VALUING THE COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE
"I look for businesses in which I think I can predict what they're going to look like in ten to fifteen years' time. Take Wrigley's chewing gum. I don't think the Internet is going to change how people chew gum. "
WARREN BUFFETT
WARREN'S REVOLUTIONARY IDEA OF THE EQUITY BOND AND HOW IT HAS MADE HIM SUPERRICH
In the late 1980s, Warren gave a talk at Columbia University about how companies with a durable competitive advantage show such great strength and predictability in earnings growth (and) that growth turns their shares into a kind of equity bond, with an ever-increasing coupon or interest payment. The "bond" is the company's shares/equity, and the "coupon/interest payment" is the company's pretax earnings. Not the dividends that the company pays out, but the actual pretax earnings of the business.
This is how Warren buys an entire business: He looks at its pretax earnings and asks if the purchase is a good deal relative to the economic strength of the company's underlying economics and the price being asked for the business. He uses the same reasoning when he is buying a partial interest in a company via the stock market.
What attracts Warren to the conceptual conversion of a company's shares into equity/bonds is that the durable competitive advantage of the business creates underlying economics that are so strong they cause a continuing increase in the company's earnings. With this increase in earnings comes an eventual increase in the price of the company's shares as the stock market acknowledges the increase in the underlying value of the company.
Thus, at the risk of being repetitive, to Warren the shares of a company with a durable competitive advantage are the equivalent of equity/bonds, and the company's pretax earnings are the equivalent of a normal bond's coupon or interest payment. But instead of the bond's coupon or interest rate being fixed, it keeps increasing year after year, which naturally increases the equity/bond's value year after year.
This is what happens when Warren buys into a company with a durable competitive advantage. The per-share earnings continue to rise over time---either through increased business, expansion of operations, the purchase of new businesses, or the repurchase of shares with money that accumulates in the company's coffers. With the rise in earnings comes a corresponding increase in the return that Warren is getting on his original investment in the equity bond.
Let's look at an example to see how his theory works.
In the late 1980s, Warren started buying shares in Coca-Cola for an average price of $6.50 a share against pretax earnings of $.70 a share, which equates to after-tax earnings of $.46 a share. Historically, Coca-Cola's earnings had been growing at an annual rate of around 15%. Seeing this, Warren could argue that he just bought a Coca-Cola equity bond that is paying an initial pretax interest rate of 10.7% on his $6.50 investment. He could also argue that that yield would increase over time at a projected annual rate of 15%.
Understand that, unlike the Graham-based value investors, Warren is not saying that Coca-Cola is worth $60 and is trading at $40 a share; therefore it is "undervalued." What he is saying is that at $6.50 a share, he was being offered a relatively risk-free initial pretax rate of return of 10.7%, which he expected to increase over the next twenty years at an annual rate of approximately 15%. Then he asked himself if that was an attractive investment given the rate of risk and return on other investments.
To the Graham-based value investors, a pretax 10.7% rate of return growing at 15% a year would not be interesting since they are only interested in the stock's market price and, regardless of what happens to the business, have no intention of holding the investment for more than a couple of years. But to Warren, who plans on owning the equity bond for twenty or more years, it is his dream investment.
Why is it his dream investment? Because with each year that passes, his return on his initial investment actually increases, and in the later years the numbers really start to pyramid. Consider this: Warren's initial investment in The Washington Post Company cost him $6.36 a share. Thirty-four years later, in 2007, the media company is earning a pretax $54 a share, which equates to an after-tax return of $34 a share. This gives Warren's Washington Post equity bonds a current pretax yield of 849%, which equates to an after-tax yield of 534%. (And you were wondering how Warren got so rich!)
So how did Warren do with his Coca-Cola equity bonds?
By 2007 Coca-Cola's pretax earnings had grown at an annual rate of approximately 9.35% to $3.96 a share, which equates to an after-tax $2.57 a share. This means that Warren can argue that his Coke equity bonds are now paying him a pretax return of $3.96 a share on his original investment of $6.50 a share, which equates to a current pretax yield of 60% and a current after-tax yield of 40%.
The stock market, seeing this return, over time, will eventually revalue Warren's equity bonds to reflect this increase in value.
Consider this: With long-term corporate interest rates at approximately 6.5% in 2007, Warren's Washington Post equity bonds/shares, with a pretax $54 earnings/interest payment, were worth approximately $830 per equity bond/share that year ($54 / .065 = $830). During 2007, Warren's Washington Post equity bonds/shares traded in a range of between $726 and $885 a share, which is right about in line with the equity bond's capitalized value of $830 a share.
We can witness the same stock market revaluing phenomenon with Warren's Coca-Cola equity bonds. In 2007 they earned a pretax $3.96 per equity bond/share, which equates to an after-tax $2.57 per equity bond/share. Capitalized at the corporate interest rate of 6.5%, Coke's pretax earnings of $3.96 are worth approximately $60 per equity bond/share ($3.96 / .065 = $60). During 2007, the stock market valued Coca-Cola between $45 and $64 a share.
One of the reasons that the stock market eventually tracks the increase in these companies' underlying values is that their earnings are so consistent, they are an open invitation to a leveraged buyout. If a company carries little debt and has a strong earnings history, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company's earnings. Thus when interest rates drop, the company's earnings are worth more, because they will support more debt, which makes the company's shares worth more. And when interest rates rise, the earnings are worth less, because they will support less debt. This makes the company's stock worth less.
What Warren has learned is that if he buys a company with a durable competitive advantage, the stock market, over time, will price the company's equity bonds/shares at a level that reflects the value of its earnings relative to the yield on long-term corporate bonds. Yes, some days the stock market is pessimistic and on others is full of wild optimism, but in the end it is long-term interest rates that determine the economic reality of what long-term investments are worth.
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