Let Buffett guide you into a play on autos.
Credit Acceptance Corporation (CACC) offers financing programs that enable automobile dealers to sell vehicles to consumers. Its financing programs are offered through a network of automobile dealers.
The company has two dealer financing programs. The Portfolio Program advances money to dealers in exchange for the right to service the underlying consumer loans while under the Purchase Program, the company buys the consumer loans from the dealers and keeps the amounts collected from the consumer.
A bedrock principle for Warren Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business.
Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Buffett would consider this firm's earnings predictable.
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In fact earnings per share for Credit Acceptance have increased every year. The company's long term historical earnings per share growth rate is 30.3%, based on the average of the 3, 4 and 5 year historical earnings per share growth rates. The company is expected to grow earnings 16.0% per year in the future, based on the analysts' consensus estimated long term growth rate.
The Buffett Checklist
Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. U.S. corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for Credit Acceptance, over the last ten years, is 31.1%, which is high enough to pass.
Buffett also requires, for financial companies, that the average Return On Assets (ROA) be at least 1% and consistent. Return On Assets is defined as the net earnings of the business divided by the total assets of the business. The average ROA for Credit Acceptance, over the last ten years, is 9.6%, which is high enough to pass.
Buffett likes companies that do not have major capital expenditures. Credit Acceptance's free cash flow per share of $28.51 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.
Buffett also likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $110.28 and compares it to the gain in earnings per share over the same period of $26.98.
Credit Acceptance's management has proven it can earn shareholders a 24.5% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.
Why to Buy
The second stage of Buffett's analysis asks "Should I buy at this price?" The Buffett strategy favors companies in which the initial rate of return is around the long-term treasury yield.
Currently, the long-term treasury yield is about 2.75%. Compare this with Credit Acceptance's initial yield of 8.03%, which will expand at an annual rate of 16.0%, based on the analysts' consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.
The Buffett-style strategy calculates the expected rate of return based on the average return on equity method and also based on average earnings per share growth. Based on the two different methods, you could expect an annual compounding rate of return somewhere between 16.0% and 29.2%.
To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 22.6% on Credit Acceptance shares for the next ten years, based on the current fundamentals.
Buffett would consider this an exceptional return, thus passing the criterion.