How is a stock like an equity bond?

DEMIAN PERRY | 06 AUG 2009

Warren Buffett described his philosophy of viewing stocks as ‘equity bonds’ in a 1977 Forbes magazine article and subsequently in a speech at Columbia Business School.  In her book, Warren Buffett and the Interpretation of Financial Statements, Mary Buffett attributes the concept to Buffett, which is interesting considering that the title of her book is a nod to an earlier work by the true father of that philosophy.

Much of Benjamin Graham’s classic tome The Intelligent Investor, which I am slogging through right now, centers on the problem of valuing stocks and bonds as complimentary investment vehicles.  Contrary to the conventional wisdom that young investors should invest most of their money in stocks and old investors should invest primarily in bonds, Graham suggests an ideal ratio of 25% bonds to 75% stocks when stocks are attractive, and the reverse when bonds are attractive.

Graham further argues that expected returns on individual stocks should be compared with prevailing bond rates by considering the historical returns of a stock and the likelihood that those returns will remain stable into the future.  To be honest, this philosophy sounded like a messy lot of work that was likely to return a steaming pile of boring stocks — public utilities, railroads and such.

In reality, it’s a quick way to whittle down the market into a manageable list of promising investments.  We begin with the Price to Earnings ratio, that great staple of every reliable stock screen.  Graham’s approach is somewhat different from the common practice of recommending a fixed P/E from which an investor should never deviate:

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings / price ratio — the reverse of the P/E ratio — at least as high as the current high-grade bond rate.  This would mean a P/E ratio no higher than 13.3 against a [presumably 10-year, corporate] AA bond yield of 7.5%.

In other words, before beginning your stock screen, the investor should divide 100 by today’s bond rate to derive a target P/E for your screen.  As of this writing, the average yield on the 10-year corporate AA bond was 5.05%, which means the average P/E of your portfolio should not exceed 20.  You can still consider stocks with P/E ratios above 20, but for every stock with a P/E of 30, you must invest an equal proportion in stocks with a P/E of 10.  Ideally, the investor will base the P/E on the current price divided by 3-year trailing earnings.  At present, setting a P/E ratio of 20 will eliminate  roughly 70% of the NYSE.

Now that the investor knows the present yield of his equity bond, he must determine the bond’s risk.  With a traditional bond, determining risk is easy.  Just go by those ever reliable (sic) Moody’s ratings.  To determine the risk of equity bonds, we must look to a basket of accounting ratios:

• Annual Sales > $500 million (Graham’s original $100 million adjusted for inflation)
• Current ratio > 2
• LT debt / net current assets < 1
• 10 years of earnings, of which the last three year’s earnings should average at least 30% more than the first 3 years.
• 20 years of uninterrupted dividends
• Price to book * P/E < 22.5

According to the footnotes in my copy of The Intelligent Investor, most of these criteria can be loaded into a screen atwww.quicken.com/investments/stocks/search/full, but I’ll save you some time by declaring that, even if this website still exists, you’ll only find a swamp full of cigar butts.

But the philosophy holds true: turn the prevailing bond rates on their head to see what your P/E target should be.  After that, all you have to determine is earnings stability.  Buffett’s innovation, it seems, was to worry less about earnings stability, and more about growth.

http://monsterhash.com/beta/2009/exclusives/money/how-is-a-stock-like-an-equity-bond/

BUFFETT’S 'EQUITY BOND' STRATEGY.

BUFFETT’S 'EQUITY BOND' STRATEGY.

(A) THE THEORY.

Warren Buffett has determined that companies which show great Strength and Predictability in Earnings Growth, especially those with Durable Competitive Advantage (DCA), can be seen as a kind of EQUITY BOND with aCOUPON.

The company’s SHARE PRICE equates with the EQUITY BOND, and their PRETAX EARNINGS/SHARE equates with a Bond’s COUPON or INTEREST PAYMENT.
Therefore ....

EQUITY BOND = SHARE PRICE
BOND COUPON = PRETAX EARNINGS/SHARE

The DIFFERENCE between a normal Bond’s Coupon Rate and an EQUITY BOND’s Coupon Rate is that the former’s rate remains static while the latter’s rate can increase yearly due to the inherent Positive Performance of a DCA company.

This is how Buffett buys an Entire Business or a Partial Interest in a company via the Stock Market.

He interrogates its PRETAX EARNINGS and then determines if the purchase is a Good Deal relative to the ECONOMIC STRENGTH of the company’s underlying Economics and its ASKING PRICE.

The strong underlying Economics of DCA companies ensures a CONTINUING INCREASE in the company’s PRETAX EARNINGS which gives an Ongoing Increase in the EQUITY BOND’s COUPON RATE.
This results in the INCREASE in the VALUE of the EQUITY BOND and hence its SHARE PRICE.

Here’s how Buffett’s Theory works ....

In the 1980’s Buffett bought Coca Cola shares for $6.50c against PRETAX EARNINGS of $0.70c/share.
Buffett saw this as buying an EQUITY BOND paying an INTEREST RATE of 10.7% (0.70/6.50) on his $6.50 investment.
Historically, Coca Cola’s Earnings had been increasing at an annual rate of about 15%.
Therefore he could argue that his 10.7% Yield would increase at a projected Annual Rate of 15%.

By 2007 Coca Cola’s PRETAX EARNINGS had grown at about 9.35%/annum to $3.96c/share.
Buffett now had an EQUITY BOND with a Pretax Yield of 61% (3.96/6.50) which could really only increase with time due to Coca Cola’s DCA “status”.

(B) DETERMINE SHARE PRICE.

From his own experience Buffett has determined that the Stock Market will price a DCA company’s EQUITY BOND at a level that approximately reflects the VALUE OF ITS EARNINGS RELATIVE TO THE YIELD ON LONG TERM CORPORATE BONDS.

This can be written as the following equation ....

EQUITY BOND = SHARE PRICE = COUPON RATE/LONG TERM CORPORATE BOND RATE (L.T.C.B.R.)

and .... COUPON RATE/(L.T.C.B.R.) = PRETAX EARNINGS/( L.T.C.B.R.)

Examples :-

(1) In 2007 The Washington Post had Pretax Earnings of $54/share = Coupon Rate.
The L.T.C.B.R. was about 6.5%.

EQUITY BOND = Coupon Rate/L.T.C.B.R. = $54/6.5% = $830/share.

In 2007 The Washington Post shares traded between $726 and $885 a share.

(2) In 2007 Coca Cola had Pretax Earnings of $3.96/share = Coupon Rate.
The L.T.C.B.R. was about 6.5%.

EQUITY BOND = Coupon Rate/L.T.C.B.R. = $3.96/6.5% = $61/share.

In 2007 Coca Cola shares traded between $45 and $64 a share.

(The following web site will give you values for Corporate Bond rates :-
http://finance.yahoo.com/bonds/composite_bond_rates )

The stock market, seeing this ongoing return, will eventually revalue these EQUITY BONDS to reflect this increase in Value.

Because the Earnings of these companies are so consistent, they are also open to a LEVERAGED BUYOUT.

If a company carries little debt and has ongoing strong earnings, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company’s earnings.

Therefore, WHEN INTEREST RATES FALL, the company’s EARNINGS ARE WORTH MORE because they will SUPPORT MORE DEBT, which makes the company’s shares worth more.

Conversely, WHEN INTEREST RATES RISE, EARNINGS ARE WORTH LESS because they will SUPPORT LESS DEBT, making the company’s shares worth less.

In the end it is LONG-TERM INTEREST RATES that determines the Economic Reality of what Long-Term investments are worth.

(C) WHEN TO BUY.

In Buffett’s world the PRICE you pay directly affects the RETURN on your INVESTMENT.

Therefore the MORE one pays for an EQUITY BOND the LOWER will be the INITIAL Rate of Return and also the LOWER the RATE OF RETURN on the company’s EARNINGS in, say, 10 years time.

Example :-

In the late 1980’s Buffett bought Coca Cola for about $6.50c/share.
The company was earning about $0.46c/share after tax.
Initial Rate of Return = 0.46/6.50 = 7%.

By 2007 Coca Cola was earning $2.57c/share, after tax.
Rate of Return = 2.57/6.50 = 40%.

If he had originally paid, say, $21/share back in the 1980’s his Initial Rate of Return would only have been 2.2%, and this would have only grown to about 12% ($2.57/$21) 20 years later in 2007, which is a lot less than 40% !

Therefore the LOWER THE PRICE one pays for a DCA company the BETTER one will do OVER THE LONGER TERM.

SO WHEN DO YOU BUY INTO DCA TYPE COMPANIES ?

One of the best times to buy into these companies is during BEAR MARKETS when the price of shares are generally depressed, in some cases due to no fault of a DCA type company but due to adverse Market conditions.

This is in line with Buffett’s creed that one should “Be Greedy When Others Are Fearful”.

In addition, one can also buy into a DCA type company when its price is at a discount to the price obtained from the formula in (B) above ....

Once again, referring to Coca Cola, we see that ...

Pretax Earnings per Shares in the late 1980’s = $0.70c.
At that time the L.T.C.B.R. was about 7%.
That would give a “Market Valuation” = $0.70/7% = $10 per share.
Buffett bought it at $6.50c/share, a “discount” of 35%.

(D) WHEN TO SELL, OR NOT TO BUY.

There are at least THREE occasions ...

(1) One can SELL when one needs the money to invest in an even BETTER company at a BETTER PRICE.

(2) One can SELL when, what was a DCA type company, is now losing its Durable Competitive Advantage.
Examples could be Newspapers and Television Stations which were great businesses until the advent of the Internet and the Durability of their Competitive Advantage could be called into question.

(3) One can SELL, or NOT BUY, during BULL MARKETS when the stock market often sends share prices through the ceiling. At these times the current selling price of a DCA’s stock often far EXCEEDS the long-term ECONOMIC REALITIES of the business.

Eventually, these Economic Realities will pull the share price back down to earth.

In fact, it may be time to SELL when one sees P/E ratios of 40, or more, in these great companies.

To once again quote Buffett ... at these times, “Be Fearful When Others Are Greedy”.

http://siliconinvestor.advfn.com/readmsg.aspx?msgid=26421355

Warren Buffett's Personal Stock Holdings (31.12.2009)

Although Buffett has 95% of his fortune invested in Berkshire Hathaway, he does maintain a very sizable personal investment portfolio.



Warren Buffett's concept of Equity Bond evidenced by Kraft Foods' increasing dividends over the years.






"Warren Buffett’s definition of a good company is one that has a limit on capital expenditure, a reliable income, and no competition. "

Unlike bond payments which are fixed, stock dividends could be raised

A good starting point for income investors is the S&P Dividend Aristocrats list, which features companies that have increased their annual dividend payments every year for more than 25 consecutive years. Here are the 20 highest yielding stocks in the index, along with their ticker, P/E ratio, dividend yield and dividend payout ratio.



A great idea for income seeking investors is investing in stocks that pay good yields and have consistent dividend payments. With inflation averaging around 3 - 4% per year, your investment in dividend paying stocks would provide you with a source for income that keeps its purchasing power over time, which unlike fixed income securities can also provide you with capital gains. Unlike bond payments which are fixed, stock dividends could be raised and thus provide stockholders with a nice raise for owning the right companies.

http://www.dividendgrowthinvestor.com/2008/06/20-highest-yielding-dividend.html

Dividend Growth Investing

Common stock dividends, an old idea for retirement income, are in vogue again

By Tom PetrunoMarket Beat

April 24, 2010

What will you do for income in retirement?

Draw a pension, if you're very lucky. Collect Social Security. Beyond those two sources of money, most people will have to rely on their savings — bank accounts, investments, home equity or an annuity.

And the challenge for many American retirees won't just be to generate income from their nest egg, but to generate rising income to keep up with inflation.

Looking for a strategy to fill that bill, some investment advisors are turning to a solution that was familiar to Eisenhower-era retirees but increasingly has been lost on generations since then: common stock dividends from big-name companies, which in this era means firms such as Johnson & Johnson, H.J. Heinz Co. and utility PG&E Corp.

"We're pushing this idea with clients now," said Rich Weiss, who as chief investment officer at City National Bank in L.A. oversees about $55 billion. "There's a great case to be made for it."

It isn't difficult to find shares of brand-name consumer products companies with annualized dividend yields of 3% to 3.5%. (A stock's yield is the dividend divided by the current share price.) Yields on utility shares average about 4.4%.

Those dividend returns compare with an interest yield of about 2.6% on a five-year U.S. Treasury note.

Yet the dividend story is likely to be a very hard sell with many people, for eminently understandable reasons.

Retirement is supposed to be about financial stability and reduced investment risk. After the stock market crash of late 2008 and early 2009 — the worst decline since the Great Depression — equities naturally seem dicier than ever to countless Americans.

That's why people have turned to bonds in huge numbers, pumping hundreds of billions of dollars into bond mutual funds over the last 15 months.

Agreed, bonds almost certainly will be a safer place for your money than stocks, particularly over any short time period. But if it's income you're going to need in retirement, bonds aren't the slam-dunk answer they may seem to be.

One reason is that, thanks to the Federal Reserve's cheap-money policies and investors' rush for havens over the last year, interest rates on many types of bonds are well below where they were for most of the last 15 years. So you're starting out with a smaller income reward.

More important is that once you buy a fixed-rate bond (or a bank CD, for that matter), your yield is set until the security matures.

As Kurt Brouwer, principal at financial advisory firm Brouwer & Janachowski in Tiburon, Calif., puts it: "The issuer of a bond is never going to call up and say, ‘We want to pay you more.' "

What about bond mutual funds? Fund investors' income can rise over time if market interest rates go up and the fund buys new bonds paying higher yields. But predicting future interest payments on a fund in a rising rate environment isn't easy because of all the variables involved — including the types of bonds the manager buys, their maturities and whether the fund has more cash leaving than coming in.

And of course you face the risk that higher market interest rates will devalue older, lower-yielding bonds in a fund, depressing the value of your shares.

Dividend-paying stocks, by contrast, can offer what individual bonds can't: the potential for rising income over time, offsetting or more than compensating for inflation.

Healthcare products company Abbott Laboratories, for example, has lifted its dividend 60% since 2005, from an annual payment of $1.10 a share that year to the current annual rate of $1.76. Johnson & Johnson's dividend has risen 71% in the same period; Heinz's payout is up 47%.

All three dividends far outpaced the U.S. consumer price index, which rose about 13% in that period.

But if only the dividend story were that simple, everyone would buy into it. Although your income may rise with a dividend-paying stock, there is the ever-present risk that the share price itself, in the short run or long run, could lose far more than any dividends you'll earn.

The other major risk is that companies can cut their dividends. Some very big firms, including General Electric Co., Macy's Inc. and CBS Corp., did exactly that in 2008 and 2009 as the recession devastated their earnings.

Worse, many banks either slashed or eliminated their payouts altogether. The financial industry had long been one of the favorite sectors of dividend-seeking investors.

So why take a chance on dividend-paying stocks now? Because amid the economy's recovery more companies are boosting their payouts. A total of 284 U.S. firms lifted their dividends in the first quarter, up from 193 in the year-earlier quarter, according to Standard & Poor's. And the number of firms reducing or omitting their dividends plunged to 48 last quarter from a horrid 367 a year earlier.

Also, the Obama administration has signaled that it wants to largely preserve the favored tax treatment of dividends as put in place by President George W. Bush. The Bush tax cuts expire at the end of this year, but Obama supports keeping the dividend tax rate at 15% for couples earning less than $250,000 a year.

For investors who own stocks and bonds outside of tax-deferred retirement accounts, the Bush tax cuts gave dividends a huge advantage over bond interest, which is taxed at ordinary rates.

Josh Peters, who tracks and recommends dividend-paying stocks for investment research firm Morningstar Inc. in Chicago, says his frustration at the moment is that he views most solid dividend-paying stocks as fairly priced, at best — meaning it's hard to find genuine bargains after the market's 13-month surge.

That means the same would be true of the dividend-focused mutual funds and exchange-traded funds that offer an easy way for small investors to invest for dividend returns, albeit without the level of control they'd have by building a portfolio of 15 to 20 individual stocks.

Still, Peters expects that some of his favorite dividend-growth plays, including Waste Management, food-service-industry products distributor Sysco Corp. and payroll-services firm Paychex, will be able to boost their dividends at least 7% a year over the next five years.

He believes that more investors nearing retirement will begin to focus the power of dividend growth in a diversified portfolio.

"I think baby boomers will realize that if they need growth of income they can't just do the bond thing," he said.

tom.petruno@latimes.com

http://www.latimes.com/business/la-fi-petruno-20100424,0,1332567,full.column

Dividend-paying companies: major shareholders must be willing to share their profits with their investors through good dividend payments.

Wednesday March 24, 2010

Dividend-paying companies

Personal Investments - By Ooi Kok Hwa

Despite investing in profit-making companies, a lot of investors have been complaining that they are not getting the desired returns from the companies that they have invested in.

One of the main reasons is that these companies usually pay very low dividends or no dividends to their investors.

Hence, even though these companies make good profits from their businesses, they are not sharing the profits with their minority investors.

Companies that pay good dividends to their investors imply that the major shareholders of these companies are willing to share their wealth with minority investors.

Given that minority investors have no control over these companies, they have only two sources of returns from their investments, namely 

• dividend returns and 
• capital gains.

If the companies refuse to reward their investors with good dividends, then investors need to make sure that they buy low and sell high in order to get capital gains.

Warren Buffett proposes one concept, which is called the one-dollar premise - for every dollar profit that a company makes, it either pays one dollar dividend to its shareholders or if that dollar is being retained, it needs to bring additional one dollar market value.

Companies with good management will always try to maximize the wealth of their investors.

The following table will show the importance of dividends to an investor.

Assuming you have invested in Company A with an average cost of RM15.

Company A generates earnings per share (EPS) of RM1.00 with price-earnings ratio (PER) of 15 times and pay out 80% of its profits as dividends or dividend per share of RM0.80.

Hence, with the purchase price of RM15, the dividend yield (DY) is 5.3%.

We also assume that Company A has a constant PER of 15 times and dividend payout ratio of 80% for the next 20 years.

Annual growth rate of EPS is 8% based on our country’s average nominal GDP growth rate of 8%.

For the first 10-year period, given that our original cost of investment is fixed at RM15, our dividend yield will be getting higher and higher.

For example, first year DY of 5.3% is computed based on DPS of RM0.80 divided by RM15.

And second year DY of 5.8% is calculated based on DPS of RM0.86 (RM0.80 x 1.08) divided by the same original purchase price of RM15.0.

As the company’s businesses continue to grow and generate higher profits, as long as the company practices a fixed dividend payout policy (our example is based on a fixed dividend payout ratio of 80%), investors’ DY will increase.

At Year 10, given that our purchase price remains the same at RM15, with a DPS of RM1.60, our DY is 10.7% (1.60/15.0).

Thus, the average DY for the first 10-year period is 7.7%.

Coupled with the annual capital gain of 8% (the share price has grown by annual growth rate of 8% from RM15 to RM29.99), investors will generate an annual total returns rate of 15.7% (7.7% + 8%)!

If we keep this stock for another 10-year period, our next 10-year annual total return is 24.7% (16.7% + 8%)!

From here, we can see that if we have invested in good companies that always reward their investors with very high dividend payments, our returns will be huge if we hold it long term.

Normally, consumer-based companies and companies that do not need high capital expenditures will be able to reward shareholders with good dividend payments.

Besides, major shareholders must be willing to share their profits with their investors through good dividend payments.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

http://biz.thestar.com.my/news/story.asp?file=/2010/3/24/business/5919730&sec=business

Also read:

*****Long term investing based on Buy and Hold works for Selected Stocks

Dividend Yield Investing - Stock Selection is still the Key

Dividend Yield Investing - Stock Selection is still the Key

Mr has left a new comment on your post "Dutch Lady posts 4Q net profit of RM16.05m, warns ...":

Dear Mr bullbear,

Sorry to write to you here, but I don't know how to reach you.

....I want to ask you if you can recommend say 5 stocks with High Dividend Yield that you can recommend to invest for long time.

I am a 43 year old family man with a full time job and no interest nor time to monitor the market. Maybe once or twice a month.

My goal is to just beat the fixed term deposit rate. Now is so low, only 2% to 2.5%. Very hard to earn passive income like this.

I need some real solid recommendation, stocks that I can hold for a long time. A friend swears by PBBANK. But I am concerned the price may be too high now.

I plan to start with RM50k first. Maybe split into 5 stocks with RM10k each.

What do you think of PBBANK? What is a good entry price? Can you recommend a few others that pay high dividend for me to consider? I appreciate the final decision is mine and mine alone, and I will not blame you for any losses. But please explain your reasons.

Thanks and kindest regards,

Mr Teoh

-----

Dear Mr. Teoh,

It is not easy to give you advice other than some very general ones.  You will find enough materials in this blog to answer your questions.

Since you asked, I thought a better approach would be for me to collate some examples to help you answer your own questions. 

Click here:  It sure beats FD rates and it is safe too.
http://spreadsheets.google.com/pub?key=tWENexpUrXS_RMxB7k73RgQ&output=html

Warren Buffett often looks at the stock he buys as equivalent to a bond.  The cost price for the stock is the 'equivalent' to the price paid for a bond.  The earning yield of the stock is the 'equivalent' to the coupon rate of a bond.

He likened his stock as equity bond.  Unlike a bond that pays a fixed coupon rate for its lifespan and repayment of the initial invested capital, an equity bond (stock) if chosen well, can deliver increasing earnings (and dividends) over many years.  Its share price likewise will appreciate with its increasing earnings.

The trick in dividend yield investing is still to focus on the earnings and earnings growth potential of the company.  All these are embodied in a simple phrase, that is, choose and only invest in good high quality companies bought at bargain or fair prices.

Regards.


Click:

Dividend-paying companies: major shareholders must be willing to share their profits with their investors through good dividend payments.

http://dividendsvalue.com/

• 
  

  Div-Net Associate Member

  
  Dividends Value
  The Dividend Guy
  Dividend Growth Investor
  Barel Karsan
  Dividend Tree
  Buying Value
  Associate Members

The best dividend-paying stocks

The best dividend-paying stocks
The best dividend-paying stocks, provide not only income, but significant capital appreciation.


Related readings:

Evaluating Dividend-Paying Companies
The importance of not buying shares near the top of the market peaks
Dividends Are Still the Linchpin
Ten Principles of Dividend Growth Investing
How and Why Do Companies Pay Dividends?
The 10 Best Dividend Stocks of the Past Decade
Investing for income: Dividend yield and Dividend cover ratio
The case for Dividend Growth Investing
The concept of valuing a share according to its dividend
Importance of dividend yield in the evaluation of the worth of a share.
Dividend yield prevents investors from being side-tracked by irrelevant events.
Dividend is a sure thing
Recession or not McDonald's increases dividend for the 32nd year 

Warren Buffett's concept of Equity Bond

Warren Buffett’s Concept of Equity Bond in Action

****Buffett Fundamental Investing: How to pick stocks like Warren Buffett

Buffett Fundamental Investing

How to Pick Stock Like Warren Buffett by Timothy Vick

1.  Intrinsic Value = sum total of future expected Earnings with each year's Earnings discounted by the Time Value of Money.

2.  A company's Growth record is the most reliable predictor of its future course.  It is best to average past Earnings to get a realistic figure.  Each year's Earnings need to be discounted by the appropriate discount rate.

3.  Is the stock more attractive than a bond?  Divide the 12 months EPS by the current rate of long-term Government Bonds e.g. EPS of $2.50 / 6% or 0.06 = $40.  If the stock trades for less than $40, it is better value than a bond.  If the share's earnings are expected to grow annually, it will beat a bond.

4.  Identify the expected Price Range, Projected future EPS 10 years out, based on average of past EPS Growth.  Multiply by the High and Low PE Ratios to find the expected Price Range.  Add in the expected Dividends for the period.  Compute an annualised Rate of Return based on the increase in the Share Price.  Buffett's hurdle is 15%.

5.  Book Value.  Ultimately, Price shoud approximate growth in Book Value and in Intrinsic Value.  Watch out the increases in Book Value which are generated artificially

• a) issuing more shares
• b) acquisitions
• c) leaving cash in the bank to earn interest, in which case ROE will slowly fall. 

Buffett is against the use of accounting charges and write-offs to artificially improve the look of future profits.

6.  Return on Equity.  ROE = Net Income (end-of-year Shareholders' Equity + start-of-year Shareholder's Equity/2).  Good returns on ROE should benefit the Share Price.  High ROE - EPS Growth - Increase in Shareholder's Equity - Intrinsic Value - Share Price.  A high ROE is difficult to maintain, as the company gets bigger.  Look for high ROE with little or no debt.  Drug and Consumer product companies can carry over 50% Debt and still have high ROEs.  Share buy-backs can be used to manipulate higher ROEs.  ROE should be 15%+.

7.  Rate of Returns.  15% Rule.  Collect and calculate figures on the following:

• current EPS
• estimate future Growth Rate of use Consensus Forecasts
• calculate historic average PE Ratio
• calculate Dividend Payout Ratio

-----
Tabulation in Table Format

Price:
EPS:
PE:
Growth Rate:
Average PE:
Dividend Payout:

Year ---- EPS
20-
20-
20-
20-
20-
20-
20-
20-
20-
20-
----------------
Total

Price needed in 10 years to get 15%:  $____

Expected 10-year Price (20--EPS* Av. PE):  $____
Plus expected Dividends:  $____

Total Return:  $____

Expected 10-year Rate of Return:   ____%

-----
Highest Price you can pay to get 15% return: $ _____

------



Stock Evaluation.  Can a company earn its present Market Cap.  in terms of future Profits?  Does the company have a consistent record of accomplishment?

Shares are Bonds with less predictable Coupons.  Shares must beat inflation, Government Bond Yields and be able to rise over time.  Shares should be bought in preference to Bonds when the current Earnings Yield (Current Earnings/Price) is at or above the level of long-term Bonds.

When To Sell:

• Bond Yields are rising and about to overtake Share Earnings Yields.
• Share Prices are rising at a greater rate than the economy is expanding.
• Excessive PE multiples, even allowing for productivity and low interest rates.
• Economy cannot get any stronger.

Takeover Arbitrage

• Buy at a Price below the target takeover Price.
• Only invest in deals already announced.
• Calculate Profits in Advance.  Annualised return of 20-30% needed.
• Ensure the deal is almost certain.  A widening spread may mean the worst.

General Criteria:

• Consistent Earnings Growth
• High Cash Flow and Low level of Spending
• Little need of long-term Debt
• High ROE 15%+
• High ROA (Return on Total Inventory plus Plant)
• Low Price relative to Valuation.

Buffett-Style Value Criteria and Filter.

1.  Earnings yield should be at least twice the AAA bond yield (which is about 5.9%)
2.  PE should be less than 40% of the share's highest PER over the previous five years.
3.  Dividend yield should be at least two thirds of the AAA bond yield.
4.  Stock price should be no more than two thirds of company's tangible book value per share.
5.  Company should be selling in the market for no more than two thirds of its net current assets.

To this, add Margin of Safety criteria:

1.  Company should owe no more than it is worth:  total debt should not exceed book value.
2.  Current assets should be at least twice current liabilities - in other words, the current ratio should exceed 2.
3.  Total debt should be less than twice net current assets.
4.  Earnings growth should be at least 7% a year compound over the past decade.
5.  As an indication of stability of earnings, there should have been no more than two annual earnings declines of 5% or more during the past decade.


Demanding a share price no more than two-thirds tangible assets is asking too much of today's market.  The basic search, therefore, used the following sieves:

1.  PE less than 8.5.  This is the implied multiple from the demand that the earnings yield should be more than twice 5.9%.  The inverse of an 11.8% earnings yield is a price-earnings multiple of 8.5.
2.  A dividend yield of at least 4% - two thirds of the 5.9% AAA bond yield.
3.  A Price to Tangible Assets Ratio of less than 0.8 - price less than four-fifths tangible assets.
4.  Gross Gearing of less than 100% -  the company does not owe more than it is worth.
5.  Current Ratio of at least two - in other words current assets are at least twice current liabilities.


http://www.docstoc.com/docs/7984050/Investment-Strategies (Page 91)