This column was originally published on RealMoney on Feb. 22 at 10:39 a.m. EST. It's being republished as a bonus for TheStreet.com readers.
Among stock market investors, none is more revered than Warren Buffett. He's been in the investing business since the 1950s, and one indicator of his success is that he is the second-wealthiest individual in the country, after
The man doesn't just theorize, he puts his money where his investing beliefs are, and he has a track record of success to show how good those beliefs are and his skill at applying them. This is borne out by the growth in share price of his investment vehicle,
, shares of which trade for a lofty $88,000. (Buffett can be a bit eccentric, and one illustration is his refusal to split his stock, which is why two or three shares can cost more than a house.)
I'd like to discuss one important aspect of Buffett's investment strategy, as I understand it, in a bit more depth than I usually do when profiling a stock. If you follow my columns on
, you know I pick stocks on the basis of strategies of Wall Street's greats. And one of those strategies is based, of course, on Buffett's writings.
Focus on Price
Almost every investor understands the importance of choosing companies that are performing well financially. Companies need to be making money and growing if they are to be good investments for the long run.
is thought of as not growing and not making money, so its stock is in the tank.
is thought of as a very fast grower generating hefty profits, so its stock is generally rising.
Sounds pretty obvious. But there's more to picking a stock than focusing on financials. And this is where Buffett is especially astute. Yes, he pays attention to financial fundamentals. But he pays equal attention to stock price. If a company is doing well but its stock is expensive, chances are good that you won't make great money with the stock, no matter how well the company does. That's because you are buying the stock at an expensive price, which means the stock has less room to rise than if the price were lower.
Worse, when very high-priced stocks stumble a bit, they often get clobbered. Google traded for more than $450 a share last month and is, at this writing, trading around $365 because it released numbers that disappointed the Street. Even at the current lower price, it has a trailing price-to-earnings ratio of about 68. That's pricey.
My purpose here is not to speculate on whether Google or another stock is or isn't a good investment. My point is that a company's good performance doesn't mean its stock is worth buying. We all can learn a lesson from Buffett. For him, the company needs to be doing well
its stock needs to be priced at a level that is likely to produce a good long-term (i.e., 10 years or more) profit for investors.
Following the Price Routes
To determine whether a company's share price is attractive, the Buffett strategy conducts a fairly extensive analysis. It goes through two parallel processes that produce projected rates of return, and then averages the results to see if the expected rate of return is acceptable.
Because we're now getting into tax time, we'll use the tax-preparation company
for an illustration. Not only does the strategy I base on Buffett like H&R Block, but so does the man himself. As of its 2004 annual report, Berkshire Hathaway owned 8.7% of the tax preparer.
Before we get to the price analysis, it's worth knowing a few of the reasons H&R Block fits with my Buffett strategy. First, it's the dominant company in its industry, which qualifies it as a Buffett-type company. Then, the strategy evaluates a number of financial performance numbers, such as the company's ability to repay debt, its return on equity and return on total capital; for H&R Block, the strategy finds that, financially, the company is doing well. That's great. But it's not enough to trigger an investment. Let's look at how the strategy then decides whether the price is right.
Route 1: Crunching Growth Numbers
The strategy first compares the stock with bonds, because at a minimum, it wants to see that the initial earnings return on a stock investment will return at least as much as an investment in a safe long term government bond. It determines the company's initial rate of return by calculating the trailing 12-month EPS, which in the case of H&R Block is $2.01, and dividing it by the stock's current market price, which was $25.12 at this writing. Given these figures, an investor purchasing the stock could expect to receive an 8.0% initial earnings rate of return.
Let's be clear about one point before we continue: The Buffett strategy treats the company as if Buffett was buying the whole thing, which he occasionally does. In buying the entire company, the buyer would receive the entire earnings. Therefore, the return on the market price is the called the initial rate of return (also known as the earnings yield). It is this yield, not the standard company's dividend yield, that the strategy then compares with that of a long-term bond.
Furthermore, the buyer could expect the rate to increase 13.3% per year, based on the analysts' consensus estimated long-term growth rate (available from such sources as Thompson First Call), because this is how fast earnings are growing.
The strategy favors companies in which the initial rate of return is around or better than the long-term 10-year Treasury yield. Currently, the long-term Treasury yield is around 4.5%. This is a lot lower than H&R Block's initial earnings yield of 8.0% plus the expected expansion at an annual rate of 13.3%. The company is the better choice, because its initial rate of return is already above the long-term bond yield and is expanding at a rapid clip.
H&R Block currently has a book value of $4.84. It is safe to say that if it can preserve its average rate of return on equity of 23.3% and continues to retain 61.7% of its earnings (which it had been), it will be able to sustain an earnings growth rate of 14.4% (calculated by using the Sustainable Growth Model, which looks at how much growth a firm can generate by maintaining the same financial relationships as the year before). This will give it a book value of $18.57 in 10 years. If the company still can earn its current annual rate of 23.3% on equity in 10 years, then expected EPS will be $4.33.
Taking that expected EPS of $4.33 and multiplying it by the five-year average P/E ratio of 14.3, you get a projected future stock price for H&R Block of $61.72.
Now, the Buffett strategy adds in the total expected dividend pool to be paid over the next 10 years, which is $16.25. This gives a total dollar amount of $77.97. Comparing today's price of $25.12 with the projected stock price in 10 years of $61.72 plus dividends of $16.25, using a Net Present Value calculation, one could expect to make a 12.0% average annual return on H&R Block's stock at the present time. The strategy looks for about a 15% return.
This is one approach to the expected rate of return. The strategy, not wanting to place all its eggs in one basket, uses a second approach as well. This one is based on average EPS growth.
Route 2: Average EPS Growth
Here we take the EPS growth of 13.3%, based on the analysts' consensus estimated long-term growth rate, and project EPS out 10 years. This is $6.98. The reason for emphasizing EPS as long as 10 years out is that the Buffett strategy compares returns with those of bonds, which have very predictable returns over the long term. For this reason, it's necessary for there to be a lot of confidence in the predictability of earnings over the next 10 years. One of the ways the strategy does that is to see that earnings have been increasing steadily over the last 10 years.
Taking the estimated earnings of $6.98, the strategy now multiplies EPS in 10 years by the five-year average P/E ratio, which is 14.3. This provides a projected stock price of $99.40. As in the other analysis, we add in the total expected dividend pool of $16.25, giving us a total dollar amount of $115.65.
Now we can figure out the expected average annual return based on the current price of $25.12 and the future expected stock price, including the dividend pool, of $115.65; it is 16.5%.
The last step is to average the expected return on the basis of these two methods. The first had an expected return of 12.0%, while the second's was 16.5%. Averaging them, investors could expect an average return of 14.2% on H&R Block's stock during the next 10 years. As noted, the strategy likes a return of about 15%. The 14.2% return is close enough to 15% to be acceptable.
I went into this detail to show you how careful Buffett is about not overpaying for a stock. This is an aspect of stock market investing in which many of us are a bit weak. We fall in love with a company and buy its stock without much regard for the stock's price. If you want to invest smartly, follow the Buffett strategy: Understand just how expensive or cheap a stock's price is, and don't go chasing a stock just because the company behind it is hot. You can't maximize your profits if you frequently overpay.
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At the time of publication, Reese was long H&R Block, although holdings can change at any time.
John P. Reese is founder and CEO of Validea.com, an investment research firm, and Validea Capital Management, an asset management firm serving affluent investors and companies. He is also co-author of the best selling book,
The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best
. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Reese appreciates your feedback.
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