Here’s an interesting passage from Buffett circa 1990 on the subject of media company valuation. He is using the Gordon Growth Model which when growth is less than inflation and both are constant:
P/ E1 = 1/(r - g)
A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)
Now change the assumption and posit that the $1 million represents “normal earning power” and that earnings will bob around this figure cyclically. A “bob-around” pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. Thus a seemingly modest shift in assumptions reduces the property’s valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).
Of course, you need to plug in real expected inflation and growth rates. But I think the comparison is qualitatively worth making between “new media” (Google, Facebook, not Amazon/ Netflix) and “old media” such as Comcast. However, it also illustrates that annuity-type assumptions will always look silly sooner or later - so it’s better to buy a “franchise business” at a “commodity-type business” price. Usually a crumbling franchise has some tail to it. Buffett was good at that. |
