Geoff Gannon April 1, 2014

Stock Price Guidelines

A recent blog post at The Brooklyn Investor discusses whether Warren Buffett pays 10x pre-tax earnings for both private companies and public stocks:

It’s amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that. Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying. And yes, right now I’m the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it’s really interesting.

(The Brooklyn Investor)

I’m often asked what’s a fair price to pay for a good business? This is a tough question, because people seem to mean different things when they say “fair price” and different things when they say “good business”.

I will suggest one awfully automatic approach to deciding what stocks are acceptable candidates for long-term investment. The simplest approach I can suggest requires 2 criteria be met. To qualify as a “good business” the stock must:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry

In other words, we are defining a good business as a stock in a “defensive” industry with at least 10 straight years of profits.

If those two business quality criteria are met, what is a fair price to pay for the stock? I suggest three yardsticks:

  1. Market Cap to Free Cash Flow: 15x
  2. Enterprise Value to Owner Earnings: 10x
  3. Enterprise Value to EBITDA: 8x

These are “fair” prices. A value investor likes to pay an unfair price. So, these are upper limits. They are prohibitions on ever paying more than 15 times free cash flow, 10 times owner earnings, or 8 times EBITDA.

At Berkshire, Buffett is willing to pay a fair price – 10 times pre-tax earnings – for 2 reasons:

  1. Berkshire amplifies its returns with leverage (“float”)
  2. Buffett has learned to find a margin of safety in places other than price

For example, Buffett talks about Coca-Cola (KO) as if the margin of safety was the profitable future growth of the company. He was paying a fair absolute price (it was a high price relative to other stocks at the time), because he knew it was a good price relative to earnings a few years out.

Let’s take a look at the 5 guidelines I laid out:

  1. Have no operating losses in the last 10 years
  2. Be in an industry to the left of “Transportation” in this graph of CFROI Persistence by Industry
  3. Market Cap to Free Cash Flow: 15x
  4. Enterprise Value to Pre-Tax Owner Earnings: 10x
  5. Enterprise Value to EBITDA: 8x

Implementation of this – or any – checklist approach requires one additional thing: common sense.

Common sense often finds itself at odds with two other types of sense:

  1. Theoretical Sense
  2. Technical
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