Professional Documents
Culture Documents
About the author Wayne A. Thorp , is senior financial analyst at 44)) and editor of Computerized Investing. (ollow him on $witter at 544))62). 7 Wayne 4. $horp %rofile 7 4ll 4rticles by Wayne 4. $horp $his book served as the basis for two stock screens developed and tracked by 44))8 Buffettology 9%, :rowth and Buffettology ,ustainable :rowth. $hese screens are also pre0built into 44)) s ,tock )nvestor %ro fundamental stock screening and research database program. )n this article, we provide an overview of Buffettology as a method of identifying promising businesses. )n addition, we present a Buffett valuation spreadsheet that uses various valuation models to measure the attractiveness of stocks passing the preliminary screens.
Warren Buffett seeks first to identify an excellent business and then to ac&uire the firm if the price is right. Buffett is a buy0and0hold investor who prefers to hold the stock of a good company earning -;< year after year over =umping from investment to investment with the hope of higher, short0term gains. !nce 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. )n his view, businesses can be divided into two basic types#
2ommodity0based firms8selling products where price is the single most important factor determining purchase. $hey are characteri>ed by high levels of competition in which the low0cost producer wins because of the freedom to establish prices. 'anagement is vital for the long0term success of these types of firms. 2onsumer monopolies8selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service uni&ue.
While Buffett is considered a value investor, he passes up the stocks of commodity0based firms even if he can purchase them at a price below the intrinsic value of the firm. 4n enterprise with poor inherent economics often remains that way. $he stock of a mediocre business generally only treads water. How do you spot a commodity0based company? Buffett watches out for these characteristics#
Low profit margins +net income divided by sales/@ Low return on e&uity +earnings per share divided by book value per share/@ 4bsence of any brand0name loyalty for its products@ $he presence of multiple producers@ $he existence of substantial excess capacity@ %rofits tend to be erratic@ and %rofitability depends upon management s ability to optimi>e the use of tangible assets.
Buffett instead seeks out consumer monopolies8companies that have managed to create a product or service that is somehow uni&ue and difficult for competitors to reproduce due to brand0name loyalty, a particular niche that only a limited number of companies can enter, or an unregulated but legal monopoly such as a patent. 2onsumer monopolies can be businesses that sell products or services. Buffett recogni>es three types of monopolies#
Businesses that make products that wear out fast or are used up &uickly and have brand0 name appeal that merchants must carry to attract customers. 4pple )nc. is a good example of a firm with a strong brand name in demand by customers. 4s a result, consumers are willing to pay a premium price for 4pple products. !ther examples include leading newspapers, drug companies with patents, and popular brand0name restaurants such as 'c1onald s. "2ommunications* firms that provide a repetitive service, which manufacturers must use to persuade the public to buy their products. 4ll businesses must advertise their items, and many of the available media face little competition. $hese used to include worldwide advertising agencies, maga>ine publishers, newspapers, and telecommunications networks. $oday, "new media* outlets such as :oogle and AahooB provide on0line 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. 9xamples include tax preparers, insurance companies, and investment firms.
)n her Buffettology book, 'ary Buffett suggests going to your local convenience store to identify many of these "must0have* products. $hese stores typically carry a very limited line of must0have products such as 'arlboro 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.
seem indispensable. 2onsumer monopolies typically have high profit margins because of their uni&ue niche@ however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. (or our screen, we look for companies with operating margins and net profit margins above their industry norms. 4dditional screens for strong earnings and high return on e&uity will also help to identify consumer monopolies. (ollow0up examinations should include a detailed study of the firm s position in the industry and how it might change over time. Do you un%erstan% ho( the business (orks' Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you should only further analy>e the companies passing all screening criteria that operate in areas you understand. #s the co!pany conser ati ely finance%' Buffett seeks out companies with conservative financing. 2onsumer monopolies tend to have strong cash flows, with little need for long0term debt. We screen for companies with total liabilities relative to total assets that are below the median for their respective industry. 4lternative screens might look for low debt to capitali>ation or low debt to e&uity. Are earnings strong an% %o they sho( an up(ar% tren%' Buffett looks for companies with strong, consistent, and expanding earnings. We screen for companies with seven0year earnings per share growth greater than C;< of all firms. $o help indicate that earnings growth is still strong, we also re&uire that the three0year earnings growth rate be higher than the seven0year growth rate. Buffett seeks out firms with consistent earnings. (ollow0up examinations should include careful examination of the year0by0year earnings per share figures. 4s 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 -D months. Does the co!pany stick (ith (hat it kno(s' 4 company should invest capital only in those businesses within its area of expertise. $his is a difficult factor to screen for on a &uantitative level. Before investing in a company, look at the company s past pattern of ac&uisitions and new directions. $hey should fit within the primary range of operation for the firm. )as the co!pany 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 shareholder0 enhancing maneuvers such as share buybacks. While we do not screen for this factor, a follow0 up examination of a company would reveal if it has a share buyback plan in place. )a e retaine% earnings been in este% (ell'
9arnings should rise as the level of retained earnings increase from profitable operations. !ther screens for strong and consistent earnings and strong return on e&uity help to the capture this factor. #s the co!pany*s return on e+uity abo e a erage' Buffett considers it a positive sign when a company is able to earn above0average returns on e&uity. 'ary Buffett indicates that the average return on e&uity for the last EF years is approximately -D<. We created a custom field that calculated the average return on e&uity over the last seven years. We then filter for companies with average return on e&uity above -D<. #s the co!pany free to a%,ust prices to inflation' $rue consumer monopolies are able to ad=ust prices to inflation without the risk of losing significant unit sales. $his factor is best applied through a &ualitative examination of the companies and industries passing all the screens. Does the co!pany nee% to constantly rein est in capital' Getained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. $his factor is best applied through a &ualitative 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.
4ppropriate 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. $he ratio of total liabilities to total assets is more encompassing than =ust looking at ratios based upon long0term debt such as the debt0e&uity ratio.
H24 4ntech W!!( passed the Buffettology ,ustainable :rowth screen as of 'ay -;, DFF., and is used in (igure - to illustrate the Buffett Haluation ,preadsheet. $he company operates the largest network of animal hospitals and veterinary diagnostic labs in the country. $he company s earnings per share are displayed in the spreadsheet. IWhile ,tock )nvestor %ro provides seven0 year growth rates, which re&uires eight years of data, the program provides seven years of financial statement data for display purposes. $he spreadsheet displays six years of data to calculate the five0year growth rates.J 4s we can see, H24 s earnings per share 9%, growth has been strong and consistent, with annual increases over each of the last five years +where Aear is the most recent year/. 4 screen re&uiring 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 re&uiring positive earnings for each of the last seven years should help to eliminate some of the commodity0 based businesses with wild earnings swings.
A Consistent Focus
2ompanies that stray too far from their base of operation often end up in trouble. %eter Lynch also avoided profitable companies diversifying into other areas. Lynch termed these "diworseifications.* Kuaker !ats purchase and subse&uent sale of ,napple is classic example. 2ompanies should expand into related areas that offer high return potential. H24 4ntech is the leader in the animal diagnostic lab business, servicing more than -L,FFF of the DD,FFF animal hospitals in the U.,. $his 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. $his is a difficult variable to screen, as most data services do not indicate buybacks. Aou can screen for a decreasing number of outstanding shares, but this factor is best analy>ed during the valuation process.
#nflation A%,ust!ents
2onsumer monopolies can typically ad=ust their prices &uickly to inflation without significant reductions in unit sales, since there is little price competition to keep prices in check. $his factor is best applied through a &ualitative examination of a company during the valuation stage.
/arnings 2iel%
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 &uickly to other investments. Buffett goes as far as to view stocks as bonds with variable yields, and their yields e&uate to the firm s underlying earnings. $he analysis is completely dependent upon the predictability and stability of the earnings, which explains the emphasis on earnings strength within the preliminary screens. H24 4ntech has an earnings yield of O.;< Icell 2-E, computed by dividing the current +trailing -D months/ earnings per share of M-.;O +cell 2./ by the closing price on 'ay -;, DFF., of MDL.FL +cell 2P/J. Buffett likes to compare the company earnings yield to the long0term government bond yield. 4n earnings yield near the government bond yield is considered attractive. With government bonds yielding slightly more than L< currently +cell 2-C/, H24 compares very favorably. By paying MDL per share for H24, an investor gets an earnings yield return greater than the interest yield on bonds. $he bond interest is cash in hand but it is static, while the earnings of H24 4ntech should grow over time and push the stock price up.
Sustainable 1ro(th
$he third valuation method detailed in "Buffettology* is based upon the sustainable growth rate model. Buffett uses the average rate of return on e&uity G!9 and average retention ratio +- V average payout ratio/ to calculate the sustainable growth rate IG!9 Q +- V payout ratio/J. (or companies that do not pay a dividend, the sustainable growth rate e&uals the return on e&uity.
$he sustainable growth rate is used to calculate the book value per share BH%, in year -F IBH%, Q +- R sustainable growth rate/-FJ. 9arnings per share can then be estimated in year -F by multiplying the average return on e&uity by the pro=ected book value per share IG!9 Q BH%,J. $o estimate the future price, you multiply the earnings per share by the average price0earnings ratio I9%, Q %N9J. )f dividends are paid, they can be added to the pro=ected price to compute the total gain. (or example, H24 4ntech s sustainable growth rate, based on average five0year data, is DD.E< IDD.E< Q +- V F.F/J. +$he sustainable growth rate is found in cell H--./ 4gain, since the company does not pay a dividend, its sustainable growth rate e&uals its return on e&uity. $hus, book value per share should grow at this rate to roughly MO;..- in -F years IMP.P- Q +- R F.DDE/-FJ. +Sote this value is found in cell BOD./ )f return on e&uity remains DD.E< +cell HO/, in the tenth year, earnings per share that year would be M-L.O. IF.DDE Q MO;..-J. +Sote this value is found in cell 2OD and also in cell 9;D./ $he estimated earnings per share can then be multiplied by the average price0earnings ratio to pro=ect the future price of MEOO.PP IM-L.O. Q D;.FJ. +Sote this value is located in cell 9;;./ )f dividends have been paid, you would use an estimate of the amount of dividends paid over the -F0year period and add this to the pro=ected price to arrive at the total gain. $his total gain is then used to pro=ect the annual rate of return of E-.E< I++MEOO.PP R MF.FF/ U MDL.FL/-N-F V -J. +Sote this return estimate is found in cell 9;P./
Data Sources
(or users of ,tock )nvestor %ro, the pro=ected returns based on the earnings growth rate and sustainable growth rate are already built into the program using seven0year data +found in the Haluations data category/. (or those who do not subscribe to ,tock )nvestor %ro, all of the data you need to populate the Buffett valuation spreadsheet can be found in company -F0W reports, which are available on0line from numerous sources. Aou will have to search through multiple years, however, in order to get the six years of data re&uired for this spreadsheet. 4lternatively, the ,mart'oney Web site +www.smartmoney.com/ provides -F years of financial statement data for free.
Conclusion
$he 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. 'ost investors have little trouble understanding Buffett s philosophy. $he 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.