 a share in earnings. The company pays $2.90 a share out in dividends. That leaves $10.35 a share for the company to retain.
Over the last 10 years, IBM has earned $104 billion. It has paid dividends of $20 billion over the last 10 years. And it has used $71 billion to buy back stock. In other words, 19% of IBM’s earnings went to dividends and 68% of IBM’s earnings went to stock buy backs over the last 10 years.
Apply this same numbers to IBM’s current earnings of $13.25 a share and you get per share uses of: $2.52 in dividends and $9.01 in stock buybacks.
The actual dividend is $2.90 a share right now.
So, when Buffett buys IBM stock, he’s getting a dividend of $2.90 a share today. That dividend has been raised each year for a while now. And he’s getting $9 in expected share buybacks. Those amounts – $2.90 a share in dividends and $9 in stock buybacks – are reasonable guesses as to how IBM might use its future earnings.
The company has done an excellent job of increasing net income without increasing invested assets very much at all. So, we don’t even have to worry about IBM’s retained earnings. Of the $13.25 in earnings we expect that maybe $1.35 a share will go to growing IBM. That additional $1.35 per share will probably be turned into a lot more than $1.35 in intrinsic value. IBM’s growth over the last 10 years has been incredibly profitable on the basis of retained earnings growth versus long-term earnings growth.
As a quick illustration, assets grew 2% a year over the last 10 years – while net income grew 16% a year. Yes, this is before stock buy backs. EPS grew more like 20%.
Okay, so that $1.35 in earnings reinvested in the actual operating business will probably earn a good return for Buffett. What about the $2.90 a share in dividends. Well, he gets to invest those himself. So he knows what the dividends are worth.
We’ve taken care of $2.90 in dividends and $1.35 in reinvested earnings. That leaves about $9 per share in share buybacks.
If we are pretty pessimistic – and just take IBM’s P/E ratio of 15 (1/15 = 6.67%) and its 10-year sales growth of around 3% – we can see how share buybacks at prices like the one IBM trades at today should deliver roughly 10% returns.
On top of that, we are using IBM’s current earnings instead of its current free cash flow. Free cash flow exceeds earnings at IBM (all the time). As a result, we’re talking about a double digit return on the money IBM invests in stock buybacks. Of course, if the price of IBM stock rises – these buybacks earn lower returns for Berkshire.
Simply put, if IBM spends $9 a share on stock buybacks, Buffett thinks IBM’s intrinsic value increases by more than $9 a share – quite possibly something like $10 to $10.25 a share.
On top of that, I doubt Warren Buffett thinks IBM’s earnings – before buybacks – will only grow around 3% a year. That 3% number was IBM’s sales growth (before buybacks) over the last 10 years. To the extent earnings growth exceeds 3% a year before buybacks – buybacks make even more sense.
So, I think Buffett sees a relative safe, predictable situation where most of the company’s earnings will be reinvested (via buybacks) at low double-digit rates of return with a possible tax advantage over dividends. (However, the advantage of buybacks to dividends at Berkshire is much less than it is for individual taxpayers due to the way dividends are taxed in the U.S.) Strange as this sounds, I think Buffett believes that IBM buying back $9 a share and paying $2.90 a share in dividends is actually equal to or better than IBM paying $12 a share in dividends. And, as we already saw the earnings IBM actually reinvests in the business are very productive (though only a tiny amount – about 10% – of IBM’s capital goes back into its business).
Now, if IBM were paying $12 a share in dividends and Buffett’s average cost was $171 a share in IBM – no one would wonder why Buffett bought the shares. They’d say he obviously bought the shares for the 7% dividend.
Well, in Buffett’s mind IBM’s capital allocation is every bit as good as if the stock actually had a dividend yield of 7%. Yes, the company is keeping the cash for itself, but it’s buying back stock in such a way that makes each dollar the company keeps worth at least as much as each dollar most companies pay out in dividends.
This IBM example is the reason I don’t think I can really answer your question about how Warren Buffett values growth. He doesn’t value sales growth. He values intrinsic value growth. How much will his initial investment grow by?
He doesn’t care about sales growth specifically. Sure, he likes at least a little sales growth because it provides protection. A stagnant business is a dying business. He doesn’t want any of those. But, beyond that, Buffett just likes a good return on his money. He wants his money to grow. Not necessarily the company’s sales, assets, etc. Since many companies reinvest a lot of their capital in their own operations – profitable growth is usually very important to him.
But not always. He bought IBM largely because it was buying back its own shares. He bought PetroChina (PTR) largely because they promised to devote a certain amount of earnings to dividends. He would not be interested in IBM if instead of paying $2.90 in dividends and $9 in share buybacks it was reinvesting all of its $13.25 a share in its operations. There is no way IBM can get a good return on $13.25 a share in reinvested earnings. The markets IBM serves are not growing fast enough to warrant that level of reinvestment in the business. IBM’s clients aren’t growing fast enough to warrant that level of reinvestment in serving them. It just wouldn’t make sense.
And I’m sure Buffett would not be interested in a company with all the same profitability metrics and price ratios and everything as IBM – but no dividend and no share buyback. That would be an unattractive investment to him. Because the return that $13.25 a share in reinvested earnings gets you in IBM’s actual operations wouldn’t be high enough for Buffett.
Buffett uses many years of data. He looks at the long-term history of a company – to see how and where it’s been putting its money. He wants to know – more than anything else – how much each dollar of today’s earnings will be worth in the future. If a company is growing with a 7% return on equity – that growth is a negative for Buffett. He doesn’t want a company putting its money back into a business like that.
Of course, without a moat and a long-history of profitable growth, Buffett isn’t going to assume that growth rates of 15% or 20% can ever be achieved with high returns on retained earnings.
So, I don’t really buy the whole idea that Buffett takes growth into account when he picks stocks. What he takes into account is the value of today’s earnings in tomorrow’s dollars. If IBM earns $13.25 a share and pays out $13.25 a share in dividends – Buffett knows exactly what that is worth. He will get a return equal to ($13.25 minus taxes) divided by IBM’s $197 price. And he can invest that however he sees fit.
What does this have to do with growth?
Not much. Buffett isn’t worried about how much a company is going to grow. He’s worried about how much his money is going to grow.
I started my article with a table showing how much you can pay for a company growing 20% a year for the next 10 years. I’ll show it again here:
|Today’s P/E||10-Year Return|
But I think it’s kind of misleading. The table is only meaningful when a company is retaining its earnings and has some kind of moat. The number of companies that have a wide moat, reinvest all their earnings in the business, and can grow 20% a year for the next 10 years is a really, really small number of companies.
I don’t think Buffett ever looks out more than 10 years when valuing a stock. And all of this assumes the issue is growth – not capital allocation. Which is unrealistic. A company can grow pretty slowly as long as it grows earnings faster than it grows reinvested earnings and it pays out the rest of its earnings in dividends or share buybacks.
So, I think this whole talk of growth versus price is really more of a Peter Lynch discussion than a Warren Buffett discussion. Warren Buffett is not a growth at a reasonable price investor. He’s a return on capital investor.
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