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Get a cup of coffee.
In this thread, I'll show you a simple way to work out a fair price to pay for a wonderful business.
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As Buffett likes to say:
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So, whenever we buy a stock, it's a good idea to ask ourselves 2 questions:
a) Is this a wonderful business? And,
b) Is it available at a fair price?
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From an investing standpoint, a "wonderful business" is one that:
a) Earns high returns on the capital invested into it. And,
b) Has opportunities to re-invest these earnings back into itself at similarly high rates of return.
For more:
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Notice that Buffett didn't just say: buy a wonderful business.
Instead, he said: buy a wonderful business *AT A FAIR PRICE*.
So the question is: how do we calculate a "fair price" to pay for a wonderful business?
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Let's put some numbers to it.
Suppose our business earns 30% per year on the capital invested into it.
In a zero interest rate world, this is a pretty, pretty, pretty good rate of return!
0:000:00
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And let's also say that the business has opportunities to re-invest every dollar of earnings back into itself -- at the same 30% rate of return.
Again, not bad!
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At the start of "Year 1", suppose the business had $1B of capital.
Then, during Year 1, the business will earn 30% of $1B = $300M.
The business will retain, and re-invest, this entire $300M of earnings back into itself.
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So, at the start of Year 2, the business will have $1B + $300M = $1.3B of capital.
And during Year 2, the business will still earn 30% -- but on this expanded capital base. So, earnings will be 30% of $1.3B = $390M.
All of which will be re-invested in Year 3.
And so on.
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Let's say this continues for 20 years.
In Year 21, the company will earn about $57B, as the table below shows:
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20 years down the line, suppose the company is trading at a forward P/E of 20 -- a reasonable multiple for a wonderful business like this.
That means the company's market cap (ie, the total value of all its shares taken together) at the time will be $57B * 20 = ~$1.14T.
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Suppose we buy the stock today, and we want to make a 25% (pre-tax) annualized return over the next 20 years on this investment.
How much can we pay for the stock today?
Working backwards from our ~$1.14T figure, we see that we can pay ~$13B for the whole company today:
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This is a P/E of roughly $13B/$300M = 43.
So, we can pay up to ~43 times earnings for the company's shares today, and we're still likely to get a ~25% return over the next 20 years -- assuming we have a wonderful business and it stays that way.
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43 times earnings seems "optically" high.
But for such a wonderful business, even paying this expensive looking price is likely worth it -- because the business earns such good returns on capital and has good prospects for re-investing earnings.
As Charlie Munger said:
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But of course, the more we pay for the business today, the lower our 20-year returns will be.
For example, if we pay 100 times earnings, our returns will go from ~25% to ~20% annualized.
At 200 times earnings, our returns will only be ~16% annualized.
And so on.
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So that's our method for calculating a "fair price" for a wonderful business.
Step 1. We estimate the business's return on capital, earnings, and re-investments for the next several years.
For example, we assumed a 30% return on capital, with all earnings re-invested.
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Step 2. We set a reasonably conservative "end multiple" for our business.
For example, we assumed that our business will trade at "20 times earnings" 20 years down the line.
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Step 3. We work backwards. How much we can pay for the business today -- and still end up with the return we want?
For example, to get a 25% (pre-tax) annualized return over 20 years, we concluded that we can pay up to ~43 times earnings for our business today.
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Dividends complicate the picture somewhat.
For example, what if our business will earn 30% on all invested capital over the next 20 years, but it can only reinvest half its earnings at this return? (The other half is returned to shareholders as dividends each year.)
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Now the calculations are more complicated.
Here's a formula for the maximum P/E multiple we can pay for a wonderful business -- given its return on capital, dividend payout, "end multiple", and our desired rate of return over the next several years:
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And here are a couple of examples applying the formula above:
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The second example tells us that if our business is able to only re-invest half its earnings each year (with the other half returned as dividends), the P/E we can pay drops from ~43 to just ~8 -- for us to bag the same 25% (pre-tax) annualized return over the next 20 years.
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This is an 80% drop in the price we can pay!
That's the power of a business re-investing earnings at high returns.
If a business can only re-invest *half* its earnings each year, it's worth *much* less than a business that can re-invest *all* its earnings.
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Here are some key lessons from this thread.
Key lesson 1: The more we pay for a business at the outset, the worse our returns will be over the next several years.
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For example, Microsoft is a wonderful business. But in spite of this, those who paid a hefty price for Microsoft shares in 1999 had to endure decades of poor returns.
As @ChrisBloomstran recounts in his excellent 2020 Semper Augustus letter:
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Key lesson 2: The more wonderful a business is (ie, the higher its return on invested capital, and the more opportunities it has for reinvesting earnings), the more we can pay for it and still get a good return over time.
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Key lesson 3: The real danger lies in misjudging business quality, not miscalculating price.
If the business is truly wonderful, it will eventually reward us for holding it -- even if we paid an optically high (but not crazy!) price for it at the outset.
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But if we misjudged business quality (eg, we mistook a mediocre business for a wonderful one), there's no such "bailout" over time.
In this case, only the capriciousness of Mr. Market can bail us out -- and that may never happen.
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As Buffett wrote in his 1989 letter: Time is the friend of the wonderful business, the enemy of the mediocre.
In the same vein, time is also a friend of the *shareholder* of a wonderful business, even if that shareholder got a bit carried away with his purchase price.
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I also very much like @ChrisBloomstran's "dual margins of safety" idea -- where safety comes from both *high business quality* and *a sensible purchase price*, not one or the other.
From Chris's 2019 Semper Augustus letter:
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As Ben Graham says in The Intelligent Investor, in any stock transaction, it's always a good idea to think about *both* "price" and "value".
I hope this thread was able to quantify this connection and make it a bit more concrete.
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If you're still with me, thank you so much!
Your unwavering support and encouragement are priceless. (For everything else, there's MasterCard.)
Please stay safe. Enjoy your weekend!
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10-K Diver @10kdiver1/
Get a cup of coffee.
In this thread, I'll help you understand Warren Buffett's famous quote: it's better to buy a wonderful business at a fair price than a fair business at a wonderful price. twitter.com
Pay what you can