What makes a company valuable and what makes a stock a "Buy"?

Buffett: Ownership of commercial "cows" (first class businesses) over any extended period of time will prove to be rewarding and by far the safest.

Our first two categories, namely cash and gold, enjoy maximum popularity at peaks of fear:

• Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. 
• We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. 
• Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. 
• On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times

-  to deliver output that will retain its purchasing-power value 
- while requiring a minimum of new capital investment. 

• Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test.
• Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more.
• Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. 

• Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. 
• Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). 

Berkshire’s goal will be to increase its ownership of first-class businesses.

• Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks.
•  I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. 
• More important, it will be by far the safest.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Growth Investing Examples from Berkshire Hathaway

-  On September 16th we acquired Lubrizol, a worldwide producer of additives and other specialty chemicals. The company has had an outstanding record since James Hambrick became CEO in 2004, with pre-tax profits increasing from $147 million to $1,085 million. Lubrizol will have many opportunities for “bolt-on” acquisitions in the specialty chemical field. Indeed, we’ve already agreed to three, costing $493 million. James is a disciplined buyer and a superb operator. Charlie and I are eager to expand his managerial domain.

Comment:  Lubrizol grew its pre-tax profits from $147 million from 2004 to $1,085 million.   Thus its pre-tax profit has grown at the compound annual growth rate of 33.05% over 7 years.

• Buffett likes this company for its good earnings growth.  
• The good earnings growth rate also is reflective of the good business fundamentals of this company.
• Buffett loves buying / owning wonderful company (that are growing).

-  Our major businesses did well last year. In fact, each of our five largest non-insurance companies – BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.

Comment:  

1994:  Mid American contributed pre-tax earnings of $393 million.

2011:  BSNF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy earned $9 billion pre-tax.

• BSNF and Lubrizol are recent acquisitions of Buffett.  
• Buffett likes these companies for their earnings and growth.  
• Buffett even projected that their aggregate earnings will top $10 billion next year, 2012 (a growth rate of 11%).

-   In total, our entire string of operating companies spent $8.2 billion for property, plant and equipment in 2011, smashing our previous record by more than $2 billion. About 95% of these outlays were made in the U.S., a fact that may surprise those who believe our country lacks investment opportunities. We welcome projects abroad, but expect the overwhelming majority of Berkshire’s future capital commitments to be in America. In 2012, these expenditures will again set a record.

Comment:  

Yes, to grow one has to re-invest.  Looks like Buffett reinvest all the free cash flows ($8.2 billion capital expenditure) for future growth.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

DISCOUNTED CASH FLOW (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. 

A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

In 1992, Warren Buffett said that:

‘Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. 

There are formulas for working out discounted cash flows and they can be complex but they give a result.

EXPLANATIONS OF DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.

A good online explanation is available here.

http://www.buffettsecrets.com/price-to-pay.htm

GOOD MANAGERS AND BAD BUSINESSES

Buffett does acknowledge that even the best managers will founder if the business is not intrinsically sound. 

His most telling comment on management is: 'When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.’

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

Warren Buffett and Keynes

WARREN BUFFETT AND KEYNES

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about …’ - Jim Keynes

What Warren Buffett says about Buying a Business

BUYING THE BUSINESS

Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company, whose business they do not understand.

WHAT WARREN BUFFET SAYS ABOUT BUYING A BUSINESS

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand.. He has repeated this message many times since. In 1992, he expanded on this theme:

‘[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.’

WHAT WARREN BUFFETT SAYS ABOUT GOOD BUSINESSES

Good businesses with that ‘protective moat’ that Warren Buffett likes have the ability to cope with inflation by raising prices. As he said in 1993:

‘The might of their brand names, the attributes of their products and the strength of their distribution systems gives them an enormous competitive advantage, setting up a protective moat around their economic activities. The average company, in contrast, does battle daily without any means of protection.’

BERKSHIRE HATHAWAY HOLDINGS

Stocks held by Berkshire Hathaway in 2002, as stated by Buffett in his letter to stockholders include:

• The Coca Cola Company
• American Express
• The Gillette Company
• H and R Block Inc
• Moody’s Corporation
• The Washington Post Company
• Wells Fargo and Company

These are all companies with a unique or special product, or with a company brand name, or in a market domination position. They or their products have a loyalty (voluntary or otherwise) that means customers want or must come back.

Another desirable quality in non-commodity companies is repeat business. Customers drink their Coke, wear out their razor blades, or finish reading their Washington Post, and then, eventually have to replace it.

Have an opinion on future growth - How can the company increase its earnings?

It is only rational to have an opinion on future growth.  Otherwise, how could you ever choose a stock?

When forming that opinion, back up quantitative information with qualitative factors.

For example, ask what management is doing to make a positive impact on earnings.

According to Peter Lynch, there are 5 basic ways a company can increase earnings:

• reduce costs; 
• raise prices; 
• expand into new markets;
• sell more of its products to the old markets; or
• revitalize, close or otherwise dispose of a losing operation.

When management is enacting growth-promoting activities, earnings may be temporarily flat.  They often soon take a giant step up.

Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.

So what's there to worry about in good earnings?  Exceptionally high earnings often attract rough competitors.  

The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.


Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.