One of the more famous investment quotes, which represents a mindset that has created one of America’s most valuable companies, from one of the most successful investors of all time:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett
And that got me thinking…At what price did Buffett purchase some of his “wonderful” businesses and how does that compare to some “wonderful” stocks today? And what is considered a “fair” price?
Below we are going to look at one stock I am looking into, which I believe is a “wonderful business”. But the high price of it scares me. (By high price, I am not referring to the ~$225 share price. I’m referring to the company’s market cap vs earnings. For more see our post: “What makes a stock expensive? Not its share price!”)
The stock I am looking at today is Transdigm, (Ticker: TDG), which I learned about from the book: The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success Which was recommended by Buffett in his 2012 Berkshire Hathaway annual shareholder letter.
At first look, Transdigm seems to be an amazing company. It is a cash generating machine, requires low capital investments to run, its competitive advantage is protected by a long list of proprietary products, the management seems very shareholder friendly….everything you should be looking for in an investment.
And the results have been stellar, Just take a look!:
(click to enlarge)
Unbelievable growth in EBITDA, EPS, Enterprise Value, Sales, etc.
And the stock has benefited greatly as well:
The cash generating ability of the business has no obvious slowdowns in sight, the company has a wide moat (competitive advantage) in its business….so what’s holding me back?
The company looks expensive based on some basic fundamental ratios:
- Enterprise Value / EBITDA ratio of 17
- P/E ratio of 66
Note: TransDigm highlights an “adjusted earnings” in their annual report which consists of net income + non-recurring expenses such as dividends, acquisition costs, stock compensation etc. Price per 2014 adjusted earnings ratio is about 28. The 66 P/E is very high as TDG paid out a special $25 per share dividend last year.
- Price per Free Cash Flow of about 23.
Now the argument toward paying this high of a price is that the company’s growth rate is stellar. Cash from operating activities is up an average of 34% each year over the last 5 years!
So I wanted to take a look at what kind of multiples Buffett paid on his more recent purchases of “great” companies and see how that compared. Did he get better deals?
First, lets look at a few of the more recent Berkshire purchases. We don’t get have the hindsight to determine if these will turn out to be great investments for Buffett or not, but it is safe to assume he was happy with the price he paid.
Buffett’s 2013 Purchase of Heinz
Heinz had not shown the growth that Transdigm is showing for a long time, but what made Heinz a great business was its consistent earnings, well known name brand (competitive advantage), and cash flow that can fuel Berkshire Hathaway’s investments in other areas. Understanding that these are not the same companies, I thought if Buffett paid similar multiples for a much slower growing company, maybe it would bode well for an investment at a similar price in a faster growing company today.
In the Heinz deal Buffett partnered with 3G Group to purchase Heinz for about $23 Billion ($28 Billion including debt) or $72.50 per share.
Based on Heinz’s 2012 annual report, this amounted to:
- Price to Free Cash Flow of about 23
- Price to Earnings (P/E) of 25.4
- Purchase price (including debt) / EBITDA ratio of 15.4
Buffett’s 2015 Purchase of Kraft
Recently Buffett made an offer with 3G (once again) to purchase Kraft, valuing the company at $46 billion.
At today’s prices this amounts to:
- P/E of 49 based on 2014 earnings.
- However Kraft’s Net earnings are pretty volatile. P/E of 21 based on average net earnings over the last 5 years.
- Price to Free Cash Flow of 85! ( Price to The average Free Cash Flow over previous 5 years = 27.6).
- Purchase price to EBITDA ratio of 25.7 based on 2014 numbers, purchase price to 5 year average EBITDA ratio is about 17.7
Buffett’s Continuing Purchases of IBM
Buffett has been accumulating shares in IBM since 2011, to where it has become one of his largest holdings today.
I do not know the exact days and prices in which Buffett has purchased IBM shares, but based on a few of his 13-F’s and the share price of IBM around that time, I am guessing he is looking at something around:
- P/E of 13
- P/FCF of 12.5
- EV/EBITDA of 9.5
IBM’s numbers show that it is much more of a “value play” than the other names highlighted here. It’s easy to see why Buffett is attracted to a company that generates so much cash and is trading at a reasonable price.
All together – Here’s how they compare (including Coca-Cola, which we discuss below):
(click to enlarge)
So those are the numbers for recent investments by Buffett and Berkshire Hathaway. Based on simple fundamental ratios, none (with maybe the exception of IBM) would really be described as “value” investments.
The “old” Buffett, who looked for those cheap, “cigar butt” stocks would have never been excited to pay 25x free cash flow for a stock. It was his partner, Charlie Munger who changed Buffett’s investing philosophy to look for great companies at fair prices, rather than just bargain bin stocks.
It is obvious that Buffett is investing for more than just simple value, as he did in the beginning of his career. You need more than a couple of basic fundamental ratios to adequately value a company.
The strength of these companies above lie in their consistent long term growth rate and cash generating abilities. So how do we factor that into our analysis? We will get into that in just a bit…
Because there is one more name I wanted to look at, one of Buffett’s most infamous investments to date, and unlike the names here, it is one where we have the hindsight to see how his investment performed.
Buffett’s 1988 Purchase of Coca-Cola
Starting in 1988, Buffett began purchasing large amounts of stock in Coca-Cola (Ticker: KO). At one time, Coca-Cola made up about 25% of Berkshire’s total investments!
His $1 billion investment then is worth more than $10 billion now! So, knowing that this investment turned out wonderfully for Buffett, what did Coca-Cola look like in 1988 and how does it compare to a “great” stock like Transdigm today?
We cover this purchase by Buffett in much more detail in an old post here:
But here are the similar numbers for Coca-Cola in 1988:
- P/E of 16
- P/FCF of 29.5
- EV/EBITDA of 9.5
A good value in the EV/EBITDA ratio, expensive on a Free Cash Flow basis and average on the P/E value. But it was certainly not a pure value investment at the time. So what attracted Buffett?
Though the P/E ratio of these names is not absurd, they are hardly “value” stocks, and most are somewhat expensive on a cash flow basis.
These basic fundamental ratios may be useful at times, but they fail to identify a company’s ability (or lack thereof) to produce future growth and compounding value for shareholders.
So what did Buffett use to value these companies?
Coca-Cola had an unbelievably excellent track record from 1886 through 1988. Buffett is said to have read 80 years’ worth of annual reports from Coca-Cola before investing. And what he saw was consistent growth in shareholder value and cash generation.
Coca Cola averaged a 21% growth in cash flow and 8% growth in shareholder equity from 1978 to 1988.
At the time of Buffett’s investment in Coca-Cola, net earnings were slightly down, and Coca-Cola was losing favor on Wall Street. But those net earnings didn’t matter to Buffett, he was concerned with long term compounding return in shareholder equity and the company’s ability to generate cash. He knew that Coca-Cola had a huge competitive advantage in its brand recognition and distribution that it was not going to go away fast. This meant Buffett had a certain “margin of safety” with his investment.
I really like Joe Ponzio’s analysis of Buffett’s margin of safety in his Coca-Cola purchase, which he describes on his site here: http://www.fwallstreet.com/article/24-buffett-coca-cola-1988-now-i-get-it
Assuming the company could continue to grow Free Cash Flow at 21.8% a year for ten years, and then slowed to 5% thereafter, and assuming Buffett wanted a 15% or more average annual return, you could value Coca-Cola at $22.3 billion, or $59.16 a share in 1988.
For new readers: The $22.3 billion is made up of $2.09 billion of Shareholder Equity and the net present value of the estimated $98.89 billion of future cash flow, discounted at 15% for a handsome return.
Of course, you shouldn’t pay full price for a company-even one as solid as Coca-Cola. If the future is a little less rosy than you projected, your returns head south. So, you need a discount. Being an industry leader (the industry leader), Coca-Cola could have been purchased with as little as a 25% Margin Of Safety (discount).
At a 25% discount to value, Coca-Cola could have been purchased at any time at or below $44.37. In 1988, the company’s stock traded between $35 and $45.25, giving Buffett a discount between 24% and 41%.”
So lets do that similar calculation for Transdigm (and you can plug in numbers for any other stock you may be looking at and follow along):
Since 2005, Transdigm has grown its free cash flow at about 24.1% per year. (From $72.735 million to $507.07 million today)
Lets assume free cash flow grows at 24% per year for another 10 years, then drops down to 5% growth after. What is the value of that future cash flow?
About $14.6 billion would be the value of Transdigm’s projected cash flow. But, this is only true if all of our assumptions end up being right.
So to be safe, we add another discount here. Transdigm has tons of proprietary products and a solid competitive advantage, so I’m comfortable with just a 25% discount.
$14.6 billion / 1.25 = $11.68 billion
Divide that by the 53.8 million shares outstanding and you get $217 per share.
Today as I type this, Transdigm has a market cap of $12.1 billion, with a share price of $227 per share.
So, would this qualify as a great company at a fair price?
Ultimately that’s up for you to decide, but from this quick calculation $227 represents about a 20% discount from the company’s worth, based on these estimated future cash flows.
More importantly, now we have a much better way to value this business than a basic P/E ratio. Using a model such as this, we are forced to think long term (are the results reasonable? Can the company grow for 20 years?), and focus on what really matters – cash flow or what Buffett refers to as “Owner’s Earnings”.
So how much is too much to pay for a “wonderful company”? The answer to that probably had nothing to do with the stock’s P/E ratio. The answer is more likely to be dependent on the company’s ability to create growth in its cash generating abilities and shareholder value.
If you plug in the numbers and find that the company will never generate the cash to justify your purchase, then it’s too expensive.
It turns out that there is more to successful investing than just finding stocks with low P/E ratios or low Cash Flow ratios. How many investors would see yahoo finance’s 66 P/E value for Transdigm and look no further?
The long term value of a business comes from steady growth in its ability to generate value for its shareholders.
But using discounted cash flows is far from a sure bet either. The basis of a discounted cash flow is assumptions of 10 or 20 years in the future – which is far from certain.
Transdigm has grown consistently over the past decade, it will be much harder to do it another 10 years. Continuing a 20+% growth rate is something that very few companies are able to do.
This is where a firm understanding of the company comes into play. Buffett read 80 years’ worth of annual reports of Coca-Cola before investing in order to understand the value and competitive advantage of Coca-Cola. Will you put in that much time for your next investment?
For those looking to go further – we have numerous articles on identifying companies with a competitive advantage, knowledge of which is key to being able to make assumptions of a business 20 years out. Here are a few:
Evaluating Stocks with a Competitive Advantage – Warren Buffett’s Concept of an “Equity/Bond”
9 Signs of a Competitive Advantage
Investing Book Series: “Competitive Strategy” Chapter 1 and Using it to Find Your Next Great Investment