Warren Buffett Calculates the Present Market Price to Buy

 

        Warren first decides What to Buy and then buys it at the Right Price. The price you pay will determine your rate of return. The lower the price you pay, the higher your rate of return is going to be. The higher the price you pay, the lower the rate of return you are going to earn. Pay more, get less. Pay less, get more.

 

Basically only two formulae are needed for the calculations:

 

Compound Interest FV= PV(1+i)n  

                                  P/E= Ratio

                                  

 

a) What is the future Earnings per share at year 20?

 

From the past 10 years of earnings per share,

find the average compound interest for the past 10 years

and the average compound interest for the last 5 years

Take the average of these figures.

 

Use Ms Excel spreadsheet to do the calculation.

 

Use the formula, i = (FV/PV)^(1/n)-1

 

[The power of sign ^ is usually found in keyboard number 6]

 

Calculate the future earnings per share for the next 10 years.

 

Use   PV= present earnings per share at year 10

           I= interest from the average compound interest for the past 10 years

          N= no. of years

 

     Use the formula, FV=PV*(1+i)^n  to find the

 

         FV= future earnings per share at year 20

 

 

b) What is the projected future market price at year 20?

 

Take average P/E ratio for the past 10 years (say 16)

 

Use Market Price = Earnings x P/E ratio

                                                                                                                

Thus, the Future market price at year 20 = Future earnings per share at 20 years (FV) x 16 [average P/E Ratio]   

 

 

c) What is the present market price at year 11 you are going to BUY the share?

 

Assume you want a compound interest rate of 12% to 18%

 

Calculate the present market price at year 11 using:

 

                         PV= FV/(1+i)n   

 

             Where,  FV= future market price at year 20,

                    I= compound interest of 0.12 and 0.18

                    N= no. of years 10

 

Alternately,

 

    d) What will be the compound Interest if you buy the share at the Present Market Price?

 

          Calculate the Compound Interest Rate using:

 

                                       i = (FV/PV)^(1/n)-1

 

                       where,    FV= Future Market Price at year 20

                                     PV= Present Market Price at year 11

                                      N =No of years 10

 

 

          See examples on how to use Ms Excel spreadsheet to calculate the various Compound Interest components.

 

Assume the following in Excel:

 

Column B at row 3 is the Present Value for Year 2014 (PV)

Column B at row 4 is the Number of Years (N)

Column B at row 5 is the interest (i)

Column C at row 3 is $1000 (say)

Column C at row 4 is 10 (say)

Column C at row 5 is 15% (say)

    

Column B at row 9 is the Number of Years (N)

Column C at row 9 is 20

 

Now to find and check the calculations:

Future Value (FV) for year 2024, click C7 (say) and type the function

                          =C3*(1+C5)^C4                                  

= $4046

[Make sure the multiplication * is type in]

 

Future Value (FV) for year 2034, click C12 (say) and type the function

                          =C3*(1+C5)^C9  

                          =$16,367   

[Make sure the multiplication * is type in]

 

Present Value (PV) for year 2014, click C15 and type the function

                              = C12/(1+C5)^C9

                              = $1000

 

        Compound Interest rate (i%), click C13 (say) and type function

                              =(C7/C3)^(1/C4)-1

                              =0.15

                              =15%

                   [Make sure that 1/C4 are bracketed]

                                                           

                                   

--------------------------------------------

 

 

For actual examples of the above calculations, see all the passages below that are taken from “The New Buffettology” by Mary Buffett and David Clark for 1) GANNETT CORPORATION, 1994 from pages 124 to 128 and 2) Berkshire Hathaway from pages 107 to 109 and.

 

 

1) ORIGINAL BUFFETTOLOGY CASE STUDIES

GANNETT CORPORATION, 1994

       

Warren's love affair with the newspaper business probably started when he was a boy living in Washington, D.C., where he had a Washington Post newspaper route. As you've read here, he later took a sizable position in that company.

       

In the summer of 1994, during the middle of an advertising recession, Warren began to buy large blocks of the Gannett Corporation, a newspaper holding company. He eventually spent $335,216,000 for 13,709,000 shares of Gannett's common stock. This equates to a split-adjusted purchase price of $24.45 a share. Let's look and see what he found so enticing. (Please note: This analysis of Warren's investment in Gannett Corporation originally appeared in the first edition of Buffettology, published in 1996. The stock split two-for-one in 1997. To assist in comparing our earlier projected results with actual results, we have adjusted the historical figures to reflect the two-for-one split.)

       

 

DOING YOUR DETECTIVE WORK

       

The scuttlebutt work on this one is easy. We all know USA Today, the newspaper that you can find on any newsstand in America. If you have read this gem of mass circulation, then you may have asked yourself, I wonder who publishes this newspaper and is it publicly traded? Well, Gannett publishes it and it is publicly traded.

       

A check of the Value Line Investment Survey tells us that Gannett publishes 190 newspapers in thirty-eight states and U.S. territories. Its two largest publications are the Detroit News (cir: 312,093) and USA Today (cir: 2.1 million). Gannett also owns thirteen radio stations and fifteen network-affiliated TV stations.

       

Once you have assembled the financial information, it's time to work through our questions.

       

1. Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity product?

    Newspapers and radio and TV stations, we know, are good businesses. Usually a newspaper is a great business if it is the only game in town— less competition means bigger advertising revenue for the owners. The majority of Gannett Corporation's newspapers are, we found, the only game in town! Nice.

   

2. Do you understand how it works?

    This is, yes, another of those cases where you, the consumer/investor, have intimate knowledge of the product. You're stuck in an out-of-town airport with nothing to do, so you go to the newsstand and buy a newspaper. Which one do you buy? The local paper? No. You haven't any interest in what is going on in local government. But, hey, there's USA Today, and it has national news!

   

3. Is the company conservatively financed?

    In 1994 the company had a total long-term debt of $767 million and a little over $1.8 billion in equity. Given its strong earnings in 1994 of $465 million, Gannett could pay off its entire debt in less than two years.

 

Year

Earnings

84

$.70

85

.79

86

.86

87

.99

88

1.13

89

1.24

90

1.18

91

1.00

92

1.20

93

1.36

94

1.62

 

         

 4. Are the earnings of the company strong and do they show an upward trend?

     Earnings in 1994 were $1.62 a share and had been growing at an annual rate of 8.75% from 1984 to 1994, and at a rate of 5.4% from 1989 to 1994 (above). Earnings were stable, increasing every year from 1984 to 1994 with the exception of 1990 and 1991, when the entire publishing and media industry was experiencing a recession due to weakening advertising rates. Remember, a general recession in an industry is often a buying opportunity.  The yearly per share earnings figures are strong and show an upward trend. That's what we are looking for.

    

5. Does company allocate capital only to businesses within its realm of experience?

     Yes. It stays in the media industry.

    

6. Has the company has been buying back its shares?

     Yes. It bought back 42.4 million of its outstanding shares from 1988 through 1994. This is a sign that management uses capital to increase shareholder value when it is possible.

    

7. Does management's investment of retained earnings appear to have increased per share earnings and therefore shareholder value?

From 1984 to 1994 the company had retained earnings of $5.82 a share. Per share earnings grew by $.92 a share, from $.70 a share at the end of 1984 to $1.62 by the end of 1994. Thus, we can argue that the retained earnings of $5.82 a share produced in 1994 an increase in after-tax corporate income of $.92, which equates to a 15.8% rate of return ($.92 / 5.82 = 15.8%).

 

 

Year

ROE

84

19.6%

85

19.9

86

19.3

87

19.8

88

20.4

89

19.9

90

18.3

91

19.6

92

21.9

93

20.8

94

25.5

 

              

 8. Is the company's return on equity above average?

     As we know, Warren considers it a good sign when a business can earn above-average returns on equity. An average return on equity for the American Corporations during the last thirty years is approximately 12%. Gannett's return on equity for the eleven years up to 1994 is as follows (above):

    

Gannett had an average annual return on equity for those eleven years of 20.4%. But more important, the company has consistently earned high returns on equity, which indicates that management is doing an excellent job in profitably allocating retained earnings to new projects.

    

9. Does the company show a consistently high return on total capital?

     Gannett's return on total capital during this period ranged from a low of 11.2% to a high of 18.8%, with an average of 15.3%— which is what we are looking for.

    

10. Is the company free to adjust prices to inflation?

     Newspapers used to cost a dime, now they cost fifty cents to a dollar. But newspapers and TV stations make their real money by selling advertising. If you own the only newspaper in town, you can charge high advertising rates because there is not much in the way of alternatives. As noted earlier, classified advertising, supermarkets, auto dealers, and entertainment businesses, such as movie theaters, must advertise in the local newspaper. As a whole, we can assume that Gannett can adjust its prices to inflation without losing sales.

    

11. Are large capital expenditures required to constantly update the company's plant and equipment?

     All the benefits of earning tons of money can be offset by a company's constantly having to make large capital expenditures to stay competitive. Newspapers and broadcast stations are Gannett's mainstays. So once its initial infrastructure is in place, not a lot is needed down the road for capital equipment or for research and development. Printing presses run for decades before they wear out, and TV and radio stations only need an occasional new transmitter.

    

This means that when Gannett makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment. Gannett can instead go out and buy more newspapers and radio stations or buy back its stock. This means that Gannett's shareholders get richer and richer.

    

 

SUMMARY OF DATA

       

Since Warren gets positive responses to the above key questions, he concludes that Gannett fits into his "realm of confidence," and that its earnings can be predicted with a fair degree of certainty. But a positive response to these questions does not invoke an automatic buy response. We still have to calculate whether the market price for the stock will allow a return equal to or better than on our other options.

  

 

PRICE ANALYSIS

  

Identify a company with a durable competitive advantage, then let the market price determine the buy decision.

  

 

INITIAL RATE OF RETURN AND RELATIVE VALUE TO GOVERNMENT BONDS

  

Gannett's per share earnings in 1994 were $1.62. Divide $1.62 by the long-term government-bond interest rate for 1994, approximately 7%, and you get a relative value of $23.14 a share. This means that if you paid $23.14 for a share of Gannett, you would be getting a return equal to that of the government bonds. In 1994 you could have bought Gannett stock for $23.10 to $29.50 a share. If you had paid what Warren paid, $24.45, you would be getting an estimated initial return of 6.6%.

  

A review of Gannett's per share earnings growth rate for the last ten years indicates that it has been growing at an annual compounding rate of 8.75%. Thus, what would you rather own—$24.45 worth of a government bond with a static return of 7% or a Gannett equity/bond with an initial rate of return of 6.6%, which has a coupon that is projected to grow at 8.75% a year?

  

 

GANNETT'S STOCK AS AN EQUITY/BOND

  

In 1994, Gannett had a per share equity value of $6.52 (as reported in Value Line). If Gannett can maintain its average annual return on equity of 20.4% over the next ten years and continues to retain a historical 60% of that return, then per share equity value should grow at an annual rate of approximately 12.24% (60% of 20.4% equals 12.24%), to approximately $20.68 a share in year 2004. (On your Texas Instruments BA-35 Solar calculator, punch in $6.52 as the present value, PV; 10 for the number of years, N; 12.24 for the annual rate of interest, %i; hit the CPT button and then the future value button, FV; and $20.68 will appear as your future value.)

  

In 2004, if per share equity value is $20.68, and Gannett is still earning a 20.4% return on equity, then Gannett should report per share earnings of $4.22 a share ($20.68 x .204 = $4.22). If Gannett is trading at its low P/E for the last ten years, 15, the stock should have a market price of approximately $63.30 a share ($4.22 x 15 = $63.30). Multiply by the ten-year high P/E of 23, and you get a per share market price of $97.06 ($4.22 x 23 = $97.06). Add in the projected total dividend pool of $11.92 a share earned from 1994 to 2004 and you get a projected total pretax annual compounding rate of return on your initial investment of $24.45 a share of somewhere between 11.87% and 16.09% for the ten years.

  

 

PROJECTING AN ANNUAL COMPOUNDING RETURN USING THE HISTORICAL ANNUAL PER SHARE EARNINGS GROWTH

  

If per share earnings continue to grow at 8.75% annually, and if Gannett continues to retain 60% of its earnings and pay out as dividends the other 40%, then the following per share earnings and dividend-disbursement picture will develop over the next ten years (below):

 

 

Year

Earnings

Dividends

 

95

        $1.76

$.70

96

1.91

.76

97

2.08

.83

98

2.26

.90

99

2.46

.98

00

2.67

1.07

01

2.91

1.16

02

3.16

1.26

03

3.44

1.37

04

3.74

1.49

 

 

        $10.52

 

         

This means that in 2004 Warren can project that Gannett will have per share earnings of $3.74. If Gannett is trading at the lowest P/E ratio that it has had in the last ten years, 15, then the market price will be $56.10 ($3.74 x 15 = $56.10). Add in the pretax dividend pool of $10.52 and our total pretax return jumps to $66.62 a share.

    

If Gannett is trading at the highest P/E that it has had in the last ten years, 23, then the market price will be $86.02 a share in 2004 ($3.74 x 23 = $86.02). Add in the pretax dividend pool of $10.52 and our total pretax return becomes $96.54.

  

If you were Warren and had spent $24.45 a share for your Gannett stock in 1994, using this method, you could project that in ten years it would be worth with dividends somewhere between $66.62 and $96.54 a share. This equates to a pretax annual compounding return of somewhere between 10.55% and 14.72%. (You can get these figures by taking out the Texas Instruments BA-35 Solar calculator and punching in $24.45 for the present value, PV; 10 for the number of years, N; and either $66.62 or $96.54 for the future value, FV. Hit the CPT key followed by the interest key, %i, and presto, your annual compounding rate of return will appear— either 10.55% or 14.72%).

  

 

SUMMARY OF ANALYSIS

  

In the summer and fall of 1994, Warren bought approximately 13,709,000 shares of Gannett common stock for $24.45 a share, for a total purchase price of $335,216,000. When Warren bought the stock, he could argue that he had just bought a Gannett equity/bond with a yield of 6.6% with a coupon projected to grow at approximately 8.75% a year. He could also figure that if he held the stock for ten years, his projected pretax annual compounding return would be between 10.55% and 16.09%.

  

This means that in ten years' time his investment of $335,216,000 in Gannett would be worth in pretax terms somewhere between $913,226,960 and $1,490,745,000.

  

 

HOW ACCURATE WERE WARREN'S GANNETT PROJECTIONS?

  

When making predictions the ultimate test is time. How good was this one? Well, we have actual figures through 2000 to check against our projections (see below):

  

As you can see, Gannett's actual results have surpassed our projections in four of the last six years, with the margin of error ranging from –2.8% to +34.1%. Per share earnings during this period grew at an annual rate of 16.2% as opposed to our projected 8.75%. The stock market, in 2002, seeing this performance has bid up Gannett's shares into the $76 range. Warren paid $24.45 a share in 1994. If he sold it in 2002 for $76 a share, his annual pretax compounding return, excluding dividends, would be approximately 15.2%. Which is right on the money.

 

 

Projected Earnings Compared to Actual Earnings

 

Year

Projected

Earnings

Actual

Earnings

Margin

Of Error

 

95

$1.76

$1.71

-2.8%

96

1.91

1.89

-1.0

97

2.08

2.50

+20.2

98

2.26

2.86

+26.5

99

2.46

3.30

+34.1

00

2.91

3.63

25.0

 

 

 

2) Berkshire Hathaway

 

Warren determines the approximate equity value of the company in ten years, then multiplies the per share equity value by the projected future rate of return on equity ten years out. This gives him the projected future per share earnings of the company. Using this figure, he is then able to project a future trading value for the company's stock. Using the price he paid for the stock as the present value, he can calculate his estimated annual compounding rate of return. He then compares this projected annual compounding rate of return to what other investments, of comparable risk, are projected to pay, and to what his needs are to keep ahead of inflation.

 

Look at Berkshire Hathaway. In 1986, Berkshire had stockholders' equity of $2,073 a share. From 1964 to 1986, Berkshire's return on stockholders' equity was 23.3% compounded annually. Back in 1986, if you had wanted to project the company's equity-per-share figure for 2000, all you had to do was get out the old and trusted Texas Instruments BA-35 Solar financial calculator and switch to the financial mode to perform a future value calculation. Let's do it.

  

First you punch in 1986's per share equity value of $2,073 as the present value (PV key), then the rate of growth for the interest rate, 23.3% (% i key), then the number of years, 14 (the N key). Hit the calculation key (CPT), then the future value key (the FV key), and the calculator tells you that, in 2000, Berkshire should have a per share equity value of $38,911.

  

You should be asking yourself, how much money am I willing to pay in 1986 for the right to own $38,911 in shareholders' equity in 2000? First of all, you need to determine your desired rate of return. If you are like Warren, then 15% is the minimum return you are willing to take. So all you have to do is discount $38,911 to present value using 15% as the appropriate discount rate.

  

First, clear your calculator of the last calculation. Punch in $38,911 as the future value (FV), then the discount rate, 15% (%i), then the number of years, 14 (N), then hit the compute button (CPT) and the present value button (PV). The calculator will tell you that in 1986 the most money you can spend on a share and expect to get a 15% annual return over the next fourteen years is $5,499 a share.

  

A check of the local newspaper in 1986 would tell you that the market was then selling a share of Berkshire's stock for around $2,700. You think, wow, I might be able to get a better return than even the 15% I'm looking for. To check it out, punch in $2,700 for the present value (PV) and $38,911 for the future value (FV) and 14 for the number of years (N). Then hit the compute button (CPT) and the interest button (%i) and the calculator will tell you that you can expect an annual compounding rate of return of 20.9%.

  

By 2000, Berkshire had in reality ended up growing its per share equity value at a compounding annual rate of approximately 23.6%, to $40,442.

  

But get this. While you were patiently waiting for the value of Berkshire to grow, the market decided it really liked Berkshire and bid the stock to a high of $71,300 and a low of $40,800 a share by 2000. If you paid $2,700 for a share of Berkshire in 1986 and sold it in 2000 for $71,300 a share, this would equate to a pretax annual compounding return of 26.39% for the fourteen years. (To get the rate of return, you would assign $2,700 as the present value, PV, and $71,300 as the future value, FV, and 14 as the number of years, N. Then you would punch the compute key, CPT, and then the interest key, %i, which equals 26.39%.) If you sold the stock for $40,800 a share in 2000, you would have earned a pretax annual compounding return of approximately 21.4%.

  

Let's say that you paid $71,300 for a share of Berkshire Hathaway in 2000. What would your projected pretax annual compounding return be if you held the stock for ten years?

  

We know that Berkshire has a per share equity value in 2000 of approximately $40,442 and that it has grown at an average annual compounding rate of approximately 23.6% a year for the last twenty-five years. Assuming this, we can project that in ten years— in the year 2010— the per share equity value of Berkshire Hathaway will be $336,524.

  

If you paid $71,300 in 2000 for a share of Berkshire that will have a per share equity value of $336,524 in 2010, what is your annual compounding rate of return? Punch in $336,524 for the future value (FV) and $71,300 for the present value (PV) and 10 for the number of years (N). Hit the CPT key followed by the interest key (%i) and presto— your annual compounding rate of return is 16.7%. Interesting, but not that interesting. Berkshire at $71,300 a share in 2000 is an iffy bargain from a business perspective.

  

Yes, the stock market may go mad by 2010 and value Berkshire considerably higher than its per share equity value. In which case today's buyers would be in luck. Then again it may value it considerably lower. But the economic reality is that if you pay $71,300 for a share of Berkshire, your annual compounding rate of return is going to be approximately 16.7%. Regardless of where the market price for the stock is short-term, the long-term economics of a business will eventually dictate the stock's market price.

  

Remember the part of Warren's philosophy that says the price you pay determines your rate of return. Well, if you bought Berkshire at its low of $40,800 a share in 2000 and sold it for its equity value of $336,524 in 2010, your pretax annual compounding return for the ten years would be 23.4%. That's far more interesting than the 16.7% you would have gotten had you paid $71,300 a share.

  

With Berkshire the lower the price you pay, the higher your rate of return is going to be. The higher the price you pay, the lower the rate of return you are going to earn. Pay more, get less. Pay less, get more. It's that easy.

  

If you think that Warren can't keep earning a 23.6% return on his capital, then you might adjust the growth rate down to a more pedestrian 15%. With a per share equity value of approximately $40,442 in 2000, we can project that at an annual growth rate of 15% it will have increased to approximately $163,610 by 2010. If you paid $40,800 for a share of Berkshire in 2000 and sold it for $163,610 in the year 2010, then your annual compounding rate of return would be approximately 14.8%. Pay the high price of $71,300 a share and your annual return drops to a measly 8.6%, which is neither very interesting nor very profitable.

  

You can make a stock market price adjustment to this calculation by figuring that over the last twenty-five years Berkshire has traded in the market for anywhere from approximately one to two times its per share equity value. If it trades at double its projected per share equity value in 2010, you are naturally going to do a lot better.

  

So let's say that you managed to pay $40,800 in 2000 for a share of Berkshire and sold it for $673,048 or two times its projected 23.6% annual compounding equity growth per share value in 2010 of $336,524. Your projected annual pretax compounding rate of return for the ten years would be approximately 32.3%. This is absolutely the best-case scenario, provided you pay the cheap price of $40,800 a share, Warren keeps hitting those 23.6% home runs, and the stock market is lusting for Berkshire in 2010. Any hope of doing better is pie in the sky.

 

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