Saturday, October 25, 2008

The New Buffettology: Chp 18

The following is a description of some suggestions presented by the authors on how to uncover great businesses (with durable competitive advantages) that might be worth investing in.

#1 Predictable Earnings: Warren is looking for a company with a strong upward trend in earnings over the past 10 years and is not interested in companies that have volatile earnings. Temporary company setbacks are potentially good buying opportunities.

#2 Initial Rate of Return: Warren looks at the earnings of a company relative to its price to determine an initial rate of return on the investment. He then adds in the earnings growth to determine how attractive the investment is. For example, if H&R Block is trading at $30/sh with earnings of $2.57, the initial rate of return is 8.6%. If the earnings are growing at 7.6% per year, then you can look at the investment in H&R Block as if you were investing in a bond that pays initially 8.6% in the first year, 9.2% in the second year and so on.

#3 Determining the Per Share Growth Rate: To grow earnings, management needs to use the company's retained earnings wisely. Compare a company's 5 year and 10 year annual earnings growth rates and understand any changes in earnings rates from a business perspective. This will help you select the appropriate growth rate to use for other valuation calculations.

#4 A Stock's Value Relative to Treasury Bonds: Investments should be compared against each other to find the best place to put your money. One benchmark is the return on treasury bonds. You can compare the value of an investment to a treasury bond by dividing the company's earnings by the treasury yield. For H&R Block, divide the $2.57/sh in earnings by 6% (in 2000) which gives a value of $42.83/sh. This means that if you paid $42.83 per share for H&R block, you would be getting a return equal to the treasury bonds at that time.

#5 Using the Per Share Earnings Annual Growth Rate: If a company has a durable competitive advantage, it is possible to use the calculated annual growth rate to project the amount of earnings a company will have in say 10 years. You could then average out the P/E ratio over the past 10 years and apply that to the projected earnings/sh and get an approximate value of the company in the future.

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