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The market’s price-to-earnings multiple has historically averaged around 16x
normalized earnings.
But what does a P/E ratio actually tell us?
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The market’s long-term average P/E multiple tells us that if you buy the market at an
average price, you should expect long-term average returns. If you buy the market at
a lower price, you’ve historically earned higher than average returns. The reverse, of
course, is also true. This is common sense.
With a long enough time horizon, we know this works if you are buying “the market” . .
. but what about buying individual businesses?
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How do we know the “right” price?
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Let’s play a little game. We have three businesses here. An investment bank. A
technology company. And a mature biotech firm.
They all trade around the same multiple of earnings. They have very different
economics. What does the P/E multiple tell you? Which of these businesses is cheap?
Which is expensive?
The point is, we need more information. A low P/E isn’t always cheap. And as we’ll see
in a moment, a high P/E isn’t always expensive.
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Let’s try another one. I’m going to give you a statistic, and you tell me which business
is the better value.
• PE
• Dividend
• Growth
OK. What are we missing? What information do we need to assess the value of these
businesses.
Would this change your opinion?
It should. Company A should trade at about 7x all else being equal. Company B – about
16x. Why? Good question. Let’s have a look.
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Common yardsticks tell you little about valuation. But they make great shortcuts for
lazy investors and good material for talking heads. But as we’ve seen, P/E’s tell us little
about value. In order to truly understand what something is worth, we need to
understand two variables. Cash in. Cash out. That’s it.
Most investors have a tendency to focus on the “cash out” – this is the fun part. It’s
what managements boast about in earnings releases. But how often have you seen a
management team tell you about the massive investment required to generate that
cash. The “cash in” is just as important!
Here’s a classic example:
Berkshire bought See’s Candy for $25 million in 1972. Its sales were $30 million. Pre-tax
earnings were less than $5 million. The capital required to run the business at the time
was $8 million.
From 1972 to 2007 See’s sales grew to $383 million. Pre-tax profits grew to $82 million.
And the business only required an additional $32 million in capital. That additional
capital generated $1.35 billion in cumulative pre-tax earnings.
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See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds. That’s a
growth rate of about 2% annually. Yet the business created tremendous value. How?
Because it generated high returns on invested capital and required little incremental
investment.
Growth creates value only when a business can invest at incremental returns higher
than its cost of capital. The higher return a business can earn on its capital, the more
cash it can produce, the more value is created.
Over time, it is hard for investors to earn returns that are much higher than the
underlying business’ return on invested capital.
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This chart illustrates the relationship between a firm’s growth rate, its return on capital
and its price-to-earnings multiple.
There are three takeaways:
First, a company earning its cost of capital will trade at “the commodity multiple”
irrespective of growth (more on this in a moment). You can visualize these companies
on a treadmill: they can speed up or slow down but it makes no difference; they aren’t
going anywhere. Companies not earning above their cost of capital must figure out
how to increase returns before they worry about growth.
Second, growth is good for companies generating returns in excess of their cost of
capital. In this case, faster growth translates into higher multiples. The value of high
return companies is very sensitive to changes in growth.
Finally, companies that earn below their cost of capital destroy shareholder value. Not
good.You’d be surprised how many fit this bill.
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So, we know that multiples alone don’t give us an indication of value.
And growth rates can be misleading without additional information.
So how do we know if something is cheap?
How do we find 50 cent dollars?
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Let’s make this as simple as possible.
We can break down the value of a firm into two components:
1. Steady state value
2. Future value creation
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Steady state value is far easier to estimate so we’ll start here.
A company arrives at its steady-state value when its incremental investments earn the
cost of capital. Think back to the prior chart. A company that borrows at 8% to invest in
projects which generate an 8% return on that capital is not creating value for
shareholders.
Note that this discussion is independent of growth. A company can continue to grow
even while it invests at the cost of capital.
It just won’t create value. So it should trade at its steady-state valuation.
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We can convert the steady-state value to a steady-state price-earnings multiple by
inverting the cost of equity. For example, an estimated 8% cost of equity translates
into a steady-state price-earnings multiple of 12.5 times.
The chart here plots this multiple over time. Let’s think about what it tells us.
1. Simplistically, if a stock trades above 12.5 times current earnings, we can assume
that the market expects it to create shareholder value;
2. Conversely, if the stock trades below that multiple, the market is assuming no
value creation.
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There are no guarantees in this business. But mean reversion comes close.
Capitalism all but guarantees that competitors will assault any business earning excess
returns.
The majority of businesses are average and average businesses ultimately see high
returns revert to the mean . . . toward the cost of capital.
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Consequently, a company’s price-earnings multiple will also migrate toward the steady
state over time.
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Let’s consider an example.
For many value investors the tech sector gets put in the too hard pile. And for good
reason. This cartoon is a great example of how I imagine most of us feel when
analyzing the sector. Change is occurring far more rapidly than ever before. As a result
forecasts are far more difficult to make a few years into the future, let alone into
perpetuity. Today’s dominant firms can be supplanted overnight.
It is very easy to get lost in the details. But we can use “good old regular data” to break
the problem down.
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Sometimes, Mr. Market makes our job easier.
Because at a low enough price, the analysis becomes much simpler.
Instead of obsessing about “future value creation” we can focus on a firm’s steady
state value and if we can buy a business at or below steady state value, we don’t need
much to go right to earn good returns.
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To estimate steady state value, we don’t even need to forecast.
So why not just look for stuff trading below steady?
This is what some would call “Cigar Butt” investing.
The problem is “stuff” is rarely stable.
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The concept of steady state useful. But it is also very deceptive.
Equilibrium itself has rarely been observed in real life . . .
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Investing is supposed to look like this.
Price is volatile (blue line). It changes far more often and more dramatic than actual
changes in business value (dotted red line).
So value investing boils down to buying something for less than its worth and waiting
for the lines to converge.
The danger when picking up cigar butts, is you can get burnt went business value turns
out more like this (solid red line).
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We know from experience.
Don’t confuse cheap with a good deal.
If you buy a bad business at a low enough price, an occasional positive surprise can
give you the chance to sell at a decent profit, even if the long-term performance of the
business is terrible.
“A cigar butt found on the street that has only one puff left in it may not offer much of
a smoke, but the “bargain” purchase will make that puff all profit.”
This type of investing can get you burned. First, the original “bargain price is often not
the “steal” you thought it was. Second, even when you do buy at a cheap price, your
margin of safety is gradually eroded by the poor returns of the business.
Time is the friend of the wonderful business; the enemy of the mediocre.
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Simply stated, there are two ways to behave as an investor.
We just covered the first. Buy something cheap, sell at a profit, and repeat. Everybody
does this to some extent. But it requires making hundreds, maybe thousands of good
decisions over the course of one’s career.
A good chunk of Berkshire’s investment success can be attributed to identifying onefoot hurdles that Charlie and Warren could step over, rater than an ability to clear
seven foot hurdles.
In one’s investment lifetime, it’s just too hard to make hundreds of smart decisions.
Better to adopt a strategy that requires being smart only a few times. Better to focus
on those one-foot hurdles.
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The second way to invest just requires one decision: buy a great business. It appears
far simpler, but is far more difficult to execute.
Almost no one does this despite the obvious advantages. Lower transaction costs.
Lower taxes. Fewer decisions. And most importantly, I would argue a far higher quality
of life.
But it requires the right investor base. And it requires patience. Lots of patience.
As the French mathematician and philosopher, Blaise Pascal, once said: “All of
humanity’s problems stem from man’s inability to sit quietly in a room alone.”
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Let’s assume for a second that we have the patience to sit quietly in a room and think.
What makes a great business? Warren Buffett has taught us that a truly great business
must have an enduring “moat” that protects its high returns on capital.
Some companies, for one reason or another, are able to repel competition and
maintain above average returns on capital for longer than average.
They possess qualities that make it difficult for competitors to enter. As a result, they
fend off mean reversion that otherwise squeezes returns on capital toward the
average.
In other words, future value creation is a much bigger piece of the “firm value” pie for
these gems. So if we want to invest making “one decision” we should spend the great
majority of our time understanding what drives future value creation.
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There are three key drivers of value creation:
1. The spread between the return on capital and the cost of capital;
2. The magnitude of the investment; and
3. How long a company can find investments at a positive spread.
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The first two drivers dictates the rate of growth.
The higher return a business earns on the capital that is invested in the business, the
more cash it will produce and the more value it will create.
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While the first two factors are easily quantifiable, the third requires more judgement.
The final component of future value creation, the competitive advantage period, is
effectively how long a company can find attractive investment opportunities.
This period is closely related to a company’s sustainable competitive advantage. It’s
why “the moat” is so important.
I think this chart does a better job of highlighting the value of a moat better than any
other. The blue bars represent the hypothetical cash flows of a “no moat” business. The
orange bars go out a bit further – you can think about this as an average business. A
wide moat allows a business to generate cash flows much further into the future.
Which business would you rather own if you were given just one decision to make over
your investment career?
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The anticipated period of value creating investment opportunities is different for
various industries.
Industries with rapid reversion to the mean deserve lower price-earnings multiples
than industries with slower rates of reversion.
We can see the impact on intrinsic value here.
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Let’s walk through an example together.
Few would argue the strength of Wal-Mart’s moat since Sam Walton opened the first
Wal-Mart store on July 2, 1962, in Rogers, Arkansas. Well, to be fair, perhaps Bezos
would take issue with just how unassailable that moat remains today.
But how many of you recognize the name Sol Price? If Sam Walton was stealing his
ideas, maybe those ideas are worth a look.
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Price launched the first FedMart in 1954 and founded Price Club in 1976. The company
went public in 1980 and merged with Costco in 1993.
Costco is a company we have long admired and followed, but until recently, have never
gotten "into the weeds" on as a potential investment. The stock has always “appeared”
too expensive.
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Over the past two decades COST has generated a cumulative return to shareholders of
1790% vs a 337% gain in the S&P. So it’s probably safe to say that COST was NOT
overvalued over this period. Because buying overvalued stocks should produce
suboptimal returns.
Maybe COST deserves to trade at 25x earnings as Munger has suggested. Let’s
explore why this may be the case.
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Here’s Munger on COST over the years.
The winning system goes almost ridiculously far in maximizing and or minimizing one
or a few variables - like the discount warehouses of Costco.
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Let’s take a look at that “winning system”
Here’s a look at WMT “everyday low prices”
And this is Costco’s mark up . . . Way down here.
A Costco membership costs about $45 per year and in exchange for that price,
members receive the benefit of shipping at Costco warehouses. People shop at Costco
because goods are priced at a fixed 14% mark up over cost.
That’s it: the consumer pays no more than 14% over what the company paid, period.
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Again.
Here are WMT’s operating costs.
And here are Costco’s operating costs.
Costco’s operating costs are extremely low. This makes life incredibly difficult for
competitors (even Wal-Mart) to compete as they can’t make money pricing goods as
low as Costco.
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In order to make money, selling stuff at 14% above cost, revenues need to be very
high.
Costco’s competitive advantage is derived from what management does with this
revenue advantage – it passes efficiency gains back to the consumer to drive more
revenue growth.
Customers benefit from the firm’s expansion which drives further declines in supplier
prices. As a result, revenues per square foot at Costco are unparalleled in retail.
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So, in a nutshell, that’s the model.
Let’s think about what it’s worth.
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Over the past two decades, Costco has traded on average at 24x forward earnings
estimates. The stock has always looked expensive.
But is it?
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On reported FY16 numbers, we estimate steady state value for COST around $74 per
share, nearly half of COST’s recent stock price.
However, we think this estimate is conservative due to a number of factors temporarily
depressing current profitability.
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COST stores are immature. Newer stores are only generating $80 – $100 million in
annual sales vs $160 on average and $180 for stores open more than ten years.
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Assuming that new stores eventually ramp up to the $162 average per store implies
that newer stores are under-earning to the tune of $8.7 billion. Note that these sales
should also generate higher margin for COST allowing the company to better leverage
its fixed cost base.
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If we consider the likelihood for a near-term hike in membership fees and the
maturation of the existing store base, normalized steady state value increases to $80
per share, approaching 60% of today’s value.
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Since COST always screens expensive, we considered what good entry points looked
like in the past. One way to think about this is to examine the ratio of steady state
value to the stock’s 52-week low in each calendar year.
From this, we can see that investors were given good opportunities to buy COST when
steady state value represented roughly three-quarters of its price from 2002-2004, and
again in 2006, 2009 and 2011.
Based on FYE16 numbers, a similar entry point for COST would approximate $100 to
$110 per share, assuming a 70% - 80% ratio of steady state value to price. The same
analysis applied to our normalized numbers would imply a price of $110 to $130 per
share.
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Now, we’ll consider the potential for future value creation at COST. Recall that future
value boils down to three factors:
1) How much management invests;
2) What spread that investment earns relative to the cost of capital; and
3) How long COST can find value-creating opportunities.
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Costco is profitable enough to self-fund growth and has done so throughout its history.
As a result, growth has been more measured in pace despite Wall Street’s cries for
“bigger, faster, stronger” – more measured also means more sustainable as COST is
not dependent upon capital markets to fund expansion.
Capital expenditures have doubled over the past ten years from $1.3 to $2.6 billion in
FY16. The company could easily finance higher growth than the planned 5% square
footage additions for FY17. Last year’s $2.6 billion in gross capex, implies COST
invested roughly $1.4 billion in new store growth (assuming maintenance capex
approximates depreciation) – at $50 million per store, this spend is in line with FY16’s
28 new stores. We estimate gross cash flow closer to $4 billion .We err on the side of
caution and assume a $3 billion investment rate in estimating future value creation.
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The knock on COST boils down to the perception that employees and customers are
treated better than shareholders. There is some truth to this statement, but this
culture is also the primary driver of the company’s moat. ROIC has increased in recent
years – the five-year average stood around 13% as of FY16 vs the company’s long-term
average ROIC of 12%. Despite the recent increase, we believe normalized returns
are greater than indicated by reported financials. Assuming the existing store base
reaches maturity, we estimate normalized ROIC closer to 16%.
Note that returns on incremental invested capital remain far greater than the
company’s cost of capital. In other words, as COST has increased their investment and
unit growth over the years, the company has continued to earn attractive returns
despite the greater level of investment.
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Assuming normalized returns closer to 16%, the company’s earning multiple should
fall somewhere in this range, depending one’s expectations for growth.
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Management appears very comfortable with the current pace of square footage
growth. Assuming 4% - 5% annual square footage growth (which approximates store
openings), total store count would be 1050 to 1150 stores in ten years.
For perspective, consider that HD and LOW have roughly 4,000 combined stores in the
US alone. And COST has a lot of room for expansion abroad.
Bulls claim that COST could reach 2000 stores split between the US and abroad. This
would imply a twenty-year runway for growth at the current pace. This seems like a
pretty good confidence interval for our competitive advantage period below – i.e. ten
years at the low end and twenty at the high end.
As a point of reference, the market-implied competitive advantage period averaged
about 8 years from 1976-2007, with a span of roughly 5 years for very competitive
industries (i.e. technology) to 15 years for industries that are more stable (i.e.
consumer, healthcare). COST is certainly at the more stable end of this spectrum.
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Putting it all together, future value for COST might be in the area of $40 – $80 per
share. Adding our earlier $80 - $90 estimated steady state value would put fair value in
the range of $120 to $170.
Bottom line: high quality businesses rarely go on sale. We’d be very happy to own
COST at a 25% discount to our estimate of intrinsic value or roughly $100 per share.
We’d note that this price is also consistent with prior “good entry points” for the stock
based on our steady state analysis.
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We believe COST would represent a very attractive investment at $100 per share and
would consider establishing a position at slightly higher levels (good businesses rarely
get as cheap as one might hope).
Sales and earnings growth have consistently compounded around 10% annually. We
believe intrinsic value will continue to growth at least this fast going forward
(assuming a 100% reinvestment-rate, the company has the potential to grow faster
given its higher level of ROIC).
Assuming mid-single digit comps and store growth, we would expect an investment in
COST at our target entry price to generate ~20% annual returns.
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We are not there yet.
Maybe we’ll get there. Maybe we won’t.
We can’t control the timing, but we can control the price we pay.
And if you were wondering, it would take about ten years to make a dollar out of 15
cents assuming a 20% CAGR.
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