Given Warren Buffett (Trades, Portfolio)’s tremendous appetite for facts and data, it should come as no surprise that metrics are an essential part in his success and the success of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
In chapter 18 of “The New Buffettology,” authors Mary Buffett and David Clark said they were setting out to look at the mathematical equations he uses, yet in many cases equations are not required, just simple calculations. We will review the equations, and other methods, in a two-part review of this chapter.
Throughout the chapter, there are many references to low prices—because the price you pay determines your returns. The authors pointed to Buffett’s experience with H&R Block (HRB, Financial) over a decade, starting in 1991:
- The share price ranged between $19 and $38 per share during the year.
- In 2001, 10 years later, the stock traded at $80 per share.
An investor who paid $19 per share would have enjoyed a cash return of $61 and an annual compounding rate of 15.4%. On the other hand, an investor who paid $38 per share would have a cash gain of $32 and a 7.7% return. Both purchase prices were available in the same year, yet the results were so different 10 years later.
Just to rub the salt in a little more, the investor who paid $19 and was enjoying compounding of 15.4% a year wound up with $418,849 after 10 years, while the investor who paid $38 would have had compounding of 7.7% and a final cash total of $209,069. In other words, you could double your money by being patient and buying at the lower price.
Not that many investors would know in advance where a stock price might go over the course of a year; in fact, trying to pick the bottom would be an exercise in timing the market, which rarely works out. Buffett knows the minimum returns he wants to earn, however, so all he has to do is wait for the market to get to the price (lots of patience required). With that, here are the first three equations.
Financial equation one: Earnings. Specifically, what do the company’s historical earnings look like? If they consistently grew over the last 10 years, then estimating future earnings is relatively straightforward. Few companies do that, of course: many will meander above and below the average, and some may even show negative returns in one or more years.
What if there are negative earnings in that history? That’s not uncommon, especially in the current year, because the share price of good quality stocks will not dip without some bad news. In such cases, investors must research the company’s recent history, or its history around the time of the losses. That could start with another look at the company’s competitive advantages: Are the advantages still in place, are they still durable and are they sufficiently robust to get the company through its current difficulties?
Financial equation two: Initial rate of return. For example, H&R Block traded around $30 per share in 2000, against expected earnings of $2.57 per share. This produced an initial rate of return of 8.6% (calculated by dividing the earnings by the amount paid for the stock).
For perspective, at about the same time, Yum Brands (YUM, Financial) traded for about $24 a share against expected earnings of $2.77 per share, and that would provide an initial return of 11.5%. If investors take the time to do that simple calculation, they will be able to compare expected returns and earnings.
Buffett takes such calculations a step further: He thinks of such “equity/bonds” as compounding entities. In the case of H&R Block, he would see an initial rate of return of 8.6% in the first year, 9.1% in the second year, 9.8% in the third year and so on until the stock is sold. While I’m a bit confused about the authors’ numbers, their point is made. Note, the authors’ began by listing the initial return as 8.6% (dividing the return by the price comes to 8.5666%). In a later discussion, they refer an initial rate of return of 8.5% as well as earnings growth of 7.6%.
Such compounding can produce dramatic results for patient investors such as Buffett; after 28 years of holding the Washington Post, for instance, his annual rate of return had increased to 116%.
Financial equation three: Per-share growth rate. As noted above, the rate of growth has a major impact on the compounded results, and Buffett has a quick and easy way of determining this growth. He compares the compounded growth rate over two time periods: The previous 10 years and the previous five years.
To illustrate, the authors used the Gannett Company (GCI, Financial), a newspaper publisher. Starting with the 10-year record, it had:
- 1990 earnings per share of $1.18 (present value).
- 2000 earnings per share of $3.70 (future value).
- Number of years: 10.
- Annual compounding rate of growth: 12.1%.
Turning to the five-year record (1995 to 2000), it had:
- 1995 earnings per share of $1.71 (present value).
- 2000 earnings per share of $3.70 (future value).
- Number of years: five.
- Annual compounding rate of growth: 16.6%.
Obviously, Gannett has been increasing its compounded growth rate since the most recent five years are higher than the most recent 10 years. Next, Buffett asks himself what factors drove this increase in earnings? Is it something that has staying power, or was it a flash in the pan? Have the business basics changed, has the company become more effective in operating its business? What about share buybacks? Buffett likes the latter strategy since it increases valuations of the stocks he owns.
Buffett begins with a relatively long list of stocks that have a durable competitive advantage. He winnows down that list with a series of financial equations or calculations that exclude less promising companies. We continue our examination of these equations and criteria in the next article, “Warren’s Key Metrics, Part 2.”
About
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”Â
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
