Valuing Stocks The Warren Buffett Way

Valuing Stocks the Warren Buffett Way
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Computerized Investing > July 2009
Valuing Stocks the Warren Buffett
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Way
by Wayne A. Thorp, CFA
Like most successful stockpickers, Warren Buffett thinks that the
efficient market theory is absolute rubbish. Buffett has backed up his
beliefs with a successful track record through Berkshire Hathaway, his
publicly traded holding company.
Unfortunately, Buffett has never expounded extensively on his
investment approach, although you can glean tidbits from his writings in
the Berkshire Hathaway annual reports. However, a cottage industry
has sprung up over the years as outsiders have attempted to explain
Buffetts investment philosophy. One book that discusses his approach
in an interesting and methodical fashion is Buffettology: The Previously
Unexplained Techniques That Have Made Warren Buffett the Worlds
Most Famous Investor (Scribner, 1999) written by Mary Buffett, a
former daughter-in-law of Buffetts, and David Clark, a family friend and
portfolio manager.
This book served as the basis for two stock screens developed and
tracked by AAIIBuffettology EPS Growth and Buffettology
Sustainable Growth. These screens are also pre-built into AAIIs Stock
Investor Pro fundamental stock screening and research database
program.
In this article, we provide an overview of Buffettology as a method of
identifying promising businesses. In addition, we present a Buffett
valuation spreadsheet that uses various valuation models to measure
the attractiveness of stocks passing the preliminary screens.
Dening an Attractive Company

Warren Buffett seeks first to identify an excellent business and then to
acquire the firm if the price is right. Buffett is a buy-and-hold investor
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who prefers to hold the stock of a good company earning 15% year after year over jumping
from investment to investment with the hope of higher, short-term gains. Once he identifies a
good company and purchases it at an attractive price, Buffett holds the stock for the long
term until the business loses its attractiveness or a more attractive alternative investment
presents itself.
Buffett seeks businesses whose product or service will be in constant and growing demand.
In his view, businesses can be divided into two basic types:
Categories: Commodity-based firmsselling products where price is the single most
important factor determining purchase. They are characterized by high levels of
competition in which the low-cost producer wins because of the freedom to establish
prices. Management is vital for the long-term success of these types of firms.
Consumer monopoliesselling products where there is no effective competitor, either
due to a patent or brand name or similar intangible that makes the product or service
unique.
While Buffett is considered a value investor, he passes up the stocks of commodity-based
firms even if he can purchase them at a price below the intrinsic value of the firm. An
enterprise with poor inherent economics often remains that way. The stock of a mediocre
business generally only treads water.
How do you spot a commodity-based company? Buffett watches out for these
characteristics:
Categories: Low profit margins (net income divided by sales);Buffett instead seeks
Low return on equity (earnings per share divided by book value per share);out
Absence of any brand-name loyalty for its products;consumer monopolies
The presence of multiple producers;The existence of substantial excess capacity;
Profits tend to be erratic; andcompanies that have managed to create a product or
Profitability depends upon managements ability to optimize the use of tangible
assets.
service that is somehow unique and difficult for competitors to reproduce due to
brand-name loyalty, a particular niche that only a limited number of companies can enter, or
an unregulated but legal monopoly such as a patent.
Consumer monopolies can be businesses that sell products or services. Buffett recognizes
three types of monopolies:
Categories: Businesses that make products that wear out fast or are used up quickly
and have brand-name appeal that merchants must carry to attract customers. Apple
Inc. is a good example of a firm with a strong brand name in demand by customers.
As a result, consumers are willing to pay a premium price for Apple products. Other
examples include leading newspapers, drug companies with patents, and popular
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brand-name restaurants such as McDonalds.

Communications firms that provide a repetitive service, which manufacturers must
use to persuade the public to buy their products. All businesses must advertise their
items, and many of the available media face little competition. These used to include
worldwide advertising agencies, magazine publishers, newspapers, and
telecommunications networks. Today, new media outlets such as Google and Yahoo!
provide on-line advertising that threatens the traditional business models of print
media.
Businesses that provide repetitive consumer services that people and businesses are
in constant need of. Examples include tax preparers, insurance companies, and
investment firms.
In her Buffettology book, Mary Buffett suggests going to your local convenience store to
identify many of these must-have products. These stores typically carry a very limited line
of must-have products such as Marlboro cigarettes and Wrigleys gum. However, with the
guidance of the factors used to identify attractive companies, we established two basic
screens to identify potential investments worthy of further analysis.
The Buffettology Screen

The criteria used for our Buffettology screens are summarized in Table 1. AAIIs Stock
Investor Pro is used to perform the screens.
Consumer monopolies typically have high profit margins because of their unique niche;
however, a simple screen for high margins may highlight weak firms in industries with
traditionally high margins, but low turnover levels.
Our first screening filters look for firms with both gross operating margins and net profit
margins above the medians for their industry. The operating margin concerns itself with the
costs directly associated with the production of the goods and services, while the net profit
margin takes all of the company activities and actions into account.
Table 1. Translating the Buffett Style Into Screening

Questions to determine the attractiveness of the business:
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Consumer monopoly or commodity?

Buffett seeks out consumer monopolies selling products in which there is no effective
competitor, either due to a patent or brand name or similar intangible that makes the product
unique. Investors can seek these companies by identifying the manufacturers of products
that seem indispensable. Consumer monopolies typically have high profit margins because
of their unique niche; however, simple screens for high margins may simply highlight firms
within industries with traditionally high margins. For our screen, we look for companies with
operating margins and net profit margins above their industry norms. Additional screens for
strong earnings and high return on equity will also help to identify consumer monopolies.
Follow-up examinations should include a detailed study of the firms position in the industry
and how it might change over time.
Do you understand how the business works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor,
you should only further analyze the companies passing all screening criteria that operate in
areas you understand.
Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to
have strong cash flows, with little need for long-term debt. We screen for companies with
total liabilities relative to total assets that are below the median for their respective industry.
Alternative screens might look for low debt to capitalization or low debt to equity.
Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screen for
companies with seven-year earnings per share growth greater than 75% of all firms. To help
indicate that earnings growth is still strong, we also require that the three-year earnings
growth rate be higher than the seven-year growth rate. Buffett seeks out firms with
consistent earnings. Follow-up examinations should include careful examination of the
year-by-year earnings per share figures. As a simple screen to exclude companies with
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more volatile earnings, we screen for companies with positive earnings for each of the last
seven years and latest 12 months.
Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is
a difficult factor to screen for on a quantitative level. Before investing in a company, look at
the companys past pattern of acquisitions and new directions. They should fit within the
primary range of operation for the firm.
Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable
opportunities exist. When companies have excess cash flow, Buffett favors shareholderenhancing maneuvers such as share buybacks. While we do not screen for this factor, a
follow-up examination of a company would reveal if it has a share buyback plan in place.
Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations.
Other screens for strong and consistent earnings and strong return on equity help to the
capture this factor.
Is the companys return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns
on equity. Mary Buffett indicates that the average return on equity for the last 30 years is
approximately 12%. We created a custom field that calculated the average return on equity
over the last seven years. We then filter for companies with average return on equity above
12%.
Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing
significant unit sales. This factor is best applied through a qualitative examination of the
companies and industries passing all the screens.
Does the company need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels,
so the lower the amount needed to maintain current operations, the better. This factor is best
applied through a qualitative examination of the company and its industry. However, a screen
for high relative levels of free cash flow may also help to capture this factor.
Understand How It Works
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As is common with successful investors, Buffett only invests in companies he can

understand. Individuals should try to invest in areas where they possess some specialized
knowledge and can more effectively judge a company, its industry, and its competitive
environment. While it is difficult to construct a quantitative filter, an investor should be able to
identify areas of interest.
The companies typically passing the Buffettology screens represent a diverse group of
companies. An investor should only consider analyzing those firms operating in areas that
they can clearly grasp.
To see the companies that are currently passing the AAII Buffettology screens, visit the
Stock Screens area of AAII.com.
Conservative Financing
Consumer monopolies tend to have strong cash flows, with little need for long-term debt.
Buffett does not object to the use of debt for a good purposefor example, if a company
uses debt to finance the purchase of another consumer monopoly. However, he does object
if the added debt is used in a way that will produce mediocre resultssuch as expanding
into a commodity line of business.
Appropriate levels of debt vary from industry to industry, so it is best to construct a relative
filter against industry norms. We screen out firms that had higher levels of total liabilities to
total assets than their industry median. The ratio of total liabilities to total assets is more
encompassing than just looking at ratios based upon long-term debt such as the debt-equity
ratio.
Strong & Improving Earnings

Buffett invests only in businesses whose future earnings are predictable to a high degree of
certainty. Companies with predictable earnings have good business economics and produce
cash that can be reinvested or paid out to shareholders. Earnings levels are critical in
valuation. As earnings increase, the stock price will eventually reflect this growth.
Buffett looks for strong long-term growth as well as an indication of an upward trend. In her
book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Pro
offers seven-year growth rates, so for the predefined Buffettology screens we use the
seven-year growth rate to filter for long-term growth and the three-year growth rate to filter
for intermediate-term growth. The Buffettology screens first require that a companys
seven-year earnings growth rate be higher than that of 75% of the stocks in the overall
database.
It is best if the earnings also show an upward trend. Buffett compares the intermediate-term
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growth rate to the long-term growth rate and looks for expanding earnings. For our next filter,
we require that the three-year growth rate in earnings be greater than the seven-year growth
rate.
Consumer monopolies should show both strong and consistent earnings. Wild swings in
earnings are characteristic of commodity businesses. An examination of year-by-year
earnings should be performed as part of the valuation.
VCA Antech (WOOF) passed the
Figure 1. Buffett Valuation Worksheet for VCA Antech
Buffettology Sustainable Growth

screen as of May 15, 2009, and is
used in Figure 1 to illustrate the
Buffett Valuation Spreadsheet. The
company operates the largest
network of animal hospitals and
veterinary diagnostic labs in the
country. The companys earnings
per share are displayed in the
spreadsheet. [While Stock Investor
Pro provides seven-year growth
rates, which requires eight years of
data, the program provides seven
years of financial statement data for
display purposes. The spreadsheet
displays six years of data to
calculate the five-year growth rates.] As we can see, VCAs earnings per share EPS growth
has been strong and consistent, with annual increases over each of the last five years
(where Year 1 is the most recent year).
A screen requiring an increase in earnings for each of the last seven years would be too
stringent and would not be in keeping with the Buffett philosophy. However, a filter requiring
positive earnings for each of the last seven years should help to eliminate some of the
commodity- based businesses with wild earnings swings.
A Consistent Focus
Companies that stray too far from their base of operation often end up in trouble. Peter
Lynch also avoided profitable companies diversifying into other areas. Lynch termed these
diworseifications. Quaker Oats purchase and subsequent sale of Snapple is classic
example.
Companies should expand into related areas that offer high return potential. VCA Antech is
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the leader in the animal diagnostic lab business, servicing more than 14,000 of the 22,000
animal hospitals in the U.S. This segment offers impressive operating margins, which should
benefit the company going forward.
Buyback of Shares
Buffett views share repurchases favorably since they cause per share earnings increases for
those who dont sell, resulting in an increase in the stocks market price. This is a difficult
variable to screen, as most data services do not indicate buybacks. You can screen for a
decreasing number of outstanding shares, but this factor is best analyzed during the
valuation process.
Investing Retained Earnings

A company should retain its earnings if its rate of return on its investment is higher than the
investor could earn on his own. Dividends should only be paid if they would be better
employed in other companies. If the earnings are properly reinvested in the company,
earnings should rise over time and stock price valuation will also rise to reflect the increasing
value of the business.
An important factor in the desire to reinvest earnings is that the earnings are not subject to
personal income taxes unless they are paid out in the form of dividends.
Buffett examines managements use of retained earnings, looking for management that has
proven it is able to employ retained earnings in the new moneymaking ventures, or for stock
buybacks when they offer a greater return.
Good Return on Equity

Buffett seeks companies with above-average return on equity. Mary Buffett indicates that the
average return on equity over the last 30 years has been around 12%. During the valuation
process, this average should be checked against more current figures to assure that the past
is still indicative of the future direction of the company. Our screen looks for average return
on equity of 12% or greater over the last seven years.
Ination Adjustments
Consumer monopolies can typically adjust their prices quickly to inflation without significant
reductions in unit sales, since there is little price competition to keep prices in check. This
factor is best applied through a qualitative examination of a company during the valuation
stage.
Reinvesting Capital
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In Buffetts view, the real value of consumer monopolies is in their intangiblesfor instance,
brand-name loyalty, regulatory licenses, and patents. They do not have to rely heavily on
investments in land, plant, and equipment, and often produce products that are low tech.
Therefore, they tend to have large free cash flows (operating cash flow less dividends and
capital expenditures) and low debt. Retained earnings must first go toward maintaining
current operations at competitive levels. This is a factor that is also best examined at the
time of the company valuation although a screen for relative levels of free cash flow might
help to confirm a companys status.
The above basic filters help to indicate whether the company is potentially a consumer
monopoly and worthy of further analysis. However, stocks passing the screens are not
automatic buys. The next test revolves around the issue of value.
The Price Is Right: Using the Buffett Valuation Spreadsheet
The price that you pay for a stock determines the rate of returnthe higher the initial price,
the lower the overall return. Likewise, the lower the initial price paid, the higher the return.
Buffett first picks the business, and then lets the price of the company determine whether to
purchase the firm. The goal is to buy an excellent company at a price that makes business
sense. Valuation equates a companys stock price to a relative benchmark. A $200 dollar per
share stock may be cheap, while a $2 per share stock may be expensive.
Buffett uses a number of different methods to evaluate share price. Three techniques are
highlighted in the Buffettology book and are used in the Buffett spreadsheet template
(Figure 1). You can download the spreadsheet from at AAII Web site: www.aaii.com/ci
/buffettology.xls.
Buffett prefers to concentrate his investments in a few strong companies that are priced
well. He feels that diversification is used by investors to protect themselves from their
stupidity.
Earnings Yield
Buffett treats earnings per share as the return on his investment, much like how a business
owner views these types of profits. Buffett likes to compute the earnings yield (earnings per
share divided by share price) because it presents a rate of return that can be compared
quickly to other investments.
Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to
the firms underlying earnings. The analysis is completely dependent upon the predictability
and stability of the earnings, which explains the emphasis on earnings strength within the
preliminary screens.
VCA Antech has an earnings yield of 6.5% [cell C13, computed by dividing the current
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(trailing 12 months) earnings per share of $1.56 (cell C9) by the closing price on May 15,
2009, of $24.04 (cell C8)]. Buffett likes to compare the company earnings yield to the
long-term government bond yield. An earnings yield near the government bond yield is
considered attractive. With government bonds yielding slightly more than 4% currently (cell
C17), VCA compares very favorably. By paying $24 per share for VCA, an investor gets an
earnings yield return greater than the interest yield on bonds. The bond interest is cash in
hand but it is static, while the earnings of VCA Antech should grow over time and push the
stock price up.
Historical Earnings Growth

Another method Buffett uses to value prospective stocks is to project the annual compound
rate of return based on historical earnings per share increases. For example, earnings per
share at VCA Antech have increased at a compound annual growth rate of 23.9% over the
last five years (cell B30). If earnings per share increase for the next 10 years at this same
growth rate of 23.9%, earnings per share in year 10 will be $13.34. [$1.56 (1 + 0.239)10].
(Note this value is found in cell B47 and also in cell E37. Using a calculator, results may
differ due to rounding.) This estimated earnings per share figure can then be multiplied by
the five-year average price-earnings ratio of 25.0 (cell H10) to provide an estimate of price
[$13.34 25.0 = $333.19]. (Note this value is found in cell E40.) While VCA does not pay a
dividend, if a company you are valuing pays dividends an estimate of the amount of
dividends paid over the 10-year period should also be added to the year 10 price. (Note that
when evaluating dividend-paying stocks, this value is found in cell E41.)
Once this future price is estimated, projected rates of return can be determined over the
10-year period based on the current selling price of the stock. Buffett requires a return of at
least 15%. For VCA Antech, comparing the projected total gain of $333.19 to the current
price of $24.04 leads to a projected annual rate of return of 30.1% [($333.19 $24.04)1/10
1]. (Note this value is found in cell E43.)
Sustainable Growth
The third valuation method detailed in Buffettology is based upon the sustainable growth
rate model. Buffett uses the average rate of return on equity (ROE) and average retention
ratio (1 average payout ratio) to calculate the sustainable growth rate [ROE (1 payout
ratio)]. For companies that do not pay a dividend, the sustainable growth rate equals the
return on equity.
The sustainable growth rate is used to calculate the book value per share (BVPS) in year 10
[BVPS (1 + sustainable growth rate)10]. Earnings per share can then be estimated in year
10 by multiplying the average return on equity by the projected book value per share [ROE
BVPS].
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To estimate the future price, you multiply the earnings per share by the average priceearnings ratio [EPS P/E]. If dividends are paid, they can be added to the projected price
to compute the total gain.
For example, VCA Antechs sustainable growth rate, based on average five-year data, is
22.3% [22.3% (1 0.0)]. (The sustainable growth rate is found in cell H11.) Again, since
the company does not pay a dividend, its sustainable growth rate equals its return on equity.
Thus, book value per share should grow at this rate to roughly $65.91 in 10 years [$8.81 (1
+ 0.223)10]. (Note this value is found in cell B62.) If return on equity remains 22.3% (cell
H6), in the tenth year, earnings per share that year would be $14.69 [0.223 $65.91]. (Note
this value is found in cell C62 and also in cell E52.)
The estimated earnings per share can then be multiplied by the average price-earnings ratio
to project the future price of $366.88 [$14.69 25.0]. (Note this value is located in cell E55.)
If dividends have been paid, you would use an estimate of the amount of dividends paid
over the 10-year period and add this to the projected price to arrive at the total gain. This
total gain is then used to project the annual rate of return of 31.3% [(($366.88 + $0.00)
$24.04)1/10 1]. (Note this return estimate is found in cell E58.)
Data Sources
For users of Stock Investor Pro, the projected returns based on the earnings growth rate and
sustainable growth rate are already built into the program using seven-year data (found in the
Valuations data category). For those who do not subscribe to Stock Investor Pro, all of the
data you need to populate the Buffett valuation spreadsheet can be found in company 10-K
reports, which are available on-line from numerous sources. You will have to search through
multiple years, however, in order to get the six years of data required for this spreadsheet.
Alternatively, the SmartMoney Web site (www.smartmoney.com) provides 10 years of
financial statement data for free.
Conclusion
The Warren Buffett approach to investing makes use of folly and discipline: the discipline
of the investor to identify excellent businesses and wait for the folly of the market to drive
down the value of these businesses to attractive levels. Most investors have little trouble
understanding Buffetts philosophy. The approach encompasses many widely held
investment principles. However, its successful implementation is dependent upon the
dedication of the investor to learn and follow the principles.
Wayne A. Thorp, CFA is a vice president and the senior financial analyst at AAII and former editor of Computerized Investing.
Follow him on Twitter at @WayneTAAII.
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Discussion
Dan from NC posted over 4 years ago:
Table 1 overlays the text of the article. How can this be overcome?
R from AZ posted over 4 years ago:

That was my first impression also;however, the text reads OK as is.
R from AZ posted over 4 years ago:

That was my first impression also;however, the text reads OK as is.
Arnold from HI posted over 3 years ago:

The spreadsheet is out of focus. No download site for spreadsheet.
Jeffrey from FL posted over 3 years ago:

Can't discover how I can download the spreadsheet in this article or many of the other spreadsheet
articles. What am I overlooking?
Randy from SC posted over 3 years ago:

While a pure review of the numbers might have led one to purchase woof in '09, the proof in the
pudding to this point says that it would have been a terrible move. What about an analysis showing
what has gone wrong? What happened that isn't shown by the numbers in the spreadsheet? The
spreadsheet would suggest that BVPS now (3/12) should be around $16 and EPS $3-$3.50 when
in reality they are ~$13 and $1.10?
LBG from CA posted over 3 years ago:

The excel spreadsheet can be found if you go to AAII "Home" and then go to "Quick Links" and
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scroll right to "Downloads".
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Computerized Investing > July 2009