A few weeks ago, I wrote an article called “Don’t be Afraid to Pay a Little Bit More.” My conclusion was that truly extraordinary businesses are rare and they rarely look cheap. So when you identify one, don’t be afraid to pay a little bit more than whatever your fair value is.
But then I realized that I didn’t answer the question what a little bit more is. Is paying 1.5 times book value for Berkshire Hathaway a little bit more? Is paying 30 times earnings for MasterCard a little bit more?
After a little while, I came to the conclusion that I’m not smart enough to figure out what exactly is “a little bit more.” Fortunately I don’t have to figure that out as Jacobbi taught us “invert, always invert.” Therefore, I decided to explore what “a little bit more” is not. Obviously anything equal to or less than the range of fair value qualifies but as my concern is not to avoid the folly of overpay, I’m not interested in exploring what’s less or equal to fair value for the purpose of this discussion. This leaves me with “paying too much.”
To answer what “paying too much” looks like, I’ve decided to study two examples of great businesses and derive some implications thereof. Luckily plenty of examples exist. Among all the studies I’ve done, the cases of Walmart and Coca Cola stand out.
Let’s first take a look at the 12 year and 13 year price data adjusted for split and dividends for Walmart and Coca Cola for the selected periods.
Walmart:
| Year | Adjusted Ending Price (Data From Yahoo Finance) |
| 1999 | 55.06 |
| 2000 | 42.51 |
| 2001 | 46.32 |
| 2002 | 40.87 |
| 2003 | 43.21 |
| 2004 | 43.43 |
| 2005 | 38.96 |
| 2006 | 39.01 |
| 2007 | 40.92 |
| 2008 | 49.10 |
| 2009 | 47.83 |
| 2010 | 49.37 |
| 2011 | 56.21 |
Coca Cola:
| Month/ Year | Adjusted Ending Price (Data from Yahoo Finance) |
| June 1998 | 29.38 |
| June 1999 | 21.51 |
| June 2000 | 20.17 |
| June 2001 | 16.02 |
| June 2002 | 20.26 |
| June 2003 | 17.11 |
| June 2004 | 18.98 |
| June 2005 | 16.10 |
| June 2006 | 17.05 |
| June 2007 | 21.30 |
| June 2008 | 21.69 |
| June 2009 | 20.73 |
| June 2010 | 22.35 |
| June 2011 | 30.89 |
I don’t know how many readers will be surprised at the data but I am quite shocked. Keep in mind these prices are adjusted for dividends and split so they reflect total return information. Had you invested in a share of Coca Cola in June 1998, your money is dead for the next 13 years. Similarly, had you put a dollar in the common stocks of Walmart in the beginning of 2000, you would have been barely better off 12 years later.
Both businesses are truly extraordinary businesses with the widest moats on earth. The ROEs for both Walmart and Coca Cola are over 20%. Coca Cola’s earnings were growing at over 15% a year and Walmart’s earnings were growing at 20% a year.
How much were investors paying for those extraordinary businesses then that they suffered for more than 10 years?
It turns out that Investors were paying 51 time earnings for Coca Cola in June 1998 and at the high of 1999, investors were paying almost 70 times earnings for Walmart.
Let me use the total return formula to explain what happened.
Total Return = Dividend Yield + % Change in EPS + % Change in P/E + (% Change in P/E * % Change in EPS)
Had the P/E for Walmart and Coca Cola not changed during the 12 year and 13 year period, total returns, assuming a 2% dividend yield and 15% EPS growth rate, for each company would be:
Walmart : 2% * 12 years + (1.15^12-1) + 0 + 0 = 459%
Coca Cola” 2%*13 years + (1.15^13-1) + 0 + 0 = 541%
We know the total return over the 12 and 13 periods are almost 0% in both cases. Reverse engineer the formula, we can derive the change in P/E ratio during these periods for WMT and KO:
WMT:
| Total Return= | Dividend | %Change in EPS | %Change in P/E | %Change in EPS * %Change in P/E |
| 0%= | 2%*12 yrs | 1.15^12-1 = 435% | ? | 435% * ? |
Solving for question mark, we get a change in P/E equal to roughly negative 85%. This means Walmart’s P/E would have to contract 85% during the 12 year period for investors to not make any money even though EPS would have quadrupled. Remember investors were paying 70 times earnings for WMT in 1999, a 85% contraction implied a P/E of 11, which is not too far from what WMT’s average P/E in 2011.
Applying the same to Coca Cola, we’ll get an even sharper drop of P/E of about 87-88%.
You may argue that this is not what happened in reality. This is because both Coca Cola and Walmart’s earnings growth had been merely 10-12% during the 12 and 13 year period instead of 15%. And when actual earnings growth is slower than the projected earnings growth, a less severe contraction of multiple is needed get to lackluster returns had you paid a very high multiple for a high quality stock.
Now we could tell, with the benefit of hindsight, that paying 50-70 times earnings for the greatest businesses on earth can be categorized as paying too much. How much should we pay for great businesses then? A reader suggested to use Graham’s formula to decide the multiples we would want to pay for a business, namely 8.5 + 2 * growth rates. My personal experiences and observation show that there is some merit to this formula but I would use it more conservatively by tweaking it a little bit.
First of all, I would eliminate all companies whose growth is impossible to predict.Secondly, I would look for companies whose earnings predictability is relatively high. And lastly, I want a business that has a ROE of 15% or more. Through a lot of backtesting, I’ve found the following different versions of Graham’s formula helpful as general rule of thumbs.
1. If growth rate is between 0-5%: 8.5+ 2*Growth Rate
2. If growth rate is between 5-10%: 5+ 2* Growth Rate
3. If growth rate is more than 10%: 2* Growth Rate with a maximum of 50
Let me remind the readers that the assumption here is a great business with high ROE and moderate to high predictability. My experiences and knowledge are very limited and this article is only the result of my study and observation.Therefore, I encourage the readers to do a few case studies on their own.
