Evaluating Stocks with a Competitive Advantage – Warren Buffett’s Concept of an “Equity/Bond”April 13, 2014 • By Begin To Invest
For our followers on social media, we had a little teaser on our Facebook and Twitter pages earlier this week, showing this chart:
This chart shows the Net Income, Retained Earnings and Treasury Stock over the last 12 years for a company. For what company? I’ll reveal in just a second…
What makes this chart so interesting anyway? Our posts on social media (Follow us on Facebook here) gave a clue:
(Click to Enlarge)
This stock stood out to me because of this company’s consistent earnings and shareholder return, and it is a brand that nearly every homeowner knows, with little competition. These factors together give this company a solid competitive advantage – which makes me start to pay attention.
The company is WD-40 company (Ticker: WDFC) – Hopefully the chart colors were a little clue.
Warren Buffett is notorious for finding companies such as this one. A with a solid history of returns, a durable competitive advantage and to top it off, the stock is off about 13% from its highs, despite reporting record net income in 2013. Now I am really starting to pay attention.
Evaluating a Company Like WD – 40. Into The Balance Sheet We Go.
How do you value a company like WD-40 Company? The company’s attractiveness doesn’t come from a huge “growth” rate. In fact, this company may be as boring as they come…for 40 years it only sold 1 product! But it dominated the market, and is a $10+ billion company today.
Today, companies like Facebook, Twitter, Tesla Motors and Amazon steal the media time (seriously, when was the last time CNBC spent time talking about WD-40? Like I said – its Boring! – But that’s good for you). Investors are seeing revenue grow by double digit percentages every year in these hot growth stocks, and investors are excited that the future may eventually see some stellar profits in these companies.
The key word is MAY.
What is Tesla Motors (Ticker: TSLA) worth today? It doesn’t make any profit for its shareholders yet, they must take on massive amounts of debt to finance any growth giving it a very small book value because of the high debt load and they have been increases outstanding shares…so the valuation is left for investors to guess. Some say hundreds of billions of dollars, others say mere millions. But both sides have nothing solid to base their guesses on. This is when what is disguised as “investing” is really just gambling.
Why Boring is Better
But here lies the strength of a company like WD-40 Company. Investors can put a very reasonable guess on next year’s profits, and even the profits of many years out! The company’s profits have been incredibly consistent over the last 12+ years as shown in the chart above.
This makes it a little easier to assign a value to a company like WD – 40, because we are able to project with some certainty how much money they will make in the future. And with that, we know the return that the company’s future profit will return compared to Shareholders’ Equity.
Return on Shareholders’ Equity, or more simply, Return on Equity (ROE) is calculated by:
So really, our chart should have looked like this to really show WD 40 Company’s competitive advantage:
Buffett’s “Equity/Bond” Concept
When a company’s earnings are so solid and so predictable, investors are able to think of their stock like a variable fixed income security, like a bond with flexible rates. Sometimes that rate may go down, but for a solid company with strong earnings, it may even go up!
Today $1 million in 10 year U.S. treasuries returns a yield of about 2.62%, or about $26,200 per year.
What does WD – 40 Company return?
We can look for an equivalent “earnings yield” for a company like WD – 40 as earnings divided by Shareholder Equity, or ROE as we described above.
WD 40 Company has averaged 20.79% ROE over the last 12 years!
$1 million in WD 40 Company returns 20.79% on average, nearly 8x the yield of 10 year U.S treasuries, or about $207,900 per year!
It would take nearly $8 million dollars in treasuries to generate the same return as $1 million in WD 40 Company stock based on the average ROE over the last 12 years.
Of course, there is no guarantee that the company’s stock price immediately rises in response to this return in shareholder’s equity…but investors like Buffett are not worried about that. Because over long periods of time, the market will take notice and patient investors will stand to profit.
Determining a Price
So what is a fair price for WD 40 Company?
Today, WD 40 company is trading at a P/E ratio of about 30. Many investors look solely at a company’s P/E ratio as a sign of value, but it is hardly an end-all-be-all indicator of value. In fact, 30 is probably too high for strict value investors to get excited about in a company at all. So a strict value investor will probably overlook WD 40 Company today because it is “expensive”.
Last year WD 40 Company made $39.81 million in net income with a $179 million in Shareholders’ Equity. In order to generate $39.81 million a year in yield from 10 year treasury bonds, you would need to purchase over $1.5 Billion worth! So it is pretty clear that treasuries would not be an adequate alternative for WD 40 Company stock, as long as earnings remain consistent.
If you bought WD 40 Company for 30 times earnings (a 30 P/E Ratio) you would pay about $1.2 billion today (about $71 a share).
If that $179 million in Shareholder Equity continues to grow at an average of 20.79% for the next 10 years, it will become $1.186 billion, which the company will be able to use to generate $246,743,482 in earnings:
So, if you can sell WD 40 Company stock in 10 years trading at 30 times earnings, it would be worth $7.4 billion, or about $437 per share! That is a 19.95% annual compounded rate of return!
Even if you can only get a 10 P/E ratio at the time of sale 10 years from now, that would still equate to buying the company for $2.46 billion or about $145 per share. Still a 7.5% annual compounded return, which is still about 3X the return of treasuries today.
How much is WD 40’s projected $1.186 billion in shareholder equity in 2024 worth today?
Generally, Buffett looks for a minimum of 15% annual compound return rate. If you want a minimum of 15% annual compounded return, what is the maximum you should pay for WD 40 Company stock today?
Using the simple equation:
FV = Future Value (Here the projected Shareholders’ Equity per share 10 years from now – $1.186 billion)
PV = Present Value (What we are solving for)
i = interest rate (here our desired 15%)
N = Number of Years (Here, 10 years)
Solving this we find that $1.186 billion discounted at a 15% rate is $293.4 million.
Divide that $293.4 million by the number of shares outstanding and we get 19.24. Now multiply 19.24 by the Price to Book ratio the company has traded at historically. For WD-40 Company, this is 6.0:
So, 19.24 x 6 = $115
If valuations stay constant with their past historical premiums, and WD 40 Company continues its stellar Return on Equity, the most an investor who desires a 15% compounded annual return should be willing to pay is $115.
Personally, I would take some of the lower P/B values and use those. Say, instead of multiplying by 6, multiply by 4.5 instead to have your estimate be on the low side. That would give us a maximum price of $86.58, about $16 per share more than it is trading for today!
As you can see, this whole calculation is only possible because we can be confident about projecting the company’s earnings forward multiple years. In order to do this, the company needs a long history of strong earnings growth and a solid competitive advantage to keep those earnings rolling in. This calculation is nothing but guesswork if done with today’s popular “growth” stocks like mentioned earlier.
How do you find a stock with a competitive advantage? See some of our latest posts on the topic here:
9 Signs of a Competitive Advantage: http://begintoinvest.com/9-signs-competitive-advantage-9-one-buffetts-favorites-look/
10 Questions to Ask Yourself Before You Buy Your Next Stock: http://begintoinvest.com/10-questions-ask-buy-next-stock/