How does Warren Buffett (Trades, Portfolio) whittle down a list of potential stocks? He starts by screening the entire universe for those that have not just a competitive advantage, but a durable competitive advantage.
In chapter 18 of “The New Buffettology,” authors Mary Buffett and David Clark take us through the financial metrics that allow him to whittle down those stocks to a manageable few. An earlier article covered the first three metrics or, as the authors call them, “financial equations”:
- Earnings.
- Initial rate of return.
- Growth of earnings.
In this part, we follow up with the final four equations.
Financial equation four
How does this stock’s valuation compare with that of a treasury bond (he normally used 10-year Treasuries)? Buffett makes a point of comparing every potential investment’s return with that of a treasury bond, although probably not so much in the past decade, with its historically low rates. However, in 2000 it was a respectable 6% per year.
In that year, Buffett and Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) bought H&R Block (HRB, Financial) shares for $24 each; they generated a yield of 11.5%, well above the 6% available on treasury bonds. In addition, the H&R Block shares were growing at 7.6% per year.
The authors make an important, final point in this section by observing that the return on treasury bonds is a pre-income tax return, while the net earnings of a company are calculated after corporate taxes have been paid. By normalizing the relationship between these figures, investors will get a more accurate picture, but a simple comparison with treasury bonds at least leads to a business perspective.
Financial equation five
Projecting a future value from the historical annual growth rate: First, to project the future earnings per share, apply the average growth rate of the past 10 years to the next 10 years, compounding each year. For example, the Gannett Co. (GCI, Financial) earned an average of 9.6% per year over the decade between 1980 and 1990. Next apply that same rate from 1990 to 2000, including the compounding. Doing so increases the per-share earnings from $1.18 in 1990 to $2.95 in 2000. Thus, an investor can make a reasonable estimate of earnings 10 years in the future.
The market price also can be projected a decade ahead. Between 1980 and 1990, Gannett’s price-earnings ratio averaged 17.5. From a 1990 perspective, project ahead to 2000 by multiplying the anticipated 2000 earnings of $2.95 by 17.5. That projects a price,10 years in the future, of $51.62.
Next, the compounding rate of return can be projected. At one point in 1990, Gannett shares could be bought for $14.80. Using that as the present value (PV) and $51.62 as the future value (FV), the compounding rate of return is calculated as 13.3%.
Those were some of the projections, or forecasts, that might have been made in 1990. As it turned out, the company had earnings per share of $3.63, well above the 1990 estimate of $2.95. In 2000, the stock traded between $53 and $70 per share, compared with the 1990 estimate of $51.62, and the compounding rate of return would have averaged out to 16.6%.
To all of this, the authors add:
“You should understand that Warren is not calculating a specific value for the stock, as many who watch and write about Warren believe. Nor is Warren saying that Gannett is worth X per share and I can buy it for half of X, as Graham used to do. Warren is instead asking, if I pay X per share for Gannett stock, given the economic realities for the company, what is my expected annual compounding rate of return going to be at the end of ten years? After determining the expected annual compounding rate of return, Warren then compares it to other investments and the annual compounding rate of return that he needs to stay ahead of inflation.”
Further, they note this knowledge allows Buffett to ignore the daily prices since he already knows roughly what his long-term annual compounding rate of return will be.
Financial equation six
High rates of return on equity: For Buffett, a company with a durable competitive advantage will have consistent earnings—consistent enough to behave like bonds. In other words, he thinks of earnings per share as the equivalent of bond’s yield. In this simple example, a company has the following:
- Equity-book value of $10 per share.
- Net earnings of $2.50 per share.
- Therefore, it has a return, or yield, of 25% ($2.50 / $10).
There is one distinction. He sees an equity or bond as the equivalent of a variable rate of return entity because earnings and prices fluctuate. The authors said, “One of the keys to understanding Warren is realizing that he is not very interested in what a company will be earning next year. He is interested in what the company will be earning in ten years.”
To think like Buffett, we must distinguish between the potential of different securities a decade from now. The company that starts with the highest return on equity will not only have a head start, but annual compounding will magnify the differences greatly after 10 years.
Financial equation seven
The annual compounding rate of return: According to the authors, Buffett has figured out how to project the annual compounding rate of return that a business with a durable competitive advantage might generate. Often, he needs to wait for those rates of return to appear, which means holding until the price of the stock falls far enough for the compounding rate of return target. As the authors wrote, “In Warren’s world the projected annual compounding rate of return rules supreme.”
They give us an example from 1993, when Buffett and Berkshire Hathaway bought nearly 1 million shares of Bristol-Myers Squibb (BMY, Financial) for approximately $12.4 million. The company had:
- Shareholder equity (total assets minus total liabilities) of $2.90 per share.
- Net earnings of $1.10 per share.
Based on these numbers, Buffett would consider it, in bond terms, as yielding 37.9% ($1.10 / $2.90).
That $1.10 in net earnings was divided into two streams:
- 35% would be held as retained earnings.
- 65% would be paid out as dividends.
The cash amount of the retained earnings would be 38 cents of the $1.10, and the dividend portion would be 72 cents.
Next, Buffett would see that 35% of the 37.9% (or 13.25%) as being added to the equity base each year. That means increasing the 1993 net earnings by 13.25% per year for the next 10 years, so $1.10 x 13.25%, or $1.25 in year one, and so on for the following nine years. At the end of 10 years, the projected per-share equity value will reach $10.05.
Projected earnings per share in 10 years, 2003, can then be calculated by multiplying $10.05 by 37.9%, which is $3.81.
Finally, the authors noted, “In the table on page 233 [not included in this article] we have projected per share earnings for ten years. In most situations this would be insanity. However, as Warren has found, if a company earns high rates of return on shareholder equity, created by some kind of durable competitive advantage, fairly accurate long-term projections of earnings can be made.”
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.” Mary Buffett is a former daughter-in-law of the "Oracle of Omaha."
(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.
