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Valuing Stocks the Warren Buffett Way

by Wayne A. Thorp, CFA

Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company. Unfortunately, Buffett has never expounded extensively on his investment approach, although you can glean tidbits from his writings in the Berkshire Hathaway annual reports. However, a cottage industry has sprung up over the years as outsiders have attempted to explain Buffett s investment philosophy. !ne book that discusses his approach in an interesting and methodical fashion is "Buffettology# $he %reviously Unexplained $echni&ues $hat Have 'ade Warren Buffett the World s 'ost (amous )nvestor* +,cribner, -.../ written by 'ary Buffett, a former daughter0in0law of Buffett s, and 1avid 2lark, a family friend and portfolio manager. Print this article

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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.

Defining an Attracti e Co!pany

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.

The Buffettology Screen

$he criteria used for our Buffettology screens are summari>ed in $able -. 44)) s ,tock )nvestor %ro is used to perform the screens. 2onsumer monopolies typically have high profit margins because of their uni&ue niche@ however, a simple screen for high margins may highlight weak firms in industries with traditionally high margins, but low turnover levels. !ur first screening filters look for firms with both gross operating margins and net profit margins above the medians for their industry. $he operating margin concerns itself with the costs directly associated with the production of the goods and services, while the net profit margin takes all of the company activities and actions into account.

Table ". Translating the Buffett Style #nto Screening

$uestions to %eter!ine the attracti eness of the business& Consu!er !onopoly or co!!o%ity' Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product uni&ue. )nvestors can seek these companies by identifying the manufacturers of products that

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.

-n%erstan% )o( #t Works

4s is common with successful investors, Buffett only invests in companies he can understand. )ndividuals should try to invest in areas where they possess some speciali>ed knowledge and can more effectively =udge a company, its industry, and its competitive environment. While it is difficult to construct a &uantitative filter, an investor should be able to identify areas of interest. $he companies typically passing the Buffettology screens represent a diverse group of companies. 4n investor should only consider analy>ing those firms operating in areas that they can clearly grasp. $o see the companies that are currently passing the 44)) Buffettology screens, visit the ,tock ,creens area of 44)).com.

Conser ati e Financing

2onsumer monopolies tend to have strong cash flows, with little need for long0term debt. Buffett does not ob=ect to the use of debt for a good purpose8for example, if a company uses debt to finance the purchase of another consumer monopoly. However, he does ob=ect if the added debt is used in a way that will produce mediocre results8such as expanding into a commodity line of business.

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.

Strong . #!pro ing /arnings

Buffett invests only in businesses whose future earnings are predictable to a high degree of certainty. 2ompanies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders. 9arnings levels are critical in valuation. 4s earnings increase, the stock price will eventually reflect this growth. Buffett looks for strong long0term growth as well as an indication of an upward trend. )n her book, 'ary Buffett looks at both the -F0 and five0year growth rates. ,tock )nvestor %ro offers seven0year growth rates, so for the predefined Buffettology screens we use the seven0year growth rate to filter for long0term growth and the three0year growth rate to filter for intermediate0term growth. $he Buffettology screens first re&uire that a company s seven0year earnings growth rate be higher than that of C;< of the stocks in the overall database. )t is best if the earnings also show an upward trend. Buffett compares the intermediate0term growth rate to the long0term growth rate and looks for expanding earnings. (or our next filter, we re&uire that the three0year growth rate in earnings be greater than the seven0year growth rate. 2onsumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. 4n examination of year0by0year earnings should be performed as part of the valuation. (igure -. Buffett Haluation Worksheet for H24 4ntech

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.

#n esting 0etaine% /arnings

4 company should retain its earnings if its rate of return on its investment is higher than the investor could earn on his own. 1ividends should only be paid if they would be better employed in other companies. )f the earnings are properly reinvested in the company, earnings should rise over time and stock price valuation will also rise to reflect the increasing value of the business. 4n important factor in the desire to reinvest earnings is that the earnings are not sub=ect to personal income taxes unless they are paid out in the form of dividends. Buffett examines management s use of retained earnings, looking for management that has proven it is able to employ retained earnings in the new moneymaking ventures, or for stock buybacks when they offer a greater return.

1oo% 0eturn on /+uity

Buffett seeks companies with above0average return on e&uity. 'ary Buffett indicates that the average return on e&uity over the last EF years has been around -D<. 1uring the valuation process, this average should be checked against more current figures to assure that the past is still indicative of the future direction of the company. !ur screen looks for average return on e&uity of -D< or greater over the last seven years.

#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.

0ein esting Capital

)n Buffett s view, the real value of consumer monopolies is in their intangibles8for instance, brand0name loyalty, regulatory licenses, and patents. $hey do not have to rely heavily on investments in land, plant, and e&uipment, and often produce products that are low tech. $herefore, they tend to have large free cash flows +operating cash flow less dividends and capital expenditures/ and low debt. Getained earnings must first go toward maintaining current operations at competitive levels. $his is a factor that is also best examined at the time of the company valuation although a screen for relative levels of free cash flow might help to confirm a company s status. $he above basic filters help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis. However, stocks passing the screens are not automatic buys. $he next test revolves around the issue of value. $he %rice )s Gight# Using the Buffett Haluation ,preadsheet $he price that you pay for a stock determines the rate of return8the higher the initial price, the lower the overall return. Likewise, the lower the initial price paid, the higher the return. Buffett first picks the business, and then lets the price of the company determine whether to purchase the firm. $he goal is to buy an excellent company at a price that makes business sense. Haluation e&uates a company s stock price to a relative benchmark. 4 MDFF dollar per share stock may be cheap, while a MD per share stock may be expensive. Buffett uses a number of different methods to evaluate share price. $hree techni&ues are highlighted in the "Buffettology* book and are used in the Buffett spreadsheet template +(igure -/. Aou can download the spreadsheet from at 44)) Web site# www.aaii.comNciNbuffettology.xls. Buffett prefers to concentrate his investments in a few strong companies that are priced well. He feels that diversification is used by investors to protect themselves from their stupidity.

/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.

)istorical /arnings 1ro(th

4nother method Buffett uses to value prospective stocks is to pro=ect the annual compound rate of return based on historical earnings per share increases. (or example, earnings per share at H24 4ntech have increased at a compound annual growth rate of DE..< over the last five years +cell BEF/. )f earnings per share increase for the next -F years at this same growth rate of DE..<, earnings per share in year -F will be M-E.EL. IM-.;O Q +- R F.DE./-FJ. +Sote this value is found in cell BLC and also in cell 9EC. Using a calculator, results may differ due to rounding./ $his estimated earnings per share figure can then be multiplied by the five0year average price0 earnings ratio of D;.F +cell H-F/ to provide an estimate of price IM-E.EL Q D;.F T MEEE.-.J. +Sote this value is found in cell 9LF./ While H24 does not pay a dividend, if a company you are valuing pays dividends an estimate of the amount of dividends paid over the -F0year period should also be added to the year -F price. +Sote that when evaluating dividend0paying stocks, this value is found in cell 9L-./ !nce this future price is estimated, pro=ected rates of return can be determined over the -F0year period based on the current selling price of the stock. Buffett re&uires a return of at least -;<. (or H24 4ntech, comparing the pro=ected total gain of MEEE.-. to the current price of MDL.FL leads to a pro=ected annual rate of return of EF.-< I+MEEE.-. U MDL.FL/-N-F V -J. +Sote this value is found in cell 9LE./

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.

$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.