[The Warren Buffett Way] All: Here's a synopsis I did a while ago of the aforementioned book. Seemed appropriate for the RA thread. I tried specifically to capture the way he analyzes an investment, so this leaves out many of the stories within the book. Those stories are very enlightening, so this isn't meant as a substitute for the book. It's pretty long so you may want to print it out and read it at your leisure:
1. Focus on return on equity, not earnings per share.
2. Calculate "owner earnings" to get the true reflection of value.
3. Look for companies with high profit margins.
4. For every dollar retained, make sure the company has created at least one dollar in market value.
Return on Equity
Buffett considers earnings per share a smokescreen. Most investors judge a companies annual performance by EPS, watching for a big increase over the previous year. Since most companies retain a portion of their previous years earnings as a way of increasing their equity capital base, he sees no reason to get excited about record earnings per share. Growth in earnings, which automatically increases earnings per share, is really meaningless. There is nothing spectacular about a company that is increasing its earnings per share by 10%, if at the same time it is growing its equity base by 10%. What's important is the achievement of high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.), not the consistent gain in earnings per share. A truer measure of a company's annual performance, because it takes into account the companies ever-growing capital base, is return on equity--the ratio of operating earnings to shareholder's equity.
To use this ratio, we need to make several adjustments. First, marketable securities should be valued at cost and not at market value. For example, if the stock market rose dramatically in one year, thereby increasing the net worth of the company, a truly outstanding operating performance would be diminished by the larger denominator. Conversely, falling prices reduce shareholder's equity, which means that mediocre operating results appear much better than they really are.
Second, investors must also control the effects that unusual items may have on the numerator of this ratio. Buffett excludes all capital gains and losses, as well as any extraordinary items that may increase or decrease operating earnings.
Further, he believes that a business should achieve good return on equity while employing little or no debt. We know that companies can increase their return on equity by increasing their debt-to-equity ratio. The idea of adding a couple points to ROE simply by taking on more debt does not impress him. A good business or investment should be able to earn a good return on equity without the aid of leverage. Companies that are only able to earn good return on equity by employing significant debt should be viewed with suspicion. Furthermore, highly leveraged companies are vulnerable during economic slowdowns.
Buffett does not give any suggestions as to what debt levels are appropriate or inappropriate for a business. Different companies, depending on their cash flows, can manage different levels of debt.
The reduced form of the return on equity equation actually consists of three separate ratios:
Net Income Sales Total Assets Net Income
Return on Equity = ---------- X ------------ X --------------- = --------------
Sales Total Assets Owner's equity Owner's Equity
or, in other words, Profit Margin on Sales x Total Asset Turnover x Financial Leverage. Thus, there are five ways a company can increase its ROE. 1) Increase Asset turnover (ratio of sales to assets). 2) Wider operating margins. 3)Pay lower taxes. 4)Increase leverage. 5)Use cheaper leverage (i.e. at a lower interest rate). Note that changes in Total Assets and Sales, although they cancel out in the equation, cause the Net Income and Owner's Equity numbers to change, giving a net change to the overall ratio. By breaking the ratio down into its constituents, the reason for a change can be more easily ascertained (as noted above the ROE number will show an increase when the company takes on more debt, all else being equal).
Owner Earnings:
The cash-generating ability of a business determines its value. Accounting earnings per share are the starting point for determining the economic value of a business, not the ending point. Buffett seeks companies that generate cash in excess of their needs, as opposed to companies that consume cash. Companies with high fixed-assets-to-profits require a larger share of retained earnings to remain viable than companies with lower fixed-assets-to-profits, because some of the earnings must be earmarked to maintain and upgrade those assets. Accounting earnings are only useful if they approximate the expected cash flow of the company.
But even cash flow is not a perfect tool for measuring value; often, it misleads investors. Cash flow is an appropriate measure for businesses that have large investments in the beginning and smaller outlays later on, such as real estate, gas fields, and cable companies. Manufacturing companies, on the other hand, which require ongoing capital expenditures, are not accurately valued using only cash flow.
A companies cash flow is customarily defined as its net income after taxes, plus depreciation, depletion, amortization, and other non-cash charges. The problem with this definition is it leaves out a critical economic fact: capital expenditures. How much of the year's earnings must the company use for new equipment, plant upgrades, and other improvements needed to maintain its economic position and unit volume? Approximately 95% of American business require capital expenditures which roughly equal their depreciation rates. These capital expenditures are as much an expense as labor or utility costs.
Buffett believes that cash flow numbers are frequently used to justify the unjustifiable, and thereby sell what should be unsaleable. You cannot focus on cash flow unless you are willing to subtract the necessary capital expenditures.
Instead of cash flow, a more accurate picture is presented by what Buffett calls "owner earnings"--a companies net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed. Calculating owner earnings requires some estimating of the future capital expenditures, and as such is not precise.
Profit margins:
High profit margins mean strong business and tenacious cost control.
The One Dollar Premise:
A quick test to judge not only the economic attractiveness of a business but how well management has accomplished its goal of creating shareholder value is in how the company utilizes retained earnings. If a company employs retained earnings nonproductively over an extended period, eventually the market will price the shares disappointingly. Conversely, if a company has been able to achieve above-average returns on augmented capital, that success will be reflected in the stock price. For every dollar retained, make sure the company has created at least one dollar in market value. Retained earnings= net income minus all dividends paid to shareholders (preferred and common). Add retained earnings over a long period, e.g. 10 years. Next, find the difference between current market value and market value 10 years ago. If the change in market value is less than the sum of retained earnings, the company is going backwards. For a good business, the gain in market value should exceed the sum of retained earnings, thus creating more than one dollar in market value for each dollar retained.
Determine the Value:
The value of a business is determined by the net cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. If owner earnings--the cash flows of the business--are flat over a long period, they should be discounted by the 30 year T-bond rate. If they show a predictable growth pattern, the discount rate can be reduced by this rate of growth. If Buffett is unable to project the future cash flows with confidence, he will not attempt to value the company. Although he admits that Microsoft is a dynamic company and he highly regards Bill Gates as a manager, he admits to not having a clue how to estimate the future cash flow of this company. If the business is simple and understandable, if it has operated with consistent earnings power, Buffett is able to determine future cash flow with a high degree of certainty.
Buffett eliminates the risk associated with debt financing by excluding from purchase those companies with high debt levels. Second, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. He puts a heavy weight on certainty because, if you do, the whole idea of a risk factor doesn't make any sense. Risk comes from not knowing what you're doing.
Growth versus Value:
According to Buffett, growth and value are joined at the hip. Value is the discounted present value of an investment's future cash flow; growth is simply a calculation used to determine value. Growth in sales, earnings, and assets can either add or detract from an investment's value. Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created. However, growth for a business earning low returns on capital can be detrimental to shareholders. For example the airline business has experienced incredible growth, but their inability to earn decent return on capital have left most shareholders in a poor position.
dh |
