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Rupert Hargreaves
Rupert Hargreaves
Articles (1135)  | Author's Website |

Warren Buffett: Focus on a Company's Future Earnings Potential

Advice from Buffett on paying a high price for stocks

January 22, 2020 | About:

One of the biggest mistakes investors can make when valuing a business is spending too much time on what has happened rather than what could happen.

This is particularly important for value investors. More often than not, I see value investors calculate the intrinsic value of a business based on historical figures. This can be quite misleading. These figures only tell us what has happened, rather than what is going to happen.

Look forward, not backward

More often than not, stocks fall in value because they are suffering from structural or cyclical problems. In either scenario, it is not sensible to rely on historical figures to try and calculate the current intrinsic value of a business. You could end up falling into a value trap if you do, especially with companies suffering from structural decline in their industries.

The newspaper industry is a fantastic example. A few years ago, I stumbled across a couple of publicly traded and newspaper companies, which looked cheap based on historical financials.

However, trying to figure out how much these stocks would be worth in five years was almost impossible. There was just no way of knowing if the companies' cashflows were sustainable and if they could grow. As it turns out, they weren't. Most of these companies have been dead money for the past few years.

The father of value investing, Benjamin Graham, relied on historical financials for his investment analysis. Warren Buffett (Trades, Portfolio) also relied on these figures in the first few years of his career.

However, in the 1960s, Buffett started to move away from deep value investing and spent more time focusing on growth businesses. These businesses cost more to buy but had much brighter long-term prospects.

Growth businesses

A great example was Coca-Cola (NYSE:KO). At the 1995 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders, Buffett explained that when he first bought the stock, it was dealing at a high price. However, as earnings expanded over the following decades, the stock grew into its valuation:

"We bought our Coca-Cola, for example, in 1988 and '89, on this stock, at a price of $11 a share. Which — as low as 9, as high as 13, but it averaged about $11. And it'll earn, we'll say, most estimates are between 230 and 240 this year. So, that's under five times this year's earnings, but it was a pretty good size multiple back when we bought it.

It's the future that counts. It's like what I wrote there, what Wayne Gretzky says, to go where the puck is going to be, not where it is. So, the current multiple interacts with the reinvestment of capital and the rate at which that capital's invested, to determine the attractiveness of something now. And we are affected in that valuation process to a considerable degree by interest rates, but not by whether they're 7.3, or 7.0, or 7.5. But I mean, we'll be thinking much differently if they're — long-term rates are 11 percent or 5 percent. And — but we don't have any magic multiples in mind. We're thinking — we want to be in the business that 10 years from now is earning a whole lot more money than it is now, and that we will still feel good about the prospects of the business at that time. That's the kind of business we're trying to buy all of, and that's the kind of business that we try and buy part of."

So, the next time you value a business, it might be sensible to follow Buffett's advice and evaluate the enterprise on what could happen, rather than what has happened.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

Rating: 5.0/5 (2 votes)



Ryan Harding
Ryan Harding - 2 months ago    Report SPAM

I took a major loss on shares in a local and regional newspaper business a few year ago as location aware internet technology started to steal away so many areas where they had been the gatekeepers for so many decades.

Being aware of future risks and things that may upset your investment thesis is a vital skill to successful value investing, and choosing how much of your portfolio to risk on a high-conviction opportunity you should bear in mind the potential of a serious adverse change in the industry. Apple at $95 and around 10% earnings yield in May 2016 was a high conviction idea for me, but there was always that chance that what happened to Nokia or Blackberry could supplant the iPhone, so I limited initial exposure to 25% and mentally planned to limit long-run exposure to maybe 50% so that the rest of my portfolio could still meet my compounding needs if it failed.

By the way, that Buffett quote presumably refers to $2.30 and $2.40, (or if you wish, 230 to 240 cents!), hence the 1988-9 average purchase price of $11 being under 5x 1994/5 EPS.

Tmuscat27 - 2 months ago    Report SPAM

so on what bases do you use for possible earning growth.

Please send ma an email because I will miss your answer for sure.

Thanks tm

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