Warren’s Mathematical Equations for Uncovering Great Businesses

 

What You Buy and the Price You Pay, will determine How Much Money You Make.

Pay More, Earn Less. Pay Less, Earn More.

 

 

  1. PREDICTING EARNINGS AT A GLANCE: Compare the company’s reported earnings per share (EPS) for a number of years.
    1. Are they consistent or inconsistent?
    2. Do earnings trend upward, or do they rocket up and plunge down like a roller coaster?
    3. Are they strong?
    4. Do they indicate a loss or earnings weakness in the current year?
    5. There are Four Types of earnings situations

                                                               i.      In a perfect situation the company’s EPS are consistently strong and show an upward trend. COMPANY 1

                                                             ii.      A company that we are not interested in has a widely erratic EPS. COMPANY 2

                                                            iii.      A company with strong competitive advantage and EPS, which recently had a drop in EPS. We need to analyze why?. COMPANY 3

                                                           iv.      A company with strong competitive advantage and EPS, which recently had a negative EPS or loss. We need to analyze why?. COMPANY 4

 

Company 1

Company 2

Company 3

Company 4

YEAR

Durable Competitive Advantage Business

Commodity Business

Probable Competitive Advantage in Trouble

Probable Competitive Advantage in Trouble

91

1.07

1.57

1.07

1.07

92

1.16

0.16

1.16

1.16

93

1.28

(1.28)

1.28

1.28

94

1.42

0.42

1.42

1.42

95

1.64

(0.23)

1.64

1.64

96

1.60

0.60

1.60

1.60

97

1.90

1.90

1.90

1.90

98

2.39

2.39

2.39

2.39

99

2.43

(0.43)

2.43

2.43

2000

2.69

0.69

0.48 (Sharp decline)

(1.69) Actual Loss

 

  1. A TEST TO DETERMINE YOUR INITIAL RATE OF RETURN (IROR): Warren has an unorthodox view of a company’s earnings. He considers them in proportion to the number of shares he owns. If the company earns $5 a share and he owns 100 shares, then, as he sees it, he has earned $500. This differs from the Wall Street Professionals who do not consider earnings their own until they are paid out as dividends.
    1. Take the EPS and divide it by market share price to get your IROR. Example if the company you bought was trading for $30 and the first years EPS was $2.57, then your IROR will be 8.6% ($2.57 / $30 = 8.6%).
    2. Remember the Price You Pay Determines your Rate of Return.

 

  1. TEST FOR DETERMINING THE PER SHARE GROWTH RATE: A fast method to check the company’s ability to increase per share earnings is to figure the annual compounded rate of growth of the company’s per share earnings for the last ten years and then for the last five years..
    1. In the above example of “Company 1”, use the Number of years (N) = 10, PV = 1.07, the FV = -2.69, PMT = 0, Interest return per annum =? (Answer = 9.66%)
    2. For the last five years the Interest return per annum = 10.95%. If the last five years was lower, then you ask yourself the question that what was the business economics that caused this?

 

  1. A STOCK’S VALUE RELATIVE TO TREASURY BONDS: Warren believes that all investments compete with one another and that the return on treasury bonds is the benchmark.
    1. The per share earnings of H&R Block was $2.77 and the bonds annual rate of return was 6%. Therefore 2.77 / 0.06 = $46.16. This means that if you paid $46.16 for a share of H&R block, then you will be getting a return equal to the Treasury bond. (You should pay less than that).

 

  1. USING THE PER SHARE EARNINGS ANNUAL GROWTH RATE TO PROJECT A STOCK’S FUTURE VALUE: It is possible to project the future price of a company’s stock by using the company’s per share earnings historical annual growth rate.
    1. First calculate the EPS for year 2000 using point 3 (FV =  $2.95).
    2. Look at the price / earnings (P/E) ratio for Gannett from 1980 to 1990. The stock traded from 11.5 times to 23 times the earnings. Average the two and you get 17.3 ((11.5 + 23) / 2 = 17.3).
    3. This will give you a projected stock price of $51 (17.3 x 2.95 EPS)
    4. If you bought at PV = 14.8 today, FV = 51, N = 10, MT = 0, then annual rate of compounding return will be I = 13 %.
    5. NOW compare your investments to what other investments are paying.

 

  1. UNDERSTANDING WARREN’S PREFERENCE FOR COMPANIES THAT EARN HIGH RATES OF RETURN ON EQUITY (ROE): If a company has a book value of $10 and a EPS of $2.5, then Warren would say that the company is getting a return on its equity of 25 % (2.5 / 10 = 25%).
    1. One should look for the highest compounding rate of return possible.
    2. Excellent businesses that benefit from a durable competitive advantage and can consistently earn high rates of return on retained earnings (shareholder’s equity) are often bargains buys at what seems to be a high price-to-earnings ratio (P/E).