Category Archives: Buy the Cheapest Business

Buffett’s Personal Account

In his October 16, 2008 New York Times op-ed piece, Warren Buffett wrote the following:

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.


A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.

In a recent CNBC interview, which I posted on November 19, 2010, Buffett said that his total tax rate would be around 16-17% of his income. He then went on to say that he would have “tens of millions” of capital gains.

From this we can surmise a few interesting things about how Buffett runs his personal portfolio.

1. Buffett is happy to be 100% in cash if he cannot find obvious bargains in the market as he was before the market turned down in 2008.

2. Buffett will scale into stocks and continue buying as they go lower. He is willing to go 100% long if the opportunity is compelling. “If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.”

3. He sells some or all of his stocks when they are no longer undervalued and have appreciated, rather than holding them indefinitely. If he had tens of millions of capital gains tax at a rate of 16 to 17%, he appears to have had capital gains in the neighborhood of $200 to $500 million. Buffett does not sell shares of Berkshire Hathaway to the best of my knowledge, so these gains appear to be from his personal account.

This is by no means an indictment of buy and hold which works well if you buy high quality franchises and do not overpay. In this case, your gains are primarily governed by the growth in intrinsic value of the business. Highly skilled investors may be able to do better – even after taxes – if they have the discipline to actively purchase obviously mis-priced securitied and sell them when they appreciate to fair value.

Acquisition Values

Acquisition values can be a useful part of an investor’s valuation toolkit. As Michael Price points out, these are particularly meaningful because they are not theoretical: they represent what an informed, sophisticated buyer is actually willing to pay for a business.

I like to pay close attention to when there is an acquisition to see what price was paid for the business, and I have begun to build a database of past deals within my circle of competence that I can refer to when evaluating a possible investment. Bear in mind that, just like the market in general, acquisitions are subject to irrational exuberance. Also, focus on deals that were done in the last couple years, keeping in mind the macro economic conditions that prevailed when the deal was done.

This morning it was announced that two private equity firms are close to a deal to purchase the clothing retailer J. Crew for $43.50 a share. J. Crew closed yesterday at $37.65 a share so the offer represents a premium of approximately 15%. One common metric used to value these types of deals is ratio of the enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA).

Caution: I think this metric has utility as a comparative metric because it normalizes differences in capital structure and tax rates and is widely used by investment banks and investment firms, but, following Buffett, I think it is deficient in helping to determine the intrinsic value of a business because it does not include the cost of capital expenditures which are essential to maintaining and growing a business.

At the offer price ($43.50), J. Crew has an EV/EBITDA of 7.3.

Based on yesterday’s closing prices, here is the EV/EBITDA ratio for several of J. Crew’s competitors:

Abercrombie & Fitch Co. – 8.1

American Eagle Outfitters Inc. – 6.8

Gap Inc. – 4.2

Urban Outfitters – 11.1

Aerospotale – 4.5

Based on this metric, Gap and Aeropostale look undervalued.

Coca-Cola (KO) Offers Good Risk-Adjusted Returns

To no surprise, Coca-cola (KO) showed up on my watchlist this week of companies with excellent long-term returns on equity. KO is widely regarded as one of the finest businesses in the world. Even after well over a hundred years of growth, the company is still expanding and has huge untapped and under-tapped markets ahead if it. Its moat is wide, and it has shown a great ability to not only grow its core brands, but also to adapt to local tastes and develop or acquire new products.

The stock has performed well as of late and is currently very close to its 52-week high.

Today, I am taking a look at KO’s valuation. I am using the general approach put forth in Prem Jain’s excellent book on Warren Buffett called Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing.

Based on KO’s long-term track record, I am estimating that EPS will grow at a rate of 8% annually over the next decade. The mean EPS estimate for 2010 is $3.50. Assuming 8% annual growth, EPS will be $7.54 in 2020. I am further assuming that given KO’s superior economics it deserves a P/E of 20, if fully valued. Its median P/E over the past decade has been 21. That would give KO a price of $150.80 in 2020. Using a discount rate of 7%, the present value of KO’s stock is $76.67.

Now let’s look at KO’s dividends. I estimate that KO will pay a dividend of $1.84 over the next 12 months and that the dividend will also grow at a rate of 8% over the next decade. By my estimate, KO’s dividend has grown by over 10% annually over the past decade. Using the same discount rate of 7%, the NPV of KO’s dividends over the next decade is $17.94.

Add the NPV of the dividends ($17.94) and the present value of the 2020 stock price ($76.67) and you get an intrinsic value of $94.61, which is a discount of about 35% from where it is currently trading. The discount coupled with KO’s formidable moat gives you a margin of safety.

By comparison, using a discount rate of 12% in the same equations gives an intrinsic value of about $62 per share. KO traded as low as $50 per share within the prior 52 weeks. Director Barry Diller purchased $20 million of the stock at $39.91 in March of 2009. Diller recently raised his stake by purchasing another 120,000 shares at a cost of $7.4 million.

Of course, when doing this type of analysis it makes sense to plug in your own assumptions for the growth rate, discount rate and terminal P/E.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

EV/EBIT Ratio Trumps P/E Ratio

Investors should make the ratio of a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT) a primary tool to evaluate its earnings power and to compare it to other companies. This is the ratio that Joel Greenblatt uses for his magic formula and that Buffett appears to use when evaluating a business.

The P/E ratio is useful as a crude screening tools but it has serious limitations. One such limitation, which the EV/EBIT ratio addresses, is that the P/E ratio does not take into account the balance sheet and, as a result, it can materially misrepresent the earnings yield of a business.

To take a very simple example, imagine that you were considering the purchase of a commercial lawn care business in your town and you had narrowed it down to two candidates. Business 1 has an asking price of $500,000 and earnings of $100,000. Business 2 has an asking price of $700,000 and earnings of $100,000. Business 1 looks like the better bargain with a P/E ratio of 5, compared to a P/E of 7 for business 2.

The problem is that without looking at the balance sheet you cannot reach a conclusion about which business is cheaper. Going back to our example, further imagine that business 1 has a bank loan for $200,000 and business 2 has a Certificate of Deposit worth $200,000. In that case, you’d really be paying 7x earnings to purchase business 1 and only 5x earnings to purchase business 2, the exact opposite of the conclusion reached by not taking the balance sheet into consideration.

Although the preceding example did not make the distinction, EBIT is also superior to GAAP earnings in that it eliminates distortions and differences arising from different tax rates.

EBIT itself is also a short-hand measure of sorts in that, without further adjustment, it assumes that a company’s expense for depreciation and amortization is equal to its expense for maintenance capital expenditures (capex). Greenblatt’s Magic Formula makes this assumption in order to simplify the calculation required for the selection of stocks. This provides an opportunity for investors who wish to improve upon the magic formula’s mechanical approach by doing further business analysis.

This assumption can distort a business’s true earnings yield and the comparison of its earnings yield to that of other businesses. The growth portion of capex in a growing business may materially understate EBIT if a distinction is not made between growth capex and maintenance capex. It is very useful to be able to evaluate what the business would look like in a steady state so you can see how cheap it is and how it compares to other opportunities.

To get a more accurate view of a business, you should calculate EBIT by subtracting actual maintenance capex from EBITDA. If a business does not disclose its maintenance capex, you can usually derive it by making some reasonable assumptions.

Interestingly, regarding the calculation of intrinsic value, some investors use EBITDA – maintenance capex in their calculation of earnings power and in their discounted cash flows, giving full credit for the free cash used to reinvest and grow the business. My own thought is that this approach can make sense if the returns on the reinvested growth capital clearly exceed the cost of capital and are therefore value creating.

Buffett was asked at the 1998 Berkshire shareholders meeting how he estimates intrinsic value for companies where the free cash flow is largely offset by reinvestments to grow the business. The shareholder specifically mentioned McDonald’s and Walgreen’s as examples. Buffett, in seeming contrast to the approach mentioned above, said that he only gives credit for the cash that is left after growth capex. He figures that if the investments are made wisely the growth in future free cash flows should more than offset the discounted value of those cash flows. If it does not, Buffett figures it was not a good use of that cash.

Buffett reiterated his view that the best kind of business is the one that grows free cash with little or no-reinvestment, although he stated he is also quite happy to own a business that requires reinvestment of capital but provides a satisfactory rate of return on that reinvestment.

EV is superior to market value as a measure of how much you’re really paying for a business because it includes not only the cost of the company’s equity but also the cost of the company’s debt. It also gives the company credit for its cash, which can be used to offset the purchase price – for example, through a special dividend – or to retire debt.

Bruce Greenwald recommends not subtracting 100% of the cash but leaving an amount equal to 2% of revenues for use as working cash. I have also seen Joel Greenblatt comment that he won’t just assume that the cash is worth full value. He analyzes the situation and may give cash only partial credit depending on his judgment of how it will be used.

It is always fascinating to me when I find a stock that does not look particularly cheap when I look at its P/E ratio that turns out to be cheap when I calculate its EV/(Adjusted EBIT). I strongly suggest that you make this a part of your analysis of any potential investment.

Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.

If you wish to learn more, please see the appendix to The Little Book That Beats the Market by Joel Greenblatt and Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald et al.

Small Stock Investing: The Path to Riches?

Some years ago, Buffett created a stir of sorts when he stated that if he were investing $1 million today he could generate annual returns of 50%. I wrote about it in an earlier post.

In an interview with blogger Jacob Wolinsky, value investor Whitney Tilson was asked if Buffett’s investment style had changed as a result of his different circumstances at Berkshire and if he would be a net-net investor if he was managing less cash. Here’s Tilson’s answer:

Yes, that is absolutely true. He has been asked this question many times and responded that if he were to be managing very little money he would be looking in the nooks and crannies looking for extreme temporary mispricings. If you know where to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million.

Recently on The Corner of Berkshire & Fairfax Message Board, an excellent investing forum run by value investor and investment manager Sanjeev Parsad, the question was asked “What percentage of your portfolio is in Fairfax Financial?” The level of discussion on the board is quite high and it’s clear many of the members are capable investors.

For those who are not familiar with the company, Fairfax is an insurance company with outstanding investing capabilities that has compounded book value at a rate of 25% over the past twenty-four years under the leadership of Pre Watsa. Fairfax is often compared to an earlier stage Berkshire Hathaway. Many members of the forum have a material investment in Fairfax.

One member, rick_v, criticized having a large investment in Fairfax because, in his view, it is easy to find cheaper micro-caps with greater opportunity. In response, another member, coc, defended investing in Fairfax and challenged the idea that it is easy to find micro-cap investments that will outperform the market.

I thought the exchange crystallized some of the important decisions investors face when defining their own investment process and philosophy. The exchange also provides some food for thought to those who, inspired by Buffett’s remark, choose to seek opportunity in micro-caps.

Here’s rick_v

I truly hope that all you guys mentioning stakes of 20-30%+ in Fairfax are either passive investors or older in age.

I think its a shame for a young or professional value investor to have such a large percentage of their portfolio in a stock like Fairfax. Afterall, even if Fairfax doubles in a few years that is not how you are going to generate alpha or get rich for that matter…

As a young or professional value investor you should be studying Fairfax and Buffet’s performance to identify your own value plays. Thats where the alpha will come from.

It is very easy with permanent capital to find securities which will outperform the market when you are looking in the 0-250m range. This range is not looked at by Prem, Buffet, and most of the other major value investors anymore due to their size. As such it represents where I see most of the opportunity for up and coming value investors.

Just my thoughts…

Here’s coc’s response:

I’m surprised you all let this go. I’d like to comment on two things, both of which I consider nonsense.

1. It is “very easy” to find securities that will outperform the market.

2. Holding Fairfax is inferior to running around finding these “very easy” securities.

I think investors vastly underestimate how good Warren Buffett was at his job back in the 1950’s and 1960’s when he was buying these niche securities. He’s even better now, but obviously runs so much capital that his returns are lower. There seems to be this “Buffett envy” going on in value investing circles whereby investors feel the need to look for little cigar butts similar to what Warren used to – largely influenced by his talks to students and his biography.

And yet, I have seen precious few investors who have successfully done it. Beyond the platitude that smaller areas of the market are “inefficient,” there are considerable risks. You are usually investing in second rate businesses that destroy value, or at least are not really building any. Often these businesses are run by inexperienced managers and have little advantage over their competitors. Thus, the business risks you assume are big ones, although most investors think a cheap valuation makes up for it. Sometimes, but not always.

Take for an example Dempster Mill Mftg – a well known Buffett investment way back when. If you think through the situation, there was a good probability that the investment was not a wise one. It took heroic efforts by a new manager to keep Dempster from going under, and even then, it was not an absolute home run. Yet, most Buffetteers admire these types of investments Warren used to make.

But what was Warren’s largest partnership investment? American Express, a well known company then and now, not a micro-cap dishwasher manufacturer. He also had a successful investment in Disney, and one in GEICO, again two companies that were well known. What was probably his best stock investment at Berkshire? The Washington Post, not exactly “unknown.”

Yet we’re told that he made all of his great returns back then because he could look small. Well, as with everything in life, the answer is yes and no. I think there is a great myth that you need to look where no-one else is looking and be creative in the investment process. That you should get points for creativity or something. But the very same people propagating this myth are students of Charlie Munger, who once wrote to Wesco shareholders that “We try to profit more from always remembering the obvious then grasping the esoteric.”

Let’s talk about a few more of Warren’s home runs. Petrochina, one of the largest companies on the planet. Freddie Mac, one of the largest companies on the planet. Coca-Cola, the most well-known brand on the planet. BYD, one of China’s most well-known and well-respected companies. These are investments where, for the first 5-10 years, he made 25%+ compound annual returns. Who are these people not getting rich by consistently generating 25% compound returns? Where is this stock market where 25% annual returns don’t generate “alpha”? Why do small investors need to run around looking at micro-caps?


Let’s also look at some other legendary investors. What sort of returns did they achieve and what were they buying? Lou Simpson – 20%+ type returns buying very well known companies. Rick Guerin – 25% type returns investing in a pretty broad range of securities small and large. Ruane, Cunniff – 15% over 40 years investing in large stocks. Eddie Lampert at ESL – you would probably know of almost every company he ever invested in – 30% CAGR for a 15-20 year period. Glenn Greenberg at Chieftain – did 25% for about 20 years, again you’d probably recognize almost every stock he owned.

These guys are legends, they’re all rich, and they invested in a huge range of securities.

Who do we know of that was investing in small securities that no one has heard of? Here’s two: Schloss and Graham. Did either of them do 50% compounded? Hell no. They’re hall-of-famers with 15-20% returns. Do I need to bring up Charlie’s returns? What has he bought over time?

So I dispute this notion that investors are somehow doing themselves a disservice by sticking with companies they know well and that others know well. Well-known companies are often just as mispriced as small ones. “To a man with a hammer, everything looks like a nail,” says Munger. Yet the Buffetteers seem to only admire one tool for finding cheap stocks (size constraints), when myopia, ignorance, and a host of other biases are just as powerful in creating misvalued securities.

To wrap this up a little, I’m not saying there aren’t lots of small mispriced stocks. Buffett did very well with them, and there are probably others doing great, too. But recognize two things: 1. Huge CAGR’s are really, really hard. 2. You can do extremely well investing in larger companies, great companies, and well-known companies, without a lot of the risks of investing in broken-down nags. This is well proven.

So if you rationally evaluate Fairfax and come to the conclusion that you’re going to get 15-20%+ CAGR (eminently reasonable given the fact that they are a relatively small player in a gigantic global insurance market and are run by one of the smarter investment teams on the planet), don’t worry about how much “alpha” you’re not generating by looking elsewhere. Was it a mistake to invest in Berkshire when it had a billion dollar market cap and was well known? I repeat, there are no points for creativity. Don’t forget it takes a unique cast of mind to just sit on some great companies and compound at high rates with no taxes, professional investor or not.

I’m probably not going to convert anyone who believes strongly that they have to be looking in the dirty alleys for cheap stocks, but if you’re on the fence, hopefully this is food for thought.

Here’s a link to the thread if you want to read more.

My own opinion is that there is no reason to limit yourself to certain investments based on market capitalization, just like it doesn’t make sense to make a false distinction between value and growth. You can get rich investing in either. For example, today large caps offer unusually strong risk-adjusted returns.

In investing, what really matters is how much cash you get back and when for the cash you invest and how certain you are of the outcome. I do think it’s fairly obvious that Buffett would be more active in small and micro caps if he were investing far less money, although not to the exclusion of investing in large caps. He would simply have greater options.

James Montier on Inverting Discounted Cash Flows

James Montier is one of the more insightful investment analysts writing today. Montier is highly skeptical about discounted cash flows (DCF) because they rely on forecasting. He believes that the approach is theoretically correct – an asset is indeed worth the discounted present value of all future cash flows – but that it is fatally flawed in practice because, in his view, no one can make accurate forecasts.

In addition, he points out the problem of the terminal value: minor changes in the terminal growth rate and the discount rate dramatically alter the terminal multiple.

I think Montier raises good points but I think these limitations can be overcome if DCFs are used sparingly and with good judgment. One rational approach is to only use DCFs to value companies that have an established track record of stable earnings and a durable competitive advantage. The terminal multiple should be very modest. For example, you could only project earnings for five to eight years and then use a no-growth terminal multiple.

In general, if you use conservative estimates, you should be able to use DCFs to usefully value any asset if the gap between the present value and current price is large enough. Another approach, which was used by Benjamin Graham, was to show an example where it was only possible to establish a wide range of possible intrinsic values. No matter how wide the range, it was still useful if the current stock price was below that range.

Notwithstanding Montier’s distrust of forecasting, he does think that DCFs can be inverted to make transparent and explicit the growth assumptions that are baked into a stock’s current price. The investor can then use these new insights to assess if he is being overly optimistic and carrying too much risk.

Here’s Montier from the September 9, 2008 issue of Mind Matters:

So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.

I thought it would be instructive to do this exercise with two widely held growth stocks: Apple (APPL) and Amazon (AMZN).


Apple’s current stock price is $287.75 (9/22/2010 close). I used consensus 2010 EPS of $14.48 (see Marketwatch) as the year 1 EPS. I assumed a discount rate of 12% or, said another way, I assumed that investors were looking for a 12% return from Apple’s stock. Assuming a no-growth terminal multiple, the current price assumes that Apple can grow at a rate of 15% per year for the next ten years.

Assuming a constant P/E ratio (and my other assumptions), this would mean Apple would need to have after tax earnings of over $50 billion in year eleven. To put that in perspective, the most profitable company in the Fortune 500 in 2009 was Exxon Mobil which earned $19.3 billion. Microsoft was second with profits of $14.6 billion. Wal-Mart Stores was third with profits of $14.3 billion. Thoughtful investors would want to look carefully at how Apple could grow its earnings to this level.


Amazon’s current stock price is $151.83 (9/22/2010 close). I used consensus 2010 EPS of $2.64 (see Marketwatch) as the year 1 EPS. I assumed a discount rate of 15% or, said another way, I assumed that investors were looking for a 15% return from Amazon’s stock. Assuming a no-growth terminal multiple, the current price assumes that Apple can grow at a rate of 37.5% per year for the next ten years.

Assuming a constant P/E ratio, this would mean Amazon would need to have after tax earnings of over $28 billion in year eleven. Based on the consensus estimates, Amazon should earn about $1.2 billion in 2010. Here again, thoughtful investors want to look carefully at how Amazon could grow its earnings to this level.

Here’s the data.

Obviously, there are many ways that these assumptions could have been done. The point is that if an investor buys a given stock at a given price, he should make explicit the assumptions he is making given the current stock price, his expected return (the discount rate), the growth rate, the terminal multiple and the future P/E ratio.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Watch List Question: Where’s the Implied Valuation and Margin of Safety?

Yesterday, I received the following comment and question regarding my watch list. I thought I would answer the question in a blog post in case others had the same question and to better explain the methodology of my watch list.

Hi Greg,

Great site, thanks very much for all of your ideas.

I’ve looked at your watch list every time you’ve posted it, but I’m finding it very unintuitive.

I think I understand your concept of Expected Return expressed as a %, but why not have an implied valuation and Margin of Safety columns as well so you can quickly see the variance from current price and best opportunity to research?

If I understand correctly, you could just rank opportunities from greatest yield to least, but the metric feels very unfamiliar.

I’m interested in your thoughts,



First, I want to thank Aron for the question. I would start by saying that there is not a perfect way to value a company. All valuations are based on future assumptions that are inherently suspect. There are two basic approaches to this reality: 1) limit future projections to companies with exceptional economics and a long track record (Buffett) or 2) don’t make projections and look for things that are cheap based on current assets and earnings power.

The idea behind the watch list is to focus on those companies that have exceptional economics as evidenced by ten years of exceptional returns on equity without undue leverage. These are the companies where an investor has at least a fighting chance of projecting long-term future earnings and growth.

In order to prioritize the list and highlight areas of opportunity, I wanted to include a valuation metric. I chose to express this as an expected return, which is the sum of the earnings yield and the expected growth rate. This is the approach used by Glenn Greenberg. (Greenberg also seems to suggest that Buffett approaches valuation in a similar way.) The benefit is that it is simple and gets you to focus on two central questions:

  1. Is it cheap today? (earnings yield)
  2. How fast can intrinsic value grow? (growth rate)

It is also easy to calculate.

Aron asks why I don’t rank opportunities from greatest yield to least. The answer is that I wanted to include growth in the valuation since growth is such an important part of a company’s intrinsic value. As Buffett pointed out in his 1991 letter to shareholders, a business with “bob-around” no growth earnings is worth 10 times after tax earnings using a discount rate of 10%. A good business that can grow earnings at 6% is worth a “whopping” 25 times after-tax earnings.

The expected return approach I take is simply another form of a discounted cash flow (DCF). There are three components to a DCF: 1) the discount rate (or expected return), 2) the projected stream of cash, and 3) the present value (PV) of those cash flows.

For a growing stream of cash flows we can use the following calculation:

PV = current earnings x 1/(discount rate) – (growth rate)

Assume I find a stock on the watch list with an earnings yield of 10% ($50 stock price and an EPS of $5) and an expected growth rate of 5%. I would calculate that stock to have an expected return of 15%.

Using the formula above, here’s the math:

$50 = $5 x 1/(15% – 5%)

We can say that the $50 stock price is discounting a 15% future return, assuming a growth rate of 5%.

Often DCF’s are done by first setting the discount rate – or alternatively, the hurdle rate – and calculating the present value of the stock. (I believe this is the approach that Aron is looking for.) If this value is greater than the current stock price, we can look at the difference between the PV and the current stock price and judge whether it provides a sufficient margin of safety, typically expressed as a percentage derived by dividing the discount by the PV of the stock

For example, let’s use a discount rate of 10%. 10% is often used as a proxy for an expected return on an equity investment. (Alternatively, we could follow Buffett and use the yield on long-term government bonds.)

In that case, the present value is far greater because of the reduction in the discount rate from 15% to 10%:

$100 = $5 x 1/(10% – 5%)

We could then say that the stock is selling at a 50% discount to present value.

What I intended to show is that the approach I take in the watch list and the approach of expressing the PV using a fixed discount rate are essentially two sides of the same coin.

Aron also asks about having a margin of safety value so it could be easily compared with that of other stocks on the list. First, I think some caution should be used in expressing the margin of safety as a single percentage in that it can give the impression that the figure is precise. Intrinsic value is better understood, I believe, as a range of values. (Of course, in fairness, the same critique could be made of expressing the expected return as a precise figure, which is why I stress that this is a starting point, nothing more.)

Having said that, the expected return does imply a margin of safety. An asset with a true expected return of 15% is worth far more than an asset with an expected return of 8%. Think of it this way: many things could go wrong with the former asset and it could still outperform or equal the latter asset paying only 8%.

I hope this answers the question. If not, please let me know. Also, I welcome all comments and questions on this most important investing topic of valuation.

Johnson & Johnson Looks Undervalued (Part 1)

Johnson & Johnson (JNJ) was formed in 1886. Over the past one-hundred and twenty-five years, it has produced an enviable record of growth and profitability and has grown into a diversified global giant with three main operating segments: consumer products, pharmaceuticals, and medical devices and diagnostics. 2009 sales were $61.9 billion with operating profits of $16.6 billion. JNJ is one of only four companies that have an AAA credit rating – the others are ADP, Exxon and Microsoft.

Operating profits have tripled over the past decade but the stock price has made relatively little progress given its high multiple at the beginning of the decade. This has caught the attention of numerous value investors who have taken large positions in the stock. Major holders include Warren Buffett, Prem Watsa, Donald Yacktman and Tweedy Browne. As a frame of reference, Buffett’s basis in the stock is just over $60.00 per share.

(click chart to enlarge)

JNJ has grown operating earnings at a CAGR of 5.5%, 8.5% and 9.6% over the past 5, 10 and 15 year periods, respectively. Although growth has slowed in the United States and Europe over the past five years owing to the recession, sales in the Asia-Pacific, Africa region have grown at 11.2% and sales in the Western Hemisphere, excluding the U.S., have grown at an accelerating 14.8%. This growth in developing regions bodes well for JNJ and should provide a long-term growth platform. JNJ should also benefit from an aging population and above-GDP levels of growth in the healthcare sector, although increased regulation may have a dampening effect in the U.S.

Here is the basic historical data and growth rates over the past 5, 10, and 15-year periods.

Leading pharmaceuticals companies have also experienced margin compression because of investor concerns over patent expirations. These concerns may prove to be overblown in the long-term as, according to Morningstar analyst Damien Conover, CFA, JNJ has, “Nine potential blockbusters in late-stage development or recently approved.” Of course, handicapping pharmaceutical blockbusters is a tricky business, even if you have considerable industry expertise. Nevertheless, JNJ has a superlative track record of innovation and spends approximately $7 billion annually on research & development.

Unlike other leading pharmaceutical companies, JNJ is well diversified with over $10 billion in operating profits coming from its two non-pharmaceutical divisions, consumer products and medical devices & diagnostics. There is evidence that JNJ operates with a strong durable competitive advantage: per Value Line, return on equity over the past ten years has ranged between 24.3% and 30.1%, with almost no leverage.

Since 2000 through 2009, JNJ added $31.8 billion in equity while growing after-tax profits by $8.1 billion for a strong 25.5% return. This is even more noteworthy because the acquisition of Pfizer’s Consumer Healthcare business in 2006 resulted in $6.6 billion in goodwill and $8.9 billion in intangible assets.


The next step is to attempt to value JNJ. Following Seth Klarman, I’m going to look at JNJ in a couple different ways and subject these valuations to sensitivity analyses. Today, I’ll be doing a simple discounted cash flow. In the next installment, I’m going to do an exercise suggested by Warren Buffett. Buffett, who is a big fan of Value Line, has said that what he is trying to do when he values a business is determine what Value Line will look like in ten years. In my judgment, Buffett would only perform this exercise with businesses where he has a high level of certainty about their future earnings.

Discounted Cash Flow Analysis (DCF)

This approach is the theoretical framework followed by Buffett who derived it from the economist John Burr Williams. The discounted cash flow of a business comprises its intrinsic value. Here’s what Buffett says about it in the Berkshire Hathaway Owner’s Manual.

“Let’s start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.”

To the best of my knowledge, it is not known precisely how Buffett performs this calculation. Charlie Munger has said that he has never seen Buffett perform a discounted cash flow computation.

Some prominent value investors, such as Bruce Greenwald of Columbia University, object to the use of discounted cash flow analyses because of the large portion of total earnings that is contained in the terminal portion of the calculation, which attempts to capture earnings in the very long term. They argue that this simply cannot be done with sufficient precision to make it useful.

At least two approaches are used to deal with this objection. First, only use very conservative assumptions and second only perform this calculation with companies that have superior earnings visibility into the distant future. An example of this type of company is Coca-Cola: a hundred-year plus track record, evident durable competitive advantages, and growth prospects far into the future (Coca-Cola accounts for less than 3% of worldwide beverage consumption). I believe JNJ’s track record, economics and future prospects put it in this category.

How Longleaf Partners Does It

In the first DCF, I’m going to follow the general approach used by Mason Hawkin’s partner Staley Cates at Longleaf Partners as disclosed in an email exchange between Cates and an investor.

According to Cates, Longleaf projects 8 years worth of free cash flows, which I understand to equate to Buffett’s “owner earnings”: reported earnings plus depreciation and other non-cash charges less capital expenditures. For JNJ, I’ll use reported earnings as, historically, depreciation and cap-ex have been roughly equal.

To be conservative, Cates also uses a terminal multiple that assumes no growth after year 8. The no-growth terminal multiple is tied to the discount rate used. For example, if you use a 10% discount rate, a no-growth terminal value is 10x. (Value = Earnings / Discount Rate.) If you use a 7% discount rate, the no-growth terminal value jumps to 14x.

In the example, I assume book value per share of $21.60 (Value Line’s estimate for 2010) and a 23.5% ROE which produces year 1 earnings of $5.08 (consensus estimates for 2011 per Marketwatch are $5.07).

Following its historical practice, I assume that JNJ will payout 70% of its earnings in the form of dividends and share repurchases, which will produce a growth in equity and earnings of approximately 7% (ROE of 23.5% x 30% of earnings reinvested = 7%). (Since 2000 through 2009, JNJ added $31.8 billion in equity and produced $89.7 billion in net profits. From this you can see that approximately 30% of profits were reinvested in the business in the form of equity.)

Also, for the record and to be conservative, 23.5% is the lowest ROE earned in the past decade.

Using a 7% discount rate produces an intrinsic value of $105 per share which would imply a 43% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $71 per share, which would imply a 15% discount at a share price of $60. The 7% discount rate is lower than many analysts would use but is closer to Buffett’s approach.

Here’s the data.

Buffett favors using the interest rate on long-term government bonds as his discount rate, and he has said that he will use a slightly higher rate when these rates are particularly low. He believes it is mistaken to compensate for risk by using a higher discount rate. Instead he limits himself to only investing in situations where he is highly certain and has a margin of safety.

In the second two examples, I use the same two discount rates, but, instead of using a no-growth terminal multiple, I project earnings out 10 years and assume that, after year 10, earnings will grow in perpetuity at 3%. In this case, using a 7% discount rate produces an intrinsic value of $167 per share which would imply a 64% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $91 per share, which would imply a 34% discount at a share price of $60.

Here’s the data (use the second tab “7% Growth 3% Terminal Growth” at the top of the page)

Of interest is that all four models produce an intrinsic value for JNJ that is higher than its current share price – in some cases, materially so.

In addition to being undervalued, JNJ looks to be in a position to grow intrinsic value in the mid to high single digit range, while simultaneously paying a generous dividend (currently over 3%) and buying back shares. The result should be a satisfactory total return.

In the next installment, following Buffett, I’ll attempt to project what JNJ’s Value Line sheet will look like in ten years.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Lessons from Buffett’s Decision not to Sell Coke: “I talked when I should have walked”

In his 2004 letter to the shareholders of Berkshire Hathaway, Warren Buffett admitted that he made a mistake by not selling certain stocks that were “priced ahead of themselves.” The episode contains some powerful lesson that we can use to improve our investment results.

Let’s look at how the businesses of our “Big Four” – American Express, Coca-Cola, Gillette and Wells Fargo – have fared since we bought into these companies. As the table shows, we invested $3.83 billion in the four, by way of multiple transactions between May 1988 and October 2003. On a composite basis, our dollar-weighted purchase date is July 1992. By yearend 2004, therefore, we had held these “business interests,” on a weighted basis, about 12½ years.

In 2004, Berkshire’s share of the group’s earnings amounted to $1.2 billion. These earnings might legitimately be considered “normal.” True, they were swelled because Gillette and Wells Fargo omitted option costs in their presentation of earnings; but on the other hand they were reduced because Coke had a non-recurring write-off.

Our share of the earnings of these four companies has grown almost every year, and now amounts to about 31.3% of our cost. Their cash distributions to us have also grown consistently, totaling $434 million in 2004, or about 11.3% of cost. All in all, the Big Four have delivered us a satisfactory, though far from spectacular, business result.

That’s true as well of our experience in the market with the group. Since our original purchases, valuation gains have somewhat exceeded earnings growth because price/earnings ratios have increased. On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true.

Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing.

Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.

As the following charts show, of the big four, Coke and Procter & Gamble reached the most extreme levels of over-valuation. According to Value Line, Coke sold at an average P/E ratio of 47.5 during 1999, its peak being considerably higher.  Procter & Gamble sold at an average P/E of 30.8 during 1999.

(all graphs show quarterly prices and P/E ranges from 1/1/1996 to 7/30/2010)

American Express


Procter & Gamble

Wells Fargo

(click images to enlarge)

What lessons can be learned from this?

If you’ve read my investing blueprint you know that I am a strong proponent of patient business-like investing for the long-term. This is a proven way to create wealth. However, at a sufficiently high price, all assets – no matter what their level of quality – should be sold.

What is sufficiently high? When the price clearly exceeds all reasonable estimates of the Net Present Value of the business’s earnings after taking taxes into consideration.

What can make this difficult is that the intrinsic value – the net present value of all future cash flows – of a truly great business may be strikingly high in relation to its current earnings. Consider that a 50-year bond with economics similar to those of Coke (ROE of 30% and a payout ratio of 66.67%) would have a net present value of 46x earnings, assuming a discount rate of 8%. (Here’s the data.)

However, unlike a bond where the coupon is set and contractually obligated, a holder of equity has no future guarantee other than his judgment about the competitive advantages of the business.  At the peak of the bubble, Coke’s price appeared to more than fully reflect the next 50 years of earnings and then some.

Plus, the proceeds of the sale could have been redeployed in cheaper assets, thereby raising the intrinsic value of Berkshire Hathaway. The challenge is that, unless you have a specific immediate purchase in mind, you never know how long you will need to wait to re-invest the funds of a sale.

If you buy or hold an overvalued security it will materially impact your future performance. Many stocks purchased during the Internet Bubble have shown a large increase in earnings with no progress in the price of the stock.

Consider an example. In 1999, Microsoft earned $.70 a share, sold for an average P/E of 49.8 and traded between $34 and $60 per share. Ten years later during 2009, it earned $1.62 per share, more than doubling its earnings, but sold for an average P/E of 13.4 and traded no higher than 31.5. Lesson: don’t overpay – it’s costly!

Confirmation Bias

Beware of confirmation bias, which Wikipedia defines as, “a tendency for people to favor information that confirms their preconceptions or hypotheses whether or not it is true.” Buffett was long on record as saying that his favorite holding period was forever, going so far in his 1990 shareholder letter as to call Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post his “permanent four”. The risk with confirmation bias is that you are liable to act irrationally even at the expense of your own interests.

How Much Cash Will You Get Back?

If you are a businesslike investor, you should actually expect that a business in which you invest will deliver more cash than you put in. This is how Buffett operates as is evident from the comments about how much of his cost for purchasing shares in the “Big Four” he had already received. This is a lesson in how to think in a businesslike fashion about investing.

“The glass is invariably fogged”

Investing – whether deciding on a new purchase or whether to hold an existing investment – is always a business of judgment fraught with many uncertainties: “the glass is invariably fogged.” Accept this and get on with it by putting a premium on hard work, exceptional research, and following a rational investing process with great discipline.

What are your thoughts? Did Buffett indeed make a mistake by not selling Coke?

Price-to-Book Ratio and ROE Offer Strong Value Clues

There is a direct relationship between the return on equity of a stock and its price to book value. Understanding this relationship can give you insight into whether a stock is undervalued. Here’s the way valuation expert Aswath Damodaran of the Stern School of Business at NYU illustrates this relationship:

(click to enlarge)

This makes sense if you follow Buffett and look at a stock as an equity bond. The primary difference between an equity bond and an actual bond is that the equity bond does not have a fixed coupon – it’s up to the business analyst to estimate it – and an equity bond frequently has a growing coupon, owing to the reinvestment of earnings back into the business, just as would happen if you reinvested interest back into a savings account.

It follows that there is a general relationship between the return on equity of a business and the price to book ratio at which it trades. For example, you can expect a decent business that generates an ROE of 6-8% to trade around 1x book. On the other hand, a business that is able to generate an ROE of 24% should trade around 4x book, especially if the business enjoys a durable competitive advantage and its long-term prospects are promising.

We can see this mathematically if we consider the following formula:

PV (present value) = initial earnings x 1/(R – G) where R is the cost of capital and G is the growth rate of earnings. In this case, following Buffett, we will assume that the cost of capital is the risk free rate of return on long-term government bonds. Buffett does not look for safety in using a higher discount rate because he thinks it is a poor substitute for the certainty he demands in an equity investment.

For the first business earning an ROE of 6% and assuming equity of $100 million, the PV is $100 million. This assumes long-term government bonds are paying 6%.

$100 million = $6 million x 1/(6% – 0)

For the second business earning an ROE of 24% and assuming equity of $100 million, the PV is $400 million.

$400 million = $24 million x 1/(6% – 0)

It follows that the second asset will sell for four times the price of the first asset. If the equity base is growing the difference in value is even more pronounced. Consider a $100,000 15-year bond that is paying 24% with a payout ratio of 60% that lets you reinvest the balance at 24%. The invested capital will grow by 9.6% annually. [G (growth) = (1 – Payout ratio) * Interest rate]

Such a bond would have a NPV of $584,130. Here’s the data.

A business with similar economics could be expected to trade at as much as 6x book value. Consider American Express which has had an average ROE in the mid to high twenties over the past decade and a payout ratio (dividends and share repurchases) of 60-70%. It has generally traded at 3x to 7x book value over the past decade.

(click to enlarge)

Obviously, the relationship between price-to-book ratio and return on equity is not fixed and can vary greatly depending on the business and its prospects. Investing can never be reduced to a simple one-variable formula. However, this relationship can give you insight into whether a business is over or undervalued.

It also underscores the tremendous value of a business that can earn a high return on equity and reinvest most or all of it back into the business at a high ROE. These types of businesses are rare. It is not widely appreciated that a large part of Berkshire Hathaway’s stellar track record owes itself to Buffett being able to do precisely this for four decades.