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 Sense

Technical sense is when you notice that Carnival (CCL) trades at more than 8x EBITDA and more than 10x Pre-Tax Earnings and disqualify the stock right there. Technically, you have applied the checklist correctly. However, let’s look at 3 companies and their 10 year average tax rate:

Village Supermarket (VLGEA): 41.8%

John Wiley (JW.A): 24.8%

Carnival: 1.1%

Common sense tells you that – when it comes to taxes – Carnival is a special case and needs to be examined as such. You must apply the spirit of the above laws rather than the letter. The letter of the law was not written with a company that pays no taxes in mind.

Theoretical sense is when you catch yourself thinking thoughts that while conceptually true are habitually dangerous. These are usually thoughts that are provable by mathematics but leave the human in you a little queasy for having thought them.

For example: let “a fair price” equal the price at which a buy and hold forever investor would earn the same return in this stock as he would in the S&P 500.

I want you to take two stocks I just mentioned: Village and John Wiley. Both companies have been public since the 1960s. Now go to your favorite data source and look up the oldest stock price you can find for each company. For example, choose Google Finance (which goes back to 1978) and use 1978 to today as your holding period. Then, plot each of these stocks against an index. You can also calculate the CAGR of the stock and the CAGR of the index. Now, work back from these calculations to find what multiple of the then current price you needed to pay for the stock to equalize its future return with that of the S&P 500 over the full holding period from then till today.

I think it will surprise you. It won’t be 1.5 times the then market price. It’ll be more like 3 or 4 times the price. In other words, if the stock had a P/E of 12 back then, it turns out it really should have had a P/E of 36 or 48 or some other absurd multiple.

Buffett’s Coca-Cola investment is well known. Go back to 1988 and try to figure out what a “fair” price for Coca-Cola stock would’ve been if we define fair to mean the price that equalizes long-term future returns between the stock and the S&P 500. Imagine this number in terms of what the P/E, EV/EBITDA, etc. would need to be to make holding Coca-Cola merely a “fair” investment from 1988 through today.

Based on these calculations, you can then go back in time and say that there were times when John Wiley or Village or Coca-Cola (or a great many other public companies) had a margin of safety of 75% or 80%.

I’ll admit this makes theoretical sense. But I won’t admit it makes common sense.

It is a dangerous habit to pay those kinds of multiples. Not because they aren’t justified. And not because the future is unknowable. Per capita consumption of Coke was going to grow. Buffett knew that.

It is dangerous to pay high multiples, because it complicates rather than simplifies you process. It requires more quantification rather than less.

The whole point of having a rule of thumb like “we pay 10 times pre-tax earnings” is to make taking the correct action easier. Warren Buffett is a focused investor – especially in the sense that he makes relatively few new purchases (of private companies or public stocks) each year. He spends a lot of time looking for things to buy and presumably passes on most. So, for Buffett, the approach that makes taking a correct action easier is one that eliminates most errors. It doesn’t matter as much to Buffett if he eliminates a lot of potentially good investments as long as he limits the number of false positives.

I think the same is true for most buy and hold investors. Try using common sense and these 5 guideposts:

  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

I think it will allow you to focus more quickly on those businesses that may be above average in quality and below average in price.

Is this what I do?

Not exactly. I was recently talking to someone who noticed that in a past issue of The Avid Hog I gave a much higher “normal” EBITDA number than the company had actually generated from 2008 through 2012. Wouldn’t it be more conservative to use an average of the recent past?

I answered: “Yes. It would be more conservative. But it would also be intellectually dishonest.”

Simply put, I did not believe that the period from 2008 through 2012 was normal. I could mention the recent past. But, I couldn’t suggest it would have anything to do with the future.

This brings me to the place where I split off from the guidelines I suggested above. When selecting a stock – and when attempting to appraise a stock – I do not think about the price in terms of today’s EBITDA, owner earnings, or free cash flow.

I don’t care what the earnings of a stock are when I buy it. I care what the earnings are when I sell it. In the example I just mentioned, I was thinking in 2013 what the EBITDA of that company was likely to be in 2016 to 2018 (3 to 5 years from my purchase date). I did not believe that the period from 2016 to 2018 would be at all like the period from 2008 through 2012. So, I did not consider the recent past to be a terribly helpful guide.

In most years, this will not be such a big problem. The more normal the economic climate is when you are selecting a stock and the more stable the industry you are looking at is – the more you can trust the most recent EBITDA and pre-tax earnings.

Of course, what I care about is free cash flow. Let’s take another look at the same 3 companies. This time I want to talk about the 10-year average ratio of free cash flow to net income as calculated by Morningstar:

Carnival: 0.31x

Village: 1.10x

John Wiley: 1.84x

In an average year, Carnival turned $1 of earnings into 31 cents of free cash flow. Village turned $1 of earnings into $1.10 of free cash flow. And John Wiley turned $1 of earnings into $1.84 of free cash flow.

I don’t agree with these exact numbers. Morningstar – and almost every other finance website – calculates the free cash flow of publishers incorrectly. However, this pre-publication item does not cause most of Wiley’s free cash flow excess over net income. In reality, Wiley does turn $1 of reported earnings into $1.50 of free cash flow. In an economy with inflation, $1 of earnings at most companies actually converts to less than $1 of free cash flow. This suggests companies that can be counted on to consistently turn $1 of earnings into $1.50 of free cash flow should trade at 50% higher price ratios. Theory says the EV/EBITDA cap of 8 should become an EV/EBITDA cap of 12 for these companies.

I want to stop here and highlight this fact: What I just said is true. It’s theoretically true. You can actually prove the point. There is no arguing that fact. Now, the question I want you to consider is whether the fact this point makes theoretical sense forces you to concede it also makes common sense. I’m serious. Think about this. Really ask yourself whether what I just said about paying 8 times EBITDA for some businesses and 12 times EBITDA for other businesses is an insight you can safely incorporate into your own investing habits. There’s a tendency for folks to either accept that because something is true it’s useful to them or conversely to start by rejecting its usefulness to them and then feeling obligated that because they’ve rejected its usefulness they now need to disprove its truth. Something can be true and useless. Whenever you think about investing, your top priority should be finding a really useful habit to pick up.

So let’s keep talking usefulness. What limits the usefulness of these ratios? I want to point out the problem with using any one ratio – Market Cap/Free Cash Flow, EV/EBIT, EV/EBITDA, etc. – by using those 3 very different companies (Carnival, Village, and Wiley). Their tax rates range from 1% to 42%. Their earnings to free cash flow conversion rates range from 31% to 184% (really more like 150%). These are make or break differences for an investment.

That is why you need to use common sense. These ratios are not flawed. It is only when they are applied in an obviously reckless way that they become flawed.

I recently exchanged emails with someone who had this sort of problem. He had done the return on capital calculation exactly the way an analyst is taught to – and yet, something was nagging at him.

It turns out the tickle he was feeling was common sense.

Here is what he was asking about:

…sells a very large chunk of their receivables at a discount. That has a very positive effect on ROIC and free cash flow as it reduces working capital without a negative impact on the EBIT – the discount paid for selling the receivables is considered a financial expense.

It doesn’t seem very fair to me and I get the feeling I could be overvaluing this company if I don’t include the discount into the operating income (and consequently free cash flow) calculations. Selling a great part of their receivables is business as usual for them; they definitely take the discount into account when pricing their merchandise, for instance.

What do you think?

And here is how I responded:

… The key is not to follow the rules you learned for how to do a generic ROIC calculation. It is to describe the specific business you are analyzing. If you believe the factoring of receivables is a core part of how this business operates, then be up front about it. Tell yourself this is a company that is dependent on factors to provide financing for its operations….

…Be as specific as possible. If you then need to compare this company to others, do it two ways. Prepare a calculation of ROIC that is the most favorable to the company and ROIC that is the least favorable. The truth is one or the other or it is something in between. This is the best description of the actual business. It will help your understanding.

Remember, this is real life problem solving you are going to base a buy/sell decision on using your own money. This is not a word problem in math class. The goal is not to get a single, correct quantifiable answer. The goal is to have confidence in your reasoning and have that reasoning be enough to take a money making action.

The truth is that 10 times pre-tax earnings is a perfectly fair price to pay for a business you understand, like, and intend to hold for the long-term.

However, it is always possible to use ratios to lie to yourself. Value investors can find that the EV/EBITDA ratio of an asset heavy company at the peak of its cycle will justify an otherwise dodgy purchase. If you want to buy into an overleveraged company, just focus exclusively on the Market Cap/Free Cash Flow ratio while ignoring enterprise value entirely.

I think guidelines are great. In fact, I think anything that gets investors away from a focus on quantities and toward a focus on reliability is a wonderful tool. A lot of investors would benefit from trying to prove two separate cases:

  1. {C}Is this an above average business?
  2. {C}Am I paying a below average price?

Rather than trying to quantify the precise extent to which the business is above average or the price is below average.

We shouldn’t spend a lot of time worrying about whether we are paying 3 times EBITDA or 5 times. Either will do. Nor should we spend time worrying about whether the business earns a 33% return on capital or a 99% return on capital. Both will get you a better than 20% after-tax return without leverage. That’s better than Berkshire.

The Brooklyn Investor began the post tackling the idea that Buffett pays 10 times pre-tax earnings. Another Buffett quote explains why the exact price paid may not be the most important consideration:

One of the things you will find, which is interesting and people don’t think of it enough, with most businesses and with most individuals, life tends to snap you at your weakest link. So it isn’t the strongest link you’re looking for among the individuals in the room. It isn’t even the average strength of the chain. It’s the weakest link that causes the problem.

For most investors, price is the weakest link in their process. Most investors are not value investors. They simply pay too much for popular stocks. They may have other weak links. They may trade too much. They may be greedy when others are greedy and fearful when others are fearful.

 

Remember, you aren’t most investors. Most investors aren’t reading this blog. You are. That means price probably isn’t your weakest link.

 

So, don’t focus on price. Just figure out a way to make sure the price you pay is good enough. And then work on correcting the errors you’ve historically made.

 

I’ve made a lot of mistakes as an investor. I can’t think of any case where my mistake was paying too high a price relative to some measure of earnings. I can’t look at any investment that went badly and say: “Oh, if only I’d gotten that at an EV/EBITDA of 4. That would’ve solved everything.”

 

I’ve misjudged people. I’ve misjudged societal change. I’ve misjudged solvency. I’ve sold too soon. And I’ve tried to do too much.

 

Those are potential weak links for me. And so my quality assurance time is better spent carefully checking those problem areas than worrying about price.

 

This is not true for everyone. I’m very unlikely to get so excited about a business, I’ll pay any price for it. I’ve followed businesses I love trade publicly for 5-10 years and never touched them because of price. If you’re like me in that respect, price is something you shouldn’t obsess about.

 

Have your standard. Apply it using common sense. But, don’t worry about whether the right multiple is 9, 10, or 11 times pre-tax earnings. If your investment case snaps, it probably won’t be because of price. And it certainly won’t be because you were off by 10%.

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