Part 4: Is The Price is Right?
Theprice that you pay for a stock determines the rate of return-the higher the initial price,the lower the overall return. The lower the initial price paid, the higher the return.Buffett first picks the business, and then lets the price of the company determine when topurchase the firm. The goal is to buy an excellent business at a price that makes businesssense. Valuation equates a company's stock price to a relative benchmark. A $500 dollarper share stock may be cheap, while a $2 per share stock may be expensive.Buffett uses a number of different methods to evaluate share price. Three techniquesare highlighted in the book with specific examples.
Buffett prefers to concentrate his investments in a few strong companies that arepriced well. He feels that diversification is performed by investors to protect themselvesfrom their stupidity.
Earnings Yield Buffett treats earnings per share as the return on hisinvestment, much like how a business owner views these types of profits. Buffett likes tocompute the earnings yield (earnings per share divided by share price) because it presentsa rate of return that can be compared quickly to other investments.
Buffett goes as far as to view stocks as bonds with variable yields, and their yieldsequate to the firm's underlying earnings. The analysis is completely dependent upon thepredictability and stability of the earnings, which explains the emphasis on earningsstrength within the preliminary screens.
Buffett likes to compare the company earnings yield to the long-term government bondyield. An earnings yield near the government bond yield is considered attractive. The bondinterest is cash in hand but it is static, while the earnings of Nike should grow overtime and push the stock price up.
Historical Earnings Growth Another approach Buffett uses is to project theannual compound rate of return based on historical earnings per share increases. Forexample, take company in which current earnings per share are $2.77 and earnings per sharehave increased at a compound annual growth rate of 18.9% over the last seven years. Ifearnings per share increase for the next 10 years at this same growth rate of 18.9%,earnings per share in year 10 will be $15.64. [$2.77 * ((1 + 0.189)^10)]. This estimatedearnings per share figure can then be multiplied by the company's historical averageprice-earnings ratio of 14.0 to provide an estimate of price [$15.64 * 14.0=$218.96]. Ifdividends are paid, an estimate of the amount of dividends paid over the 10-year periodshould also be added to the year 10 price [$218.96 + $13.32 = $232.28].
Once this future price is estimated, projected rates of return can be determined overthe 10-year period based on the current selling price of the stock. Buffett requires areturn of at least 15%. For our example, comparing the projected total gain of $232.28 tothe current price of $48.25 leads projected rate of return of 17.0% [($232.28/$48.25) ^(1/10) - 1]. Our first table lists the stocks passing the consumer monopoly screen thathave a projected rate of return of 15% based upon historical earnings growth model.
Sustainable Growth The third approach detailed in "Buffettology"is based upon the sustainable growth rate model. Buffett uses the average rate of returnon equity and average retention ratio (1 - average payout ratio) to calculate thesustainable growth rate [ ROE * ( 1 - payout ratio)]. The sustainable growth rate is usedto calculate the book value per share in year 10 [BVPS ((1 + sustainable growth rate)^10)]. Earnings per share can be estimated in year 10 by multiplying the average returnon equity by the projected book value per share [ROE * BVPS]. To estimate the futureprice, you multiply the earnings by the average price-earnings ratio [EPS * P/E]. Ifdividends are paid, they can be added to the projected price to compute the total gain.
For example, a company would have a sustainable growth rate of 19.2% if its average ROEwas 22.8%, and average payout ratio was 15.9% [22.8% * (1 - 0.159)]. Thus, its currentbook value per share of $11.38 should grow at this rate to roughly $65.90 in 10 years[$11.38 * ((1 + 0.192)^10)]. If return on equity remains 22.8% in the tenth year, earningsper share that year would be $15.03 [ 0.228 * $65.90]. The estimated earnings per sharecan then be multiplied by the average price-earnings ratio of 14.0 to project the price of$210.42 [$15.03 * 14.0]. Since dividends are paid, use an estimate of the amount ofdividends paid over the 10-year period to project the rate of return of 16.5% [(($210.42 +$12.71)/ $48.25) ^ (1/10) - 1].
The final Buffett screen establishes a minimum projected return from the sustainablegrowth rate model of 15%. A critical aspect to analysis is determining whether thecompanies will continue their past pattern of growth and profitability.
