Warren Buffett: Earnings and not book value are what determine the value of a business.

 

 

@5.45  

Earnings are what determine value and not book value.  Book value is not a factor we consider.  Future earnings are a factor we consider.  

Earnings have been poor for many great Japanese companies.  If you think the return on equity of the Japanese companies is going to increase dramatically, then you are going to make a lot of money in Japanese stocks.  But the returns on equity of Japanese businesses have been quite low, and that makes a  low price to book ratio very appropriate because earnings are measured against books.  

A company earning 5% on book value, I do not want to buy it at book value, if I think it is going to keep earning 5% on book value.     A low price to book ratio means nothing to us.  It does not intrigue us.  In fact, if anything, we are less likely to look at something that sells at a lower value in relation to book than something that sells at a higher relation to book.  The chances are we are looking at a poor business in the first case and a good business in the second case.

Can you benefit from forecasts and extrapolations?

We have two classes of forecasters: 

• Those who don’t know – and 
• those who don’t know they don’t know.

Many believe that the future is unknowable.

Some favorite quotes on this subject. (The first one may be the greatest ever):

No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.
Ian E. Wilson (former Chairman of GE)

Those who have knowledge don’t predict; those who predict don’t have knowledge.
Lao Tzu

People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.
George Orwell

Forecasts create the mirage that the future is knowable.
Peter Bernstein

I never think of the future – it comes soon enough.
Albert Einstein

The future you shall know when it has come; before then forget it.
Aeschylus

Forecasts usually tell us more of the forecaster than of the future.
Warren Buffett



There actually are things we know about the macro future. 

However, this is an extreme oversimplification and not entirely correct. There actually are things we know about the macro future. The trouble is that, mostly, they’re things everyone knows. 

Examples include

• the fact that U.S. GDP grows about 2% per year on average; 
• heating oil consumption increases in winter; and 
• a great deal of shopping is moving on-line. 

But since everyone knows these things, they’re unlikely to be much help in the pursuit of above average returns. 

The things most people expect to happen – consensus forecasts – are by definition incorporated into asset prices at any point in time. 




Most forecasts – and especially macro forecasts – are extrapolations of recent trends and current levels.

Since the future is usually a lot like the past, most forecasts – and especially macro forecasts – are
extrapolations of recent trends and current levels, and they’re built into prices.

Since extrapolation is appropriate most of the time, most people’s forecasts are roughly correct.

But because they’re already reflected in security prices, most extrapolations aren’t a source of above average returns.




The forecasts that produce great profits.

The forecasts that produce great profits are the ones that presciently foresee radical deviations from the past. 

But that kind of forecast is, first, very hard to make and, second, rarely right. 

Thus most forecasts of deviation from trend also aren’t a source of above average returns.




Summary

So let me recap:
(a) only correct forecasts of a very different future are valuable,
(b) it’s hard to make forecasts like that,
(c) such unconventional predictions are rarely right, 
(d) thus it’s hard to be an above average forecaster, and
(e) it’s only above average forecasts that lead to above average returns.



So there’s a conundrum:

• Investing is the art of positioning capital so as to profit from future developments.
• Most professional investors strive for above average returns (i.e., they want to beat the market and earn their fees).
• However, according to the above logic, macro forecasts shouldn’t be expected to lead to above average returns.
• Yet very few people are content to invest while practicing agnosticism with regard to the macro future. They may on some level understand the difficulty entailed in forecasting, but their reluctance to admit their ignorance of the future (especially to themselves) usually overcomes that understanding with ease.
• And so they keep trying to predict future events – and the investment industry produces a large volume of forecasts.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

How do you value this company OPQ?

I have been looking at this company.  Its business is doing very well.  It has grown its revenues, profit before tax and earnings consistently over many  years.  Its business is growing due to its excellent products and marketing.

Its PBT margin and net profit margins have grown over the years from single digits to double digits.  It latest PBT margin and net profit margins were 17.4% and 13% respectively.  Its ROE is consistently above 30% for many quarters and the last few years.  It DPO ratio averages 70%.

Its latest trailing-twelve months earnings was $110 million and its market capitalisation recently was $ 3200 million.  It is projected that it will probably deliver $130 million in this financial year with a high degree of predictability.

(A)  Calculating the value of this company today.
How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $110 million per year?
3.  Answer:  $110 million / 4% = $2750 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about $77 million.
5.  How much deposit would you need to put in the bank to earn $77 million at present prevailing interest rate of 4% per year?
6.  Answer:  $77 million / 4% = $1925 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 110 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 110 million / (4% - 2%) = $ 5500 million.
12.  With its dividend of $ 77 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 77 million / (4% - 2%) = $ 3850 million.


To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 2750 million.
- the dividends stream is the equivalent to an asset of $1925 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 5500 million.
- the dividends stream is $ 3850 million.

This company's market capitalization was $ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $1925 million (this price is supported by its dividend yield) and $ 2750 million (supported by its earning yield).

At $ 3200 million, its reward:risk ratio is against the investor as the current price of this company is higher than your calculated intrinsic value of $ 2750 million.

(B)  Calculating the value of this company at the end of this financial year, using (projected earnings and dividends).

However, it is projected that this company will deliver $ 130 million in earnings and at DPO of 70%, $91 million in dividends.

Let's recalculate the values you will place on these earnings stream and dividend streams.

How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $130 million per year?
3.  Answer:  $130 million / 4% = $ 3250 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about $91 million.
5.  How much deposit would you need to put in the bank to earn $91 million at present prevailing interest rate of 4% per year?
6.  Answer:  $91 million / 4% = $ 2275 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 130 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 130 million / (4% - 2%) = $ 6500 million.
12.  With its dividend of $ 91million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 91 million / (4% - 2%) = $ 4550 million.

To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 3250 million.
- the dividends stream is the equivalent to an asset of $ 2275 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 6500 million.
- the dividends stream is $ 4550 million.

This company's market capitalization was $ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $ 3250 million (this price is supported by its dividend yield) and $ 2275 million (supported by its earning yield), at the end of its financial year..

At $ 3200 million, it is priced close to the calculated intrinsic value for the company in the end of its financial year of $ 3250 million.  There is little margin of safety as demanded by Benjamin Graham in his teaching.  The upside reward = 50 million and the downside risk = 925 million, that is, a reward;risk ratio = 1 : 18.5.

But what if you also factored in the strong growth of this company?  What would be its intrinsic value?

Conclusion:

Since, this company is projected to grow its earnings with a high degree of predictability in the future, will you buy this company at its current price of $ 3200 million?

Those with a short term perspective in their "investing" will realise that the current price has priced in the growth expected for this financial year. 

However, for those with a longer term perspective in their investing, for example 5 years, they will realise that the earnings of this company will continue to grow consistently and predictably.  Considering the earnings growth potential, and including this factor into their calculation of intrinsic value, they may rightly be of the opinion that this company is indeed undervalued.  

Stocks with Low PE Multiples Outperform those with High Multiples. Investors are warned repeatedly about the dangers of very high-multiple stocks that are currently fashionable.

In 1934, Dodd and Graham argued that "value" wins over time for investors.  To find value, investors should look for stocks with low PE ratios and low prices relative to book value, P/BV.  Value is based on current realities rather than on projections of future growth.  This is consistent with the views that investors tend to be overconfident in their ability to project high earnings growth and thus overpay for "growth" stocks.

Stocks with Low PE Multiples Outperform those with High Multiples
One approach of stock selection is to look for companies with good growth prospects that have yet to be discovered by the stock market and thus are selling at relatively low earnings multiple.  This approach is often described as GARP, growth at a reasonable price.  

Earnings growth is so hard to forecast, it's far better to be in low-multiple stocks; if growth does materialize, both the earnings and the earnings multiple will likely increase, giving the investor a double benefit.  Buying a high-multiple stock whose earnings growth fails to materialize subjects investors to a double whammy.  Both the earnings and the multiple can fall.  Therefore investors are warned repeatedly about the dangers of very high-multiple stocks that are currently fashionable.

There is some evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of cash flow and of sales) produces above-average rates of return even after adjustment for risk.  This strategy was tested and had been confirmed by several researchers who showed that as the PE of a group of stocks increased, the return decreased.

This "PE effect," however, appears to vary over time - it is not dependable over every investment period.  And even if it does persist on average over a long period of time, one can never be sure whether the excess returns are due to increased risk or to market abnormalities.

And low PEs are often justified.  Companies on the verge of some financial disaster will frequently sell at very low multiples of reported earnings.  The low multiples might reflect not value but a profound concern about the viability of the companies.  

Avoid Extrapolated Future Earnings Growth figures

Avoid assumptions about extrapolated growth in future earnings
Assumptions about growth in future earnings extrapolated from current or past earnings are unreliable for a valuation exercise.

Also suspect for pure value investors are assumptions about growth in future earnings extrapolated from current or past earnings.

Unlike extreme devotees of growth investing, value investors consider current earnings – adjusted as described – to be the best estimate of sustainable future cash flows.

A key reason to deny estimated and unknown earnings growth is that absent sustainable competitive advantages or barriers to competitor entry, growth lacks value.

If new entrants can join a company’s industry as equal competitors, the effect drives a company’s returns to just equal their costs – no upside is sustainable so growth adds nothing.

Growing a business measured in sales requires growing the business measured in assets. Growing assets requires capital, which also poses a cost. Facing competitive entrants, the process goes nowhere (except remotely due to luck and temporarily – benefits value investors do not pay for).


Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)