Valuing Stocks the Warren Buffett Way
Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company.
Unfortunately, Buffett has never expounded extensively on his investment approach, although you can glean tidbits from his writings in the Berkshire Hathaway annual reports. However, a cottage industry has sprung up over the years as outsiders have attempted to explain Buffett’s investment philosophy. One book that discusses his approach in an interesting and methodical fashion is “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor” (Scribner, 1999) written by Mary Buffett, a former daughter-in-law of Buffett’s, and David Clark, a family friend and portfolio manager.
This book served as the basis for two stock screens developed and tracked by AAII—Buffettology EPS Growth and Buffettology Sustainable Growth. These screens are also pre-built into AAII’s Stock Investor Pro fundamental stock screening and research database program.
In this article, we provide an overview of Buffettology as a method of identifying promising businesses. In addition, we present a Buffett valuation spreadsheet that uses various valuation models to measure the attractiveness of stocks passing the preliminary screens.
Defining an Attractive Company
Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right. Buffett is a buy-and-hold investor who prefers to hold the stock of a good company earning 15% year after year over jumping from investment to investment with the hope of higher, short-term gains. Once he identifies a good company and purchases it at an attractive price, Buffett holds the stock for the long term until the business loses its attractiveness or a more attractive alternative investment presents itself.
Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types:
- Commodity-based firms—selling products where price is the single most important factor determining purchase. They are characterized by high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is vital for the long-term success of these types of firms.
- Consumer monopolies—selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.
While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if he can purchase them at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business generally only treads water.
How do you spot a commodity-based company? Buffett watches out for these characteristics:
- Low profit margins (net income divided by sales);
- Low return on equity (earnings per share divided by book value per share);
- Absence of any brand-name loyalty for its products;
- The presence of multiple producers;
- The existence of substantial excess capacity;
- Profits tend to be erratic; and
- Profitability depends upon management’s ability to optimize the use of tangible assets.
Buffett instead seeks out consumer monopolies—companies that have managed to create a product or service that is somehow unique and difficult for competitors to reproduce due to brand-name loyalty, a particular niche that only a limited number of companies can enter, or an unregulated but legal monopoly such as a patent.
Consumer monopolies can be businesses that sell products or services. Buffett recognizes three types of monopolies:
- Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Apple Inc. is a good example of a firm with a strong brand name in demand by customers. As a result, consumers are willing to pay a premium price for Apple products. Other examples include leading newspapers, drug companies with patents, and popular brand-name restaurants such as McDonald’s.
- “Communications” firms that provide a repetitive service, which manufacturers must use to persuade the public to buy their products. All businesses must advertise their items, and many of the available media face little competition. These used to include worldwide advertising agencies, magazine publishers, newspapers, and telecommunications networks. Today, “new media” outlets such as Google and Yahoo! provide on-line advertising that threatens the traditional business models of print media.
- Businesses that provide repetitive consumer services that people and businesses are in constant need of. Examples include tax preparers, insurance companies, and investment firms.
In her Buffettology book, Mary Buffett suggests going to your local convenience store to identify many of these “must-have” products. These stores typically carry a very limited line of must-have products such as Marlboro cigarettes and Wrigley’s gum. However, with the guidance of the factors used to identify attractive companies, we established two basic screens to identify potential investments worthy of further analysis.
The Buffettology Screen
The criteria used for our Buffettology screens are summarized in Table 1. AAII’s Stock Investor Pro is used to perform the screens.
Consumer monopolies typically have high profit margins because of their unique niche; however, a simple screen for high margins may highlight weak firms in industries with traditionally high margins, but low turnover levels.
Our first screening filters look for firms with both gross operating margins and net profit margins above the medians for their industry. The operating margin concerns itself with the costs directly associated with the production of the goods and services, while the net profit margin takes all of the company activities and actions into account.
Questions to determine the attractiveness of the business:
Consumer monopoly or commodity?
Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. Investors can seek these companies by identifying the manufacturers of products that seem indispensable. Consumer monopolies typically have high profit margins because of their unique niche; however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. For our screen, we look for companies with operating margins and net profit margins above their industry norms. Additional screens for strong earnings and high return on equity will also help to identify consumer monopolies. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it might change over time.
Do you understand how the business works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you should only further analyze the companies passing all screening criteria that operate in areas you understand.
Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to have strong cash flows, with little need for long-term debt. We screen for companies with total liabilities relative to total assets that are below the median for their respective industry. Alternative screens might look for low debt to capitalization or low debt to equity.
Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screen for companies with seven-year earnings per share growth greater than 75% of all firms. To help indicate that earnings growth is still strong, we also require that the three-year earnings growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent earnings. Follow-up examinations should include careful examination of the year-by-year earnings per share figures. As a simple screen to exclude companies with more volatile earnings, we screen for companies with positive earnings for each of the last seven years and latest 12 months.
Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is a difficult factor to screen for on a quantitative level. Before investing in a company, look at the company’s past pattern of acquisitions and new directions. They should fit within the primary range of operation for the firm.
Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favors shareholder-enhancing maneuvers such as share buybacks. While we do not screen for this factor, a follow-up examination of a company would reveal if it has a share buyback plan in place.
Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations. Other screens for strong and consistent earnings and strong return on equity help to the capture this factor.
Is the company’s return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns on equity. Mary Buffett indicates that the average return on equity for the last 30 years is approximately 12%. We created a custom field that calculated the average return on equity over the last seven years. We then filter for companies with average return on equity above 12%.
Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. This factor is best applied through a qualitative examination of the companies and industries passing all the screens.
Does the company need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. This factor is best applied through a qualitative examination of the company and its industry. However, a screen for high relative levels of free cash flow may also help to capture this factor.
Understand How It Works
As is common with successful investors, Buffett only invests in companies he can understand. Individuals should try to invest in areas where they possess some specialized knowledge and can more effectively judge a company, its industry, and its competitive environment. While it is difficult to construct a quantitative filter, an investor should be able to identify areas of interest.
The companies typically passing the Buffettology screens represent a diverse group of companies. An investor should only consider analyzing those firms operating in areas that they can clearly grasp.
To see the companies that are currently passing the AAII Buffettology screens, visit the Stock Screens area of AAII.com.
Consumer monopolies tend to have strong cash flows, with little need for long-term debt. Buffett does not object to the use of debt for a good purpose—for example, if a company uses debt to finance the purchase of another consumer monopoly. However, he does object if the added debt is used in a way that will produce mediocre results—such as expanding into a commodity line of business.
Appropriate levels of debt vary from industry to industry, so it is best to construct a relative filter against industry norms. We screen out firms that had higher levels of total liabilities to total assets than their industry median. The ratio of total liabilities to total assets is more encompassing than just looking at ratios based upon long-term debt such as the debt-equity ratio.
Strong & Improving Earnings
Buffett invests only in businesses whose future earnings are predictable to a high degree of certainty. Companies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders. Earnings levels are critical in valuation. As earnings increase, the stock price will eventually reflect this growth.
Buffett looks for strong long-term growth as well as an indication of an upward trend. In her book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Pro offers seven-year growth rates, so for the predefined Buffettology screens we use the seven-year growth rate to filter for long-term growth and the three-year growth rate to filter for intermediate-term growth. The Buffettology screens first require that a company’s seven-year earnings growth rate be higher than that of 75% of the stocks in the overall database.
It is best if the earnings also show an upward trend. Buffett compares the intermediate-term growth rate to the long-term growth rate and looks for expanding earnings. For our next filter, we require that the three-year growth rate in earnings be greater than the seven-year growth rate.
Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. An examination of year-by-year earnings should be performed as part of the valuation.
VCA Antech (WOOF) passed the Buffettology Sustainable Growth screen as of May 15, 2009, and is used in Figure 1 to illustrate the Buffett Valuation Spreadsheet. The company operates the largest network of animal hospitals and veterinary diagnostic labs in the country. The company’s earnings per share are displayed in the spreadsheet. [While Stock Investor Pro provides seven-year growth rates, which requires eight years of data, the program provides seven years of financial statement data for display purposes. The spreadsheet displays six years of data to calculate the five-year growth rates.] As we can see, VCA’s earnings per share growth has been strong and consistent, with annual increases over each of the last five years (where Year 1 is the most recent year).
A screen requiring an increase in earnings for each of the last seven years would be too stringent and would not be in keeping with the Buffett philosophy. However, a filter requiring positive earnings for each of the last seven years should help to eliminate some of the commodity- based businesses with wild earnings swings.
A Consistent Focus
Companies that stray too far from their base of operation often end up in trouble. Peter Lynch also avoided profitable companies diversifying into other areas. Lynch termed these “diworseifications.” Quaker Oats’ purchase and subsequent sale of Snapple is classic example.
Companies should expand into related areas that offer high return potential. VCA Antech is the leader in the animal diagnostic lab business, servicing more than 14,000 of the 22,000 animal hospitals in the U.S. This segment offers impressive operating margins, which should benefit the company going forward.
Buyback of Shares
Buffett views share repurchases favorably since they cause per share earnings increases for those who don’t sell, resulting in an increase in the stock’s market price. This is a difficult variable to screen, as most data services do not indicate buybacks. You can screen for a decreasing number of outstanding shares, but this factor is best analyzed during the valuation process.
Investing Retained Earnings
A company should retain its earnings if its rate of return on its investment is higher than the investor could earn on his own. Dividends should only be paid if they would be better employed in other companies. If the earnings are properly reinvested in the company, earnings should rise over time and stock price valuation will also rise to reflect the increasing value of the business.
An important factor in the desire to reinvest earnings is that the earnings are not subject to personal income taxes unless they are paid out in the form of dividends.
Buffett examines management’s use of retained earnings, looking for management that has proven it is able to employ retained earnings in the new moneymaking ventures, or for stock buybacks when they offer a greater return.
Good Return on Equity
Buffett seeks companies with above-average return on equity. Mary Buffett indicates that the average return on equity over the last 30 years has been around 12%. During the valuation process, this average should be checked against more current figures to assure that the past is still indicative of the future direction of the company. Our screen looks for average return on equity of 12% or greater over the last seven years.
Consumer monopolies can typically adjust their prices quickly to inflation without significant reductions in unit sales, since there is little price competition to keep prices in check. This factor is best applied through a qualitative examination of a company during the valuation stage.
In Buffett’s view, the real value of consumer monopolies is in their intangibles—for instance, brand-name loyalty, regulatory licenses, and patents. They do not have to rely heavily on investments in land, plant, and equipment, and often produce products that are low tech. Therefore, they tend to have large free cash flows (operating cash flow less dividends and capital expenditures) and low debt. Retained earnings must first go toward maintaining current operations at competitive levels. This is a factor that is also best examined at the time of the company valuation although a screen for relative levels of free cash flow might help to confirm a company’s status.
The above basic filters help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis. However, stocks passing the screens are not automatic buys. The next test revolves around the issue of value.
The Price Is Right: Using the Buffett Valuation Spreadsheet
The price that you pay for a stock determines the rate of return—the higher the initial price, the lower the overall return. Likewise, the lower the initial price paid, the higher the return. Buffett first picks the business, and then lets the price of the company determine whether to purchase the firm. The goal is to buy an excellent company at a price that makes business sense. Valuation equates a company’s stock price to a relative benchmark. A $200 dollar per 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 techniques are highlighted in the “Buffettology” book and are used in the Buffett spreadsheet template (Figure 1). You can download the spreadsheet from at AAII Web site: www.aaii.com/ci/buffettology.xls.
Buffett prefers to concentrate his investments in a few strong companies that are priced well. He feels that diversification is used by investors to protect themselves from their stupidity.
Buffett treats earnings per share as the return on his investment, much like how a business owner views these types of profits. Buffett likes to compute the earnings yield (earnings per share divided by share price) because it presents a 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 yields equate to the firm’s underlying earnings. The analysis is completely dependent upon the predictability and stability of the earnings, which explains the emphasis on earnings strength within the preliminary screens.
VCA Antech has an earnings yield of 6.5% [cell C13, computed by dividing the current (trailing 12 months) earnings per share of $1.56 (cell C9) by the closing price on May 15, 2009, of $24.04 (cell C8)]. Buffett likes to compare the company earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. With government bonds yielding slightly more than 4% currently (cell C17), VCA compares very favorably. By paying $24 per share for VCA, an investor gets an earnings yield return greater than the interest yield on bonds. The bond interest is cash in hand but it is static, while the earnings of VCA Antech should grow over time and push the stock price up.
Historical Earnings Growth
Another method Buffett uses to value prospective stocks is to project the annual compound rate of return based on historical earnings per share increases. For example, earnings per share at VCA Antech have increased at a compound annual growth rate of 23.9% over the last five years (cell B30). If earnings per share increase for the next 10 years at this same growth rate of 23.9%, earnings per share in year 10 will be $13.34. [$1.56 × (1 + 0.239)10]. (Note this value is found in cell B47 and also in cell E37. Using a calculator, results may differ due to rounding.) This estimated earnings per share figure can then be multiplied by the five-year average price-earnings ratio of 25.0 (cell H10) to provide an estimate of price [$13.34 × 25.0 = $333.19]. (Note this value is found in cell E40.) While VCA does not pay a dividend, if a company you are valuing pays dividends an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 price. (Note that when evaluating dividend-paying stocks, this value is found in cell E41.)
Once this future price is estimated, projected rates of return can be determined over the 10-year period based on the current selling price of the stock. Buffett requires a return of at least 15%. For VCA Antech, comparing the projected total gain of $333.19 to the current price of $24.04 leads to a projected annual rate of return of 30.1% [($333.19 ÷ $24.04)1/10 – 1]. (Note this value is found in cell E43.)
The third valuation method detailed in “Buffettology” is based upon the sustainable growth rate model. Buffett uses the average rate of return on equity (and average retention ratio (1 – average payout ratio) to calculate the sustainable growth rate [ROE × (1 – payout ratio)]. For companies that do not pay a dividend, the sustainable growth rate equals the return on equity.
The sustainable growth rate is used to calculate the book value per share (in year 10 [BVPS × (1 + sustainable growth rate)10]. Earnings per share can then be estimated in year 10 by multiplying the average return on equity by the projected book value per share [ROE × BVPS].
To estimate the future price, you multiply the earnings per share by the average price-earnings ratio [EPS × P/E]. If dividends are paid, they can be added to the projected price to compute the total gain.
For example, VCA Antech’s sustainable growth rate, based on average five-year data, is 22.3% [22.3% × (1 – 0.0)]. (The sustainable growth rate is found in cell H11.) Again, since the company does not pay a dividend, its sustainable growth rate equals its return on equity. Thus, book value per share should grow at this rate to roughly $65.91 in 10 years [$8.81 × (1 + 0.223)10]. (Note this value is found in cell B62.) If return on equity remains 22.3% (cell H6), in the tenth year, earnings per share that year would be $14.69 [0.223 × $65.91]. (Note this value is found in cell C62 and also in cell E52.)
The estimated earnings per share can then be multiplied by the average price-earnings ratio to project the future price of $366.88 [$14.69 × 25.0]. (Note this value is located in cell E55.) If dividends have been paid, you would use an estimate of the amount of dividends paid over the 10-year period and add this to the projected price to arrive at the total gain. This total gain is then used to project the annual rate of return of 31.3% [(($366.88 + $0.00) ÷ $24.04)1/10 – 1]. (Note this return estimate is found in cell E58.)
For users of Stock Investor Pro, the projected returns based on the earnings growth rate and sustainable growth rate are already built into the program using seven-year data (found in the Valuations data category). For those who do not subscribe to Stock Investor Pro, all of the data you need to populate the Buffett valuation spreadsheet can be found in company 10-K reports, which are available on-line from numerous sources. You will have to search through multiple years, however, in order to get the six years of data required for this spreadsheet. Alternatively, the SmartMoney Web site (www.smartmoney.com) provides 10 years of financial statement data for free.
The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to drive down the value of these businesses to attractive levels. Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.