Buffettolotgy?

[Sarge85]

Buffett Way – is it a good valuation technique.

I’ve read Buffettology and have taken to the principals listed in the book.

Basically the style supports finding companies that are “Consumer Monopolies”. I think the trend is to call consumer monopolies companies with large moats. The company is basically offering a service or good that a consumer is almost required to buy, or a reseller is “required” to have.

Furthermore the companies must have solid financials, with predictable earnings. Looking at the last 10 years, there needs to be growth each year. Warren is looking at companies compounding at a rate of 12% or higher. Generally these companies have an above average Return on Equity. I would say over 20%.

Now his valuation technique seems to be this.---

Take current Book Value (Shareholder’s Equity per Share), multiply by average ROE over the past 10 Years. This will give you your forward EPS.
If the company pays a dividend, figure out how much of the EPS will be retained by the company, and how much will be paid out in a dividend.
Add back into the Book Value the retained EPS.

Repeat the equation. I generally do it for ten years, to get a predicted EPS for 5 and 10 years.

Now using the average, high, and low PE’s over the past ten years – you can forecast what a price may be in 5 and 10 years. With the forecasted price, you can figure out what your rate of return is based on the current price.

So a few questions:

If you are familiar with this method – what am I missing?
If I’m not missing anything – is this a “good” way to value a company?
I find that my forward looking EPS seem to be grossly high – to the point of almost unrealistic. Ok not a question, but why is this happening?

Sarge/images/graemlins/diamond.gif

[DesertCat]

[ QUOTE ]
Buffett Way – is it a good valuation technique.

I’ve read Buffettology and have taken to the principals listed in the book.


[/ QUOTE ]

It's been a long time since I read the book, but I really liked it and it got me started on the road to becoming an investor. I can't remember enough to say if I'd still agree with everything in it today, however.

[ QUOTE ]

Basically the style supports finding companies that are “Consumer Monopolies”. ....
Generally these companies have an above average Return on Equity. I would say over 20%.

[/ QUOTE ]

You can use similar techniques with any companies, but they are only as accurate as the future earnings stream is predictable. "consumer monopolies" tend to be very predictable.
High ROE is an attribute of a predictable quasi-monopolies.

[ QUOTE ]

Take current Book Value (Shareholder’s Equity per Share), multiply by average ROE over the past 10 Years. This will give you your forward EPS.


[/ QUOTE ]

Hmm, this doesn't sound exactly right. Shouldn't the equity grow by the compounded ROE rate over ten years (minus dividends)? Then in ten years your tenth year earnings is the end book value multiplied by the ROE.

[ QUOTE ]

If you are familiar with this method – what am I missing?
If I’m not missing anything – is this a “good” way to value a company?
I find that my forward looking EPS seem to be grossly high – to the point of almost unrealistic. Ok not a question, but why is this happening?


[/ QUOTE ]

Why don't you post the specifics of one of your calculations and I'll provide some commentary to see if it looks right to me

[buffett]

One caveat: When you say things like
[ QUOTE ]
Warren is looking at .... his valuation technique....

[/ QUOTE ]
keep in mind that this book was written by a relative of his (daughter-in-law, I think?) and he does not endorse it.

The Residual Income method the book describes is one of many ways of valuing a company. (Btw, you seem to have a pretty good grasp of it, and yes it is a useful tool to have in your valuation toolbox. Other tools would be discounted cash flows, enterprise value to cash flow multiples, price to sales multiples, etc., etc.) I use it primarily for financial companies where book value really matters. I believe Mr. Buffett has recently intimated that some of his companies (including See's) are now worth possibly more than 10x what they're carried for on the balance sheet, which in my mind renders Residual Income much less meaningful for companies like these.

I'm not sure why you're getting an unrealistically high forward EPS number, though. If you've computed the average ROE correctly, and if it's fairly stable over time, then multiplying it by the book value should get you pretty close to earnings.

Keep in mind that, when most people compute ROE they're using "average book value" in the denominator (that is, last year's BV plus this year's BV all divided by 2).

-web

[AceHigh]

[ QUOTE ]
I find that my forward looking EPS seem to be grossly high – to the point of almost unrealistic. Ok not a question, but why is this happening?

[/ QUOTE ]

Your methodology is flawed. Book value is not a good indicator of future value of the company. Look at a company like Google (GOOG), the great potential behind Google is that they can increase earnings without increasing book value much at all. They don't have to open stores to get more customers, they just add a few computers which are a very small part of the compainies overall value.

[Sarge85]

[ QUOTE ]

Why don't you post the specifics of one of your calculations and I'll provide some commentary to see if it looks right to me

[/ QUOTE ]

Sure, (Though the formatting here makes it kind of hard to read)

Here are two “easy” companies – BUD and ADBE

Here is my break down for BUD:
Year Book Value Avg ROE EPS DIV % Retained New Book
Base $3.40 $2.77 $0.93 66% $5.24
Year 1 $5.24 39.97% $2.09 $0.70 66% $6.63
Year 2 $6.63 39.97% $2.65 $0.89 66% $8.39
Year 3 $8.39 39.97% $3.35 $1.13 66% $10.62
Year 4 $10.62 39.97% $4.24 $1.43 66% $13.44
Year 5 $13.44 39.97% $5.37 $1.80 66% $17.00
Year 6 $17.00 39.97% $6.80 $2.28 66% $21.52
Year 7 $21.52 39.97% $8.60 $2.89 66% $27.23
Year 8 $27.23 39.97% $10.89 $3.66 66% $34.46
Year 9 $34.46 39.97% $13.78 $4.63 66% $43.61
Year 10 $43.61 39.97% $17.43 $17.43



ADBE
Year Book Value Avg ROE EPS DIV % Retained New Book
Base $2.94 $0.91 $0.03 $3.82
Year 1 $3.82 26.55% $1.01 $0.03 $4.80
Year 2 $4.80 26.55% $1.28 $0.03 $6.05
Year 3 $6.05 26.55% $1.61 $0.03 $7.62
Year 4 $7.62 26.55% $2.02 $0.03 $9.62
Year 5 $9.62 26.55% $2.55 $0.03 $12.14
Year 6 $12.14 26.55% $3.22 $0.03 $15.34
Year 7 $15.34 26.55% $4.07 $0.03 $19.38
Year 8 $19.38 26.55% $5.15 $0.03 $24.50
Year 9 $24.50 26.55% $6.51 $0.03 $30.97
Year 10 $30.97 26.55% $8.22 $0.03

Notice on Adobe I just used a .03 dividend. That’s what they have had prior, and I can’t see increasing it. With the BUD dividend, I used what appears to be a “historical” figure, based on what they have been retaining on the EPS in the past.

Sarge/images/graemlins/diamond.gif

[Sarge85]

[ QUOTE ]
Your methodology is flawed. Book value is not a good indicator of future value of the company.

[/ QUOTE ]

I'm looking at how a company puts their earnnings back into the company.

So let's say a company retains it's earnings (ie net profit). That's could be arugued as cash right? The cash could either be paid out as a dividend, or it could be used to put back into the company, and used to make more money.

If it's not paid out in dividend then it's put back into the company right? We should be able to look at how well that money will be used based on hisorical return on equity.

Book Value X ROE = EPS

Am i over simplyfing, or am i just really in left field?

Sarge/images/graemlins/diamond.gif

[DesertCat]

[ QUOTE ]


Here is my break down for BUD:
Year Book Value Avg ROE EPS DIV % Retained New Book
Base $3.40 $2.77 $0.93 66% $5.24
Year 1 $5.24 39.97% $2.09 $0.70 66% $6.63
Year 2 $6.63 39.97% $2.65 $0.89 66% $8.39
Year 3 $8.39 39.97% $3.35 $1.13 66% $10.62
Year 4 $10.62 39.97% $4.24 $1.43 66% $13.44
Year 5 $13.44 39.97% $5.37 $1.80 66% $17.00
Year 6 $17.00 39.97% $6.80 $2.28 66% $21.52
Year 7 $21.52 39.97% $8.60 $2.89 66% $27.23
Year 8 $27.23 39.97% $10.89 $3.66 66% $34.46
Year 9 $34.46 39.97% $13.78 $4.63 66% $43.61
Year 10 $43.61 39.97% $17.43 $17.43


[/ QUOTE ]

I think your problem here is that BUD can't keep up a high ROE on a large book value. It's ROE is high because it's book value is low, so using ROE to estimate earnings isn't wise in this case.

Instead you should look at net earnings growth over the last 5 years or so, and extrapolate those earnings out ten years. Then make your estimates of what they'll do with those earnings (pay dividends, re-invest in co, or buy shares back), and figure out how many shares and how much EPS and book value that gives BUD in ten years.

I think Adobe is in a similar situation. Both companies have semi-mature businesses, they can't grow arbitrarily fast just by adding capital. They can get really high returns on equity because they have good pricing power and don't require a great deal of capital within their businesses.

If they try to convince twice as many people to purchase and use their products their ROE would plummet. So they have to "milk" their current business efficiently, invest in reasonable growth as the market allows, and return all remaining cash to shareholders.

[AceHigh]

[ QUOTE ]
Am i over simplyfing, or am i just really in left field?

[/ QUOTE ]

Yes. For example a company like BUD might be reducing equity, so there ROE is still at X%, but there earnings are decreasing. And instead of investing in a growing business you are investing in a company that is steadily losing value.