Everyone knows the key to making money in the stock market is to buy low and sell high. In the past, we didn’t have a clue as to what was high and what was low. In this chapter, you will learn how to calculate both a purchase price and a sell price in order to obtain your long-term required return. After all, this is how Warren Buffett became one of the richest individuals in the world.
In this chapter, I will show you how, according to Mary Buffett and David Clark in their book Buffettology, Warren Buffett determines a “target” price and a “purchase” price. A slight problem is even Mary and David don’t know that Warren Buffett uses Clean Surplus Accounting. But thank you, Mary and David, for showing the world the target price and purchase price calculations.
Warren Buffett uses Clean Surplus Accounting to determine the level of operating efficiency (return on equity, or ROE) and the consistency of that operating efficiency. The more consistent a company is in its operating efficiency, the better he (or anyone) is able to predict a future price. If he can effectively predict a future price, he can then determine when the value (market price) of the company gets to a low enough level (purchase price) that will generate his required return over the next decade. The difference between his purchase price and his target price is his profit.
Possibly the most unique aspect of Warren Buffett is that he is extremely patient. He selects his security purchase price very, very carefully. Then he waits and waits until an opportunity arises that presents him with this previously calculated purchase price.
I don’t think there is another person in the world who is as patient as Buffett. How can he be so patient? He has other uses for his cash while he is waiting for the “right” price. For one thing, he engages in arbitrage. And he is not opposed to buying preferred stock, which will pay him a very nice return for the use of his cash. In other words, he knows what to do with his “idle” time and money.
Most of us do not have the time (nor the cash) to learn and then put into action what Warren does so successfully with his short-term cash. All we can do for the moment is determine what he does with his long-term cash, which is invest in good growth stocks at a good value (price). Or we can just determine what the best stocks are, buy them, and let the very good company managers continue their good work. The market eventually recognizes good work, and our good stocks will give us a very nice profit.
What is meant by management performing “good work” in a growth company? First of all, we want management to earn a very good return on shareholders’ equity. Second of all we want to see most or all of that profit being reinvested back into the company and then generating an equally good return on that reinvested capital. Just think of a bank account that is paying 10 percent per year consistently year after year. All we have to do as investors is search out these stocks.
We will construct a superior performing portfolio with those stocks that will allow us a greater predictive ability in a later chapter. For now, let’s look at examples and practice using those examples. Let’s see how Warren Buffett uses Clean Surplus Accounting to determine when a company represents a good value (Table 13.1).
Table 13.1 Bank A and Bank B
| Bank A | Bank B | |||||
| Year | Equity | Interest | ROE | Equity | Interest | ROE |
| Year 15 | $378.00 | $37.80 | 10.00% | ???? | ??? | ??? |
| 5—the present | $146.00 | $14.60 | 10.00% | $142.45 | $11.40 | 8.00% |
| 4 | $133.00 | $13.30 | 10.00% | $131.29 | $11.00 | 8.50% |
| 3 | $121.00 | $12.10 | 10.00% | $120.45 | $10.85 | 9.00% |
| 2 | $110.00 | $11.00 | 10.00% | $110.00 | $10.45 | 9.50% |
| 1 | $110.00 | $10.00 | 10.00% | $100.00 | $10.00 | 10.00% |
Bank Account A is acting very much like a bond. It is returning 10 percent per year on our money. If we owned a bond paying 10 percent and were able to reinvest our interest payments also at a rate of 10 percent, we would have Bank Account A.
If the bond paid 10 percent per year for the past 10 or 15 years, we could make a pretty good assumption that the bond may very well return 10 percent to us over the next 10 years.
The problem with the stock market is common stocks are just not as consistent as bonds. However, it is our job (not that difficult) to find the companies that do indeed earn a fairly consistent return on the invested equity capital.
Notice the amount of money in the account of Bank A in year five. It is $146. We began year one (five years previously) with just $100. Therefore, $46 of the $146 is retained interest (retained earnings).
What is so important is that in year five, Bank A is returning 10 percent on the entire $146. This means that Bank A is earning 10 percent on the original $100 and also earning 10 percent on the reinvested capital of $46.
In other words, Bank A is earning a high return on the reinvested capital as well as the original capital.
Look at Bank B. It is earning an ever-lower rate of return on the money in the account. This is not a good sign. It means that Bank B is not deploying its new (reinvested) capital as efficiently as Bank A nor is it earning the same rate of return on its reinvested capital as it did in previous years.
If we assume that the bank (or bond, or stock) will pay us 10 percent per year for the next 10 years, and we are reinvesting all of that money back into the account (retaining 100 percent of earnings), then we can, with some degree of accuracy, project out and estimate how much money we will have in Bank A 10 years from now (Table 13.1, repeated here).
Table 13.1 Bank A and Bank B
| Bank A | Bank B | |||||
| Year | Equity | Interest | ROE | Equity | Interest | ROE |
| Year 15 | $378.00 | $37.80 | 10.00% | ???? | ??? | ??? |
| 5—the present | $146.00 | $14.60 | 10.00% | $142.45 | $11.40 | 8.00% |
| 4 | $133.00 | $13.30 | 10.00% | $131.29 | $11.00 | 8.50% |
| 3 | $121.00 | $12.10 | 10.00% | $120.45 | $10.85 | 9.00% |
| 2 | $110.00 | $11.00 | 10.00% | $110.00 | $10.45 | 9.50% |
| 1 | $110.00 | $10.00 | 10.00% | $100.00 | $10.00 | 10.00% |
How do we do this? We begin with the amount (equity) we have in Bank A in year five (the present time), which is $146. We know, or are assuming with a certain degree of confidence, that the future rate of return on our capital will continue to be 10 percent. We know we are retaining all that we earn. Thus, we project this $146 out for 10 years at the growth rate of 10 percent.
Only if you’re really interested, the actual calculation is: $146 × (1 + (0.10 × 1.0) ^ 10). It is the amount of $146 which we multiply by 1 plus the interest rate (10 percent or 0.10) times the retention rate (reinvested rate) of 100 percent (or 1.0) all raised to the 10th power. The 10th power represents compounding over the time period of 10 years.
Of course, we use a computer spreadsheet, put the formula in once, and save the formula to all the stocks in my program database. Got to love computers.
This calculation gives us the amount of money (equity) we will have in Bank A 10 years from now. If we know with some certainty the amount (asset base) we will have in the bank in year 15 ($378), and we assume our rate of return is still going to be 10 percent, we can then calculate our interest (net income) in year 15 which is 10 years from now.
The earnings or interest we will earn in year 15 will be the amount we have in the bank in year 15 ($378) times the 10 percent which we feel Bank A will still be earning for us at that time. Ten percent times $378 gives us interest (net income) of $37.80, which is the amount we estimate we will earn in year 15 in Bank A.
Let’s look at the account of Bank B. It has a decreasing rate of return. The big question is how in the world will we be able to figure out what we will have in the bank in year 15 (10 years from now) if we don’t know what the rate of return on our invested money will be over the next 10 years? The answer is we don’t know. We don’t have a good consistent rate of return upon which we are able to base our projections. If we can’t make a good assumption because of inconsistency, then why even think of investing in Bank B when Bank A is just around the corner? And yet some people will invest in Bank B because they feel somehow, by some grace of Lady Luck, it will turn around and earn much more than Bank A or because they like the name of the company or they heard something positive from a friend or . . . .
Watch that word “turnaround.” Buffett has been heard to say that turnarounds seldom turn. Why even take the chance? Especially when you have no clue as to the probability of a turnaround. Buffett loves probabilities, and yet he won’t take many chances like that, so why should we?
I want to use two stocks I used in several of my university classes many years ago. They are General Electric (GE) and General Motors (GM). These are both great examples because General Electric eventually fell from grace, and General Motors eventually went bankrupt.
We will use the original numbers and dates here, and we will bring these two companies up to date later. Do not use the following data as a guide as whether or not to invest in these companies. However, GE and GM were such good examples back in the day (one good and the other bad) that I want to use them here so you will be aware that long-term holding does not mean forever. Long-term holding means that you buy a good stock and hold it until it is not a good stock any longer. This was indeed the case for General Electric. The case for General Motors is you never should have bought this stock in the first place. Even the blind kid (in Chapter 14) knew not to buy this stock way back in 1999.
Just to let you know, we sold GE at the very beginning of 2004, and we will show you why as we go along.
Let’s look at a real stock (Table 13.2).
Table 13.2 General Electric—NYSE GE
| Projected OE | Net Income | 10-Yr. Avg. P/E Ratio | 10-Yr. Target Price | Required Return | Buy Price | |||
| 2012 | $21.15 | $4.35 | 23 | $100 | 12.6% | $31 | ||
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity | 10-Year Average ROE | Retention Rate | 10-Year Average Retention |
| 2002 | $7.14 | $1.60 | $0.72 | $0.88 | 22.4% | 55.0% | ||
| 2001 | $6.37 | $1.41 | $0.64 | $0.77 | 22.1% | 54.6% | ||
| 2000 | $5.67 | $1.27 | $0.57 | $0.70 | 22.4% | 55.1% | ||
| 1999 | $5.09 | $1.07 | $0.49 | $0.58 | 21.0% | 54.2% | ||
| 1998 | $4.58 | $0.93 | $0.42 | $0.51 | 20.3% | 54.8% | ||
| 1997 | $4.11 | $0.83 | $0.36 | $0.47 | 20.2% | 56.6% | ||
| 1996 | $3.70 | $0.73 | $0.32 | $0.41 | 19.7% | 56.2% | ||
| 1995 | $3.33 | $0.65 | $0.28 | $0.37 | 19.5% | 56.9% | ||
| 1994 | $3.00 | $0.58 | $0.25 | $0.33 | 19.3% | 56.9% | ||
| 1993 | $2.71 | $0.51 | $0.22 | $0.29 | 18.8% | 20.6% | 56.9% | 55.7% |
We see that GE had a pretty consistent ROE right up until 2002. In fact, the ROE was steadily increasing, which is a very good thing. The most important aspect of these calculations is that the more consistent a stock’s ROE, the more accurate our projections will be.
Buffett likes to take averages over periods of 10 years. He will take the past 10-year average of the ROE, which in the case of GE is 20.6 percent.
The next question: Is GE putting all of its earnings back into the company? The answer is no. It is paying some of the earnings out in the form of dividends. Net income minus the dividends gives us the Clean Surplus retained earnings or the amount of the net income GE is putting back into the company.
The retained earnings is the amount of money from earnings put back into the company each year. However, in order to compare one company to another company when it comes to the amount of money put back into the company each year, we use a ratio called the “retention rate.”
In order to calculate the retention rate, we simply divide the retained earnings by the total net income.
For 2002 (see Table 13.3), retained earnings of $0.88 divided by net income of $1.60 ($0.88/$1.60) gives us a retention rate of 55.0 percent. The retention rate is the percentage of the earnings (net income) retained or put back into the company. You can see this in the retention rate column.
Table 13.3 General Electric (GE)—Retention Rate
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity | 10-Year Average ROE | Retention Rate | 10-Year Average Retention |
| 2002 | $7.14 | $1.60 | $0.72 | $0.88 | 22.4% | 20.6% | 55.0% | 55.7% |
Buffett then takes the average retention rate of, you guessed it, the past 10 years, which is 55.7 percent (Table 13.4).
Table 13.4 General Electric (GE)—Retention Rate—10 Yr. Avg. ROE
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity | 10-Year Average ROE | Retention Rate | 10-Year Average Retention |
| 2002 | $7.14 | $1.60 | $0.72 | $0.88 | 22.4% | 20.6% | 55.0% | 55.7% |
Let’s catch up here for a moment. GE has an average 10-year ROE of 20.6 percent. Of that amount, GE has averaged, over the past 10 years, a retention rate of 55.7 percent. So we know GE’s 10-year ROE on invested equity (20.6 percent) and how much of those earnings that GE is retaining (55.7 percent) or putting back into the company. Remember, these are all 10-year averages.
Why does Buffett use 10-year averages? I don’t know, but it could be that over any 10-year period, the economy goes through recessions and also economic expansions. As the economy goes through these cycles, expectations about a company’s future will rise and fall with the mood of all of us. Thus, he probably feels that over a 10-year period, we see the average of at least one complete economic cycle, and of course, the ensuing mood swings that accompany both the good and bad times. Hey, makes sense to me.
Speaking about mood swings, the price-to-earnings (P/E) ratio reflects these mood swings. The price-to-earnings ratio reflects investor expectations about the future earnings of the company, and these expectations rise and fall with the performance of the economy, both actual and perceived.
Back in the late 1990s during the dot.com-era, everyone was happy and investors expected earnings to go to the sky. The growth of some stocks was expected to rise exponentially (like, way above the sky). These fantastic expectations were reflected in the very high P/E ratios at that time.
Then around 2002 as well as 2008, the mood shift had taken a 180-degree turn. Everyone was focused on all the negatives in the world, and that mental depression was being reflected in the stock market. The news seemingly could not get any worse, and people were selling into each and every rally. As stock prices declined, the P/E ratio declined because of very low expectations.
The bottom line on the P/E ratio is that it represents a certain multiple of earnings for which the stock is selling. This multiple is different for each company and each industry and each cycle in the economy (whew!). The P/E ratio is based on the price of a stock that reflects the perceived growth of earnings, either up or down for whatever reason or reasons.
Please be aware that the P/E ratio is configured differently by the different reporting sources. One source uses present price relative to the trailing 12 months of earnings, while another source will use the past six months of actual earnings and the next six months of its own projected earnings. Many other sources use future earnings based upon present price. Again, beware of which P/E people are referring to.
Please remember to look at the spreadsheet of GE as I go on with the numbers. We discussed how to obtain a future earnings projection. Just reviewing a bit, we take the owners’ equity of 2002 ($7.14) and project that out 10 years by using the return on that equity (past 10-year average of 20.6 percent) times the retention rate (past 10-year average of 55.7 percent). This calculation gives us 2012 owners’ equity of $21.15 (Table 13.5).
Table 13.5 General Electric GE
| Projected OE | Net Income | 10-Yr. Avg. P/E Ratio | 10-Yr Target Price | Required Return | Buy Price | |||
| 2012 | $21.15 | $4.35 | 23 | $100 | 12.6% | $31 | ||
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity | 10-Year Average ROE | Retention Rate | 10-Year Average Retention |
| 2002 | $7.14 | $1.60 | $0.72 | $0.88 | 22.4% | 55.0% | ||
| 2001 | $6.37 | $1.41 | $0.64 | $0.77 | 22.1% | 54.6% | ||
| 2000 | $5.67 | $1.27 | $0.57 | $0.70 | 22.4% | 55.1% | ||
| 1999 | $5.09 | $1.07 | $0.49 | $0.58 | 21.0% | 54.2% | ||
| 1998 | $4.58 | $0.93 | $0.42 | $0.51 | 20.3% | 54.8% | ||
| 1997 | $4.11 | $0.83 | $0.36 | $0.47 | 20.2% | 56.6% | ||
| 1996 | $3.70 | $0.73 | $0.32 | $0.41 | 19.7% | 56.2% | ||
| 1995 | $3.33 | $0.65 | $0.28 | $0.37 | 19.5% | 56.9% | ||
| 1994 | $3.00 | $0.58 | $0.25 | $0.33 | 19.3% | 56.9% | ||
| 1993 | $2.71 | $0.51 | $0.22 | $0.29 | 18.8% | 20.6% | 56.9% | 55.7% |
In order to obtain 2012 net income, we multiply 2012 owners’ equity ($21.15) by the past 10-year average of ROE (20.60 percent), which gives us 2012 net income of $4.35.
Once we calculate 2012 net income, we then multiply the net income ($4.35) by the past average 10-year P/E ratio (23) to give us our expected price in 10 years of $100. ($4.35 × 23 = $100). This $100 becomes our approximate 10-year projected target price.
But now we must discount the future price of $100 back to the present (2002) in order to determine a proper purchase price. Let’s see how we do this.
Once we obtain the 10-year future target price, we can then discount that future price back to the present.
What? We just forecasted a price 10 years out; why do we want to get back to the present?
We’ve got to figure out the purchase price or value at which we want to purchase the stock today. You see, if we can assume with a fair degree of certainty what the future price will be in 10 years, we still must calculate the price to purchase today, which will generate for us our required return. And that purchase price is based on the return we require per year over the next 10 years.
This is such an important concept and represents the pure genius of Warren Buffett. Everyone in the entire world is trying to put a value on a stock, and of course as I’ve mentioned several times before, the academic pricing models do not work very well, if at all. If they did work, all the professors in all the universities who teach these models would be as rich as Buffett, and they’re not.
You see, by using Buffett’s method, we are not putting a value on the company relative to its worth (we can’t); we are putting a value on a stock relative to what it is worth to us. We should purchase GE at a price of $31 per share today if we want a total return of 15 percent per year, which would include 2.4 percent in dividends and 12.6 percent in stock appreciation.
Remember that old saying, buy low and sell high? Well, we just figured out the high price, which is the 2012 target price. Now, we’ve got to figure out the purchase price, which is the “low” part of that very famous saying.
Let’s say we desire a 15 percent rate of return. Why did I say 15 percent? Well, in a case study of Warren E. Buffett found in Robert Bruner’s Case Studies in Finance, he (Bruner) suggests that Buffett’s required rate of return is 15 percent. So let’s use 15 percent.
Let’s use General Electric once again. Back in 2002, GE was trading at approximately $29. It was paying a dividend of $0.72 a share, which represented a 2.4 percent dividend return. Thus, if we want a 15 percent per year return, we are already receiving 2.4 percent in dividends. Therefore, the stock must appreciate (price increase only) just 12.6 percent per year (15% − 2.4%). Please remember that a stock’s total return is price appreciation plus dividends.
In order to calculate our purchase price, we must put the required return of 12.6 percent in the required return box of our spreadsheet or the computer program that accompanies this book. The computer will automatically discount back the future price 10 years at the rate of 12.6 percent, and give us a buy price of $31 (see Table 13.6).
Table 13.6 General Electric (GE)—Buy Price
| Projected OE | Net Income | 10-Yr. Avg. P/E Ratio | 10-Yr Target Price | Required Return | Buy Price | |||
| 2012 | $21.15 | $4.35 | 23 | $100 | 12.6% | $31 | ||
| Year | Owners’ Equity | Net Income | Dividends Paid | Retained Earnings | Return on Equity | 10-Year Average ROE | Retention Rate | 10-Year Average Retention |
| 2002 | $7.14 | $1.60 | $0.72 | $0.88 | 22.4% | 55.0% | ||
| 2001 | $6.37 | $1.41 | $0.64 | $0.77 | 22.1% | 54.6% | ||
| 2000 | $5.67 | $1.27 | $0.57 | $0.70 | 22.4% | 55.1% |
If you really need to know the formula, it is the future price ($100) divided by 1.12610. Or the future price divided by 1 plus our required return of 12.6 percent (0.126) raised to the 10th power. The 10th power represents the number of years we are discounting back. Yep, 10 years.
As you can now see, the purchase price of GE should be approximately $31 per share. This means that if GE continues to generate a return on equity of approximately 20 percent and continues to reinvest approximately 56 percent of those earnings back into the company for growth, the 10-year future price (target price) should be approximately $100 per share. Discount the future price of $100 per share back by 12.6 percent (required appreciation), and we obtain a purchase price of $31 per share.
Bottom line here is if the assumptions are correct, and in the past they had been up to 2002, and we could purchase GE at $31 a share, we should see GE at approximately $100 a share 10 years from 2002. This price appreciation plus the dividends will generate a total of 15 percent yearly rate of return for us.
Now you understand the importance of the purchase price. The purchase price is the basis for the return that a stock will generate for us over the next 10 years.
As you can see, I use numbers like 12.6 percent and $100 target price and retention rate of 55.7 percent. Please don’t get hung up on the decimal places or exact numbers. Buffett says that it is better to be approximately correct than precisely wrong. The future of the economics of the world, country, and individual company can only be approximated. If the past has been consistent, then we are assuming the future will be consistent. So “approximately” is the word of the day.
The other side of the market (other than economics) is the human emotion. I can tell you this with exactness. Human emotion can take those precise numbers and make them all look rather silly.
Put both economics and human emotion together and think about this for a moment. Think about how much you were worth in 1999 and how much you were worth at the end of 2002. I would say your worth was not exactly the same.
So maybe you might think about how I handle the situation and do what Warren Buffett suggests. It’s better to be approximately correct than precisely wrong. And I leave it at that.
The last three short paragraphs have proven to be extremely important since I last wrote them. The financial crisis of 2008 has proven to be very long lasting to say the least.
General Electric changed part of its business model in that it became very involved with financing and, as with most companies, GE was susceptible to swings in the worldwide economy. Over the years, the economies of the world have become more and more correlated. What this means is what happens in the United States also happens around the world.
Let’s bring the GE numbers up to the present time (Table 13.7) and see where we would have sold it using the Buffett and Beyond rules of investing.
Table 13.7 GE ROE to Present Date
| ROE | |
| ~2015 | 10.8% |
| 2014 | 10.4% |
| 2013 | 10.6% |
| 2012 | 10.4% |
| 2011 | 9.4% |
| 2010 | 8.7% |
| 2009 | 8.0% |
| 2008 | 14.4% |
| 2007 | 19.5% |
| 2006 | 19.3% |
| 2005 | 18.1% |
| 2004 | 18.5% |
| 2003 | 19.5% |
| 2002 | 22.4% |
| 2001 | 22.1% |
| 2000 | 22.4% |
Pretty simple, isn’t it? There are a few more basic rules which we’ll cover later, but just these two rules will help you structure a portfolio which will in all probability outperform 96 percent of professional money managers of the world. Again, pretty simple.
Up to this point, we’ve been showing GE up to 2002. However, in 2003, the ROE dropped below our threshold of 20 percent. The difficult question becomes this: Is half percent below 20 percent worth selling a stock that had been so very consistent in the past? The same thing happened to AutoZone in that the ROE dropped slightly below 20 percent, and AZO came back and continued to be a stellar stock.
However, 2004 saw GE’s ROE continue to drop, and if you didn’t sell in 2003, you surely had to sell in 2004 according to our guidelines.
GE continued to be pretty good for the next three years from 2005 to 2007, but then the ROE began to decline drastically until it began to recover slightly into 2011. The company is beginning to come back, but it seems as though this company will never be the generator of earnings that it once was. As things look at the present time, GE will probably never again grace our growth portfolio. However, it may be a candidate for our income portfolio, which we will discuss in the Chapters 21 22, and 23.
The lesson here for a growth stock? When a company changes for the worst, it will show up in the Clean Surplus ROE sooner or later, and then it is time to replace the company with the declining ROE for a company with a nice, high ROE.