In the 1991 Berkshire Hathaway (BRK.A)(BRK.B) annual report, Buffett explained that the intrinsic value of a perpetual annuity cash payment of $1.00, discounted at an annual interest rate of 10%, is $10.00. He further explained that the intrinsic value of a perpetual annuity that pays $1.00 in the first year, and then increases by 6% in each subsequent year (i.e. to $1.06 in Year 2, $1.12 Year 3), discounted at the same 10% annual interest rate, is worth significantly more: $25.00.
The big lesson is future growth has a significant impact on intrinsic value as calculated according to the discounted cash flow method of determining intrinsic value that is used by Warren Buffett.
The Full Example Below
[/b] “The industry's weakened franchise has an impact on its value
that goes far beyond the immediate effect on earnings. For an
understanding of this phenomenon, let's look at some much over-
simplified, but relevant, math.
A few years ago the conventional wisdom held that a newspaper,
television or magazine property would forever increase its earnings
at 6% or so annually and would do so without the employment of
additional capital, for the reason that depreciation charges would
roughly match capital expenditures and working capital requirements
would be minor. Therefore, reported earnings (before amortization
of intangibles) were also freely-distributable earnings, which
meant that ownership of a media property could be construed as akin
to owning a perpetual annuity set to grow at 6% a year. Say, next,
that a discount rate of 10% was used to determine the present value
of that earnings stream. One could then calculate that it was
appropriate to pay a whopping $25 million for a property with
current after-tax earnings of $1 million. (This after-tax multiplier
of 25 translates to a multiplier on pre-tax earnings of about 16.)
Now change the assumption and posit that the $1 million
represents "normal earning power" and that earnings will bob around
this figure cyclically. A "bob-around" pattern is indeed the lot of
most businesses, whose income stream grows only if their owners are
willing to commit more capital (usually in the form of retained
earnings). Under our revised assumption, $1 million of earnings,
discounted by the same 10%, translates to a $10 million valuation.
Thus a seemingly modest shift in assumptions reduces the property's
valuation to 10 times after-tax earnings (or about 6 1/2 times
Dollars are dollars whether they are derived from the
operation of media properties or of steel mills. What in the past
caused buyers to value a dollar of earnings from media far higher
than a dollar from steel was that the earnings of a media property
were expected to constantly grow (without the business requiring
much additional capital), whereas steel earnings clearly fell in
the bob-around category. Now, however, expectations for media have
moved toward the bob-around model. And, as our simplified example
illustrates, valuations must change dramatically when expectations
[/i]Below there are 38 questions from Appendix D of the Tweedy Browne Paper, “Investing for Higher After-Tax Returns,” called the [b]Buffett 101 Checklist:
1. What does your global competition look like over the next several years?
2. What have your competitors done in the last three years to upset these global dynamics?
3. What have you done to them in the last three years to affect those dynamics?
4. How might your competitor attack you in the future?
5. What are your plans to leapfrog the competition?
6. Expected rates of overall same-store internal revenue growth for the industry/product area that the company operates in over the next 5 to 10 years? Expected rate of overall unit growth and price increases/decreases over the next 5 to 10 years for the company’s product area?
7. Study the company’s competitors: Compare their balance sheets and income statements: Gross margins, SG&A and profit percentages, return on equity, return on capital, ratio of sales to various asset categories and capital, etc. Compare growth rates of sales over the last five years and recently. Describe market share percentages. Compare growth in assets, such as property, plant and equipment.
8. Who is growing fastest and gaining market share? Why?
9. Who is the toughest competitor? Why?
10. What has occurred and what is expected to occur in the overall industry with respect to additions to capacity, additions to inventory? Has the overall industry been adding to assets or is it expected to add to assets such as property, plant and equipment, or inventory at a faster rate than expected growth of overall industry unit demand? (For example, over expansion of the inventory of manufactured homes in relation to unit demand led to very crummy unit pricing for manufactured homes as dealers cleared out bloated inventories.)
11. Describe pricing behavior in the company’s industry: Which competitor, if any, typically increases prices first? What has happened next? Who cuts prices? What happens next? Has pricing behavior been rational/“statesmanlike” in the company’s field of business? Describe pricing “signaling” behavior in the company’s field of business. Describe recent pricing moves.
12. Who is the lowest cost competitor? Why? How sustainable is the competitor’s cost advantage? How easy would it be for another company, perhaps doing business in a way that is different from the way that most competitors do business now, to operate with much lower costs than most of the competitors. (For example, Charles Schwab, a stock brokerage firm that does not pay sales commissions to brokers, can transact share trades at a lower cost per share than Merrill Lynch, which pays brokers commissions on the stock transactions of its customers.)
13. Could new technology have a dramatic impact on the company’s business model, earning power and growth prospects? (For example, when CD rom technology enabled Microsoft to put an encyclopedia on a CD rom that cost less than $1.00 to stamp out, this encyclopedia was sold for $49.00, as compared to prices of $650 - $850 for a printed World Book set and $1600 for an Encyclopedia Britannica set. In some instances, Microsoft’s Encarta encyclopedia was given away as a freebie to purchasers of personal computers. Microsoft’s Encarta took significant unit sales away from World Book and Encyclopedia Britannica and ruined the pricing structures and earning power of these two previously dominant encyclopedia publishers.) How is the Internet affecting, or could it affect, the company and competitors in its field of business? Describe how, if applicable, the Internet has enabled new entrants to compete in the company’s field of business. Describe the new Internet competitors, and the advantage/disadvantages of their business models.
14. Describe the expansion plans and strategies of competitors, including new entrants. Read the annual reports and analysts’ reports concerning competitors to gain a better understanding of their plans.
15. Consider whether the company’s products’ prices are so high that they encourage lower priced product offerings from competitors. In other words, is product pricing so high that competition from lower priced products cause doubt about the sustainability of future earning power and cause doubt about growth prospects over the next 5 to 10 years. (For example, Eastman Kodak had wonderful earnings growth from its U.S. photographic film business until Fuji Photo was able to offer similar quality film at retail prices that were one third less than Kodak’s prices. Kodak’s retail film prices were high enough to permit Fuji to enter the film business in the U.S., and this competition has negatively impacted Kodak’s profitability and earnings growth. Similarly, Kellogg Company had an excellent record of earnings growth that was driven by price increases on its cereal products. High retail prices for Kellogg’s Corn Flakes and Rice Krispies has permitted new copy-cat store brand competitors to enter the business with “Brand X” retail corn flakes priced at a discount to Kellogg’s cereals. These new lower priced generic, copycat cereals have been taking sales away from Kellogg, and Kellogg’s earnings growth has halted.)
16. Would it make sense for some existing competitor or new competitor to offer a product similar to the company’s product as a “freebie” giveaway? If so, how might this development affect the company’s competitiveness, earning power and growth prospects? (For example, several companies offer Internet access as a freebie in competition with Internet access provider businesses that charge their customers $20.00 per month for this service. Similarly, American Express recently offered stock brokerage transaction services as a freebie if you open an account with them of a certain asset size.)
17. Talk to customers about the competitive landscape. (For example, when we were studying Dow Jones Company’s Telerate financial information business, we talked to a customer who subscribed to Telerate’s service and learned that most customers subscribed to Telerate in order to obtain certain information about treasury bond prices that would soon become freely available. Once that happened, this customer planned to cancel its many subscriptions to Telerate’s service throughout its offices. This information pointed out a significant risk to Telerate’s earning power and growth prospects.)
18. Talk to competitors about the particular company that is being examined. How do they view its strengths/weaknesses and earnings growth prospects? What do they think of the company’s management?
19. Talk to sales people about the company and the competitive landscape.
20. Talk to the company’s trade association about the particular company and the competitive landscape and dynamics.
21. How do you see competition playing out over the next 5 - 10 years? How do you read the strategies of your competitors? How easy is it to enter the business? What prevents new competitors from entering? Are entry barriers sustainable?
22. How does the marketing/sales process work at the customer transaction level in the company’s field of business? Fixed price bids? Long term contracts?, etc.
23. Describe your competitive advantages/disadvantages as compared to each of your competitors. How sustainable are the particular company’s advantages? Why? What prevents the company’s earnings power and growth prospects from getting wrecked by competition? If it seems hard to wreck, then the company probably has sustainable economic advantage.
24. What worries management about the company and competitors’ moves and potential moves?
25. Looking out five years, what is the company’s best guess concerning the growth rate of revenues, and e.p.s.?
26. Looking out 5 to 10 years, how does the company plan to invest cash that is retained in the business? Expected return on equity on incremental investment?
27. What new investments, new ventures, new experiments, that the company is working on (or envisions) could have a significant positive impact on the value of the company in the future? What exciting stuff does the company have up its sleeve? (Several of our best long term holdings, such as Jefferies Group and Fingerhut, generated significant shareholder wealth from new investments/ventures that were only a “gleam in the eye” of management when we initially bought these stocks. Jefferies Group’s investment in Investment Technology Group and Fingerhut’s investment in Metris Corp. were both highly successful new ventures that we obtained for free when we acquired shares of Jefferies Group and Fingerhut.)
28. What is the company’s philosophy/strategy with respect to using free cash flow for stock buybacks when it is not required to support same-store growth?
29. How is management paid/incentivized?
30. How are personnel who make risk decisions, such as insurance underwriters, security traders, bank loan officers, etc. paid? Do they have “one-way” incentives which encourage risk but do not punish loss such as bonuses based on insurance sales, loan volume or trading gains without the particular individual sharing in the losses from unprofitable insurance policies, loans that have gone sour or trading losses? Does management have a history of enhancing shareholder value?
31. Company’s acquisition plans? When the company’s stock is cheap, how does it view buying back stock versus acquiring companies at full value?
32. What are the company’s plans concerning its capital structure over the next five years: Debt/equity, leasing assets, spinning off capital intensive assets such as bottling facilities or hotel assets, off-balance sheet financing?
33. Who makes pricing decisions for the company’s products? How are pricing decisions made?
34. What else is important? What should we ask about, but didn’t?
35. What information does management monitor and consider to be important in managing its business? How does the company’s information compare to competitors’ information? Does the company have an edge that is sustainable?
36. Are there substitutes for the company’s products that are gaining or likely to gain ground? (For example, Kellogg Company has faced substitute competition to its cereal products from bagels as a breakfast food. Producers of checks, such as Deluxe and John Harland, face increased substitution competition from Paypal, CheckFree and other electronic forms of payment as well as (in Finland right now) cell phones that can make wireless payments including even for the purchase of a Coke from a vending machine. )
37. In light of what we have learned about the particular company and the competitive game in which it is a player, do the historical financial statements of the company seem to be representative of the nature of the company, or has there been or is there likely to be such a change in the competitive game that the future financial statements are unlikely to look like the historical record? (We know that, on average, most companies with great 10-year e.p.s. growth and return on equity records tend to perform poorly or in a very average way over the next seven years. Only about one-fifth of the companies continue to be top performers over the next seven years. These companies had sustainable competitive advantages. They were able to maintain or enhance their positions in the competitive games in which they operate.)
38. Does the information cross-check? Warren Buffett has often mentioned how much he has learned and benefitted form Philip Fisher’s book, [i]Common Stocks and Uncommon Profits. The Philip Fisher method of researching a company, which Mr. Fisher refers to as the “scuttlebutt” method, is to interview several sources, piecing together an information mosaic about a company and its field of business. It is easier to have greater confidence in information and insights when several sources confirm the same insight or the same murkiness and uncertainty (which, in itself, is also an insight) about a company and its competitive position and economics. The facts may be so simple and obvious and make so much sense that questioning other sources to seek additional confirmation of an insight may be unnecessary.
Further reading you may enjoy are 10 Don'ts for Investors from Phillip Fisher & The Quality of Business Earnings - Checklist of Questions.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”- Warren Buffett
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain