Buffettology
November 7, 1998
Friday's close: Dow 8975, S&P500 1141, NASDAQ 1856
November 1: Dow 8592, S&P500 1098, NASDAQ 1771
July peak: Dow 9337, S&P500 1186, NASDAQ 2014
Well I've certainly had my comeupance in this initial foray into writing
about the market: I've been uniformly bearish and the market has gone
straight up! In fact, the Dow is now within 4% of its all-time high.
But I can't be too unhappy - I'm still mostly long stocks. And we still
are waiting to see if this is a bear trap, or a genuine continuation of
the long running bull market. If the Dow closes above 9337 I'll change
my tune and become bullish. Unless and until that happens, I'm sticking
with the Dow Theory bear market signal.
Warren Buffett's former daughter-in-law, Mary Buffett, has written (with
co-author David Clark) a wonderful book called "Buffettology: The Previously
Unexplained Techniques That Have Made Warren Buffett the World's Most Famous
Investor." It explains Warren Buffet's approach to the market in
quantitative terms, and how it differs from Benjamin Graham's old-time
value approach.
Buffett elaborates an interesting formula for predicting future stock
prices (well not quite a formula, but I have turned it into one). It works
like this: Start with the stock price, earnings, dividends and book value
(Book value is assets minus liabilities divided by the number of shares).
The ratio of earnings to book value gives a value for return on equity, ie.
what kind of return does the company get for the money it has invested in
the business. We can project next year's earnings by adding this years
retained earnings (earnings minus dividends) to book value and then apply
our established ROE value to see what return we'll get from this, ie. next
year's earnings. Assume the current payout ratio (dividends divided by
earnings) continues to apply and you can project future dividends too.
Run this out five years or so and you can also project the future stock
price by taking expected earnings at that point and multiplying them by
expected P/E ratio (which I just take to be today's P/E ratio).
From all this projecting, one can figure one's expected 5 year gain, both
from capital gains and dividends, allow for taxes, and compute an expected
rate of return on one's investment. Here's what you get by applying this
to the 30 Dow Jones Industrials:
Symbol Price Earn Div Book 5yr Price Divs AfterTax 5yr RR
KO $73 $1.51 $0.60 $3.24 $322.36 $9.35 $205.19 30.7%
IBM $150 $6.19 $0.88 $19.43 $639.22 $13.37 $399.54 29.7%
CAT $49 $4.47 $1.20 $14.07 $171.68 $15.93 $107.86 26.2%
PG $90 $2.63 $1.14 $7.74 $258.83 $13.25 $143.14 21.0%
ALD $42 $2.21 $0.60 $8.59 $117.73 $6.85 $64.77 20.5%
UTX $99 $4.86 $1.44 $18.82 $269.60 $16.14 $146.33 19.9%
MRK $145 $4.16 $2.16 $11.44 $381.25 $23.65 $203.42 19.2%
AXP $97 $4.50 $0.90 $20.35 $257.76 $9.92 $134.66 19.0%
UK $45 $3.94 $0.90 $18.26 $113.37 $9.58 $60.54 18.6%
MO $53 $2.80 $1.76 $6.59 $127.68 $18.19 $70.84 18.5%
JNJ $82 $2.62 $1.00 $9.90 $203.57 $10.54 $103.69 17.8%
WMT $71 $1.75 $0.31 $8.68 $178.33 $3.29 $87.87 17.5%
T $64 $3.49 $1.32 $14.70 $146.21 $13.18 $73.81 16.6%
MCD $69 $2.28 $0.36 $12.93 $158.35 $3.61 $73.68 15.6%
GE $90 $2.72 $1.20 $10.94 $196.45 $11.63 $92.26 15.2%
HWP $63 $2.84 $0.64 $16.70 $132.38 $6.05 $59.19 14.2%
AA $79 $4.93 $1.00 $31.43 $160.19 $9.25 $70.59 13.6%
S $47 $2.71 $0.92 $15.76 $89.62 $8.18 $39.09 12.9%
GT $56 $3.49 $1.20 $23.54 $97.75 $10.09 $39.55 11.3%
CCI $46 $2.45 $0.72 $18.16 $79.41 $6.01 $30.39 10.7%
GM $67 $3.98 $2.00 $23.96 $107.89 $15.99 $42.46 10.3%
XON $74 $2.99 $1.64 $17.73 $114.93 $12.82 $40.57 9.1%
MMM $81 $3.25 $2.20 $14.96 $121.69 $16.85 $42.83 8.9%
DIS $30 $0.89 $0.21 $9.28 $45.86 $1.63 $13.68 7.8%
JPM $104 $6.79 $3.80 $62.39 $137.73 $26.94 $43.42 7.2%
CHV $83 $3.67 $2.44 $27.01 $108.42 $17.16 $30.80 6.5%
DD $62 $1.82 $1.40 $10.60 $78.28 $9.64 $18.91 5.5%
IP $46 $1.04 $1.00 $29.32 $46.38 $6.03 $3.98 1.7%
BA $42 $0.18 $0.56 $12.95 $35.13 $3.03 -$3.65 -1.8%
EK $78 $1.16 $1.76 $11.06 $55.82 $8.73 -$12.42 -3.4%
Interesting, isn't it? Buffett's long time favorite stock, Coca-Cola, comes
out on top. Boeing and Kodak are projected to lose money. Both high P/E
stocks like Coke and low ones like Caterpillar appear in the top slots.
Having a low book value helps - it implies that you can make a lot with
a little more capital. Note that you can really only apply this kind of
formula to an established company with positive book value and positive
earnings, so we won't be applying it to those Internet darlings.
The obvious caveats apply: Buffett's approach is a lot more than just
applying a formula, and Mary Buffett may have imperfectly understood Warren's
methods. Still, it's a useful tool to apply to mature companies.
Richard Gillmann (richard@nwfolk.com)
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