Thursday, April 17, 2008

Important realisation

Buffettology is really a good book. I think I'm going to get this book for sure, as I think I'll re-read 12 times. I made an important realisation when I'm a quarter into the book. This realisation is handy to quickly get a rough value of a business entity that sounds promising. First of all, I need to assume 2 things:
1. When I buy shares of a company, I am a partial owner of the business entity, hence I'm entitled to get a part of the earnings generated by the entity. Hence, EPS (earnings per share) of the company is also my earnings, though the earnings can either be put back into the business to generate more future earnings, or it can be distributed to shareholders like me as dividends.

2. The market will someday price the company at the right value.

We can calculate the earnings yield of a business, which is also the inverse of the P/E ratio. Supposing that the PE of a company is 12, then the earnings yield will be 8.33% (1 / 12 = 8.33%). This will be like a bond where you pay the price of the stock and expect to get an earnings of 8.33% with 2 major exceptions. First is that you might not get the principal back at the end of the period - which is both a good or bad thing because you might get more or less than the principal you put in. Second, the returns of 8.33% per year can vary - it can go up or down.

Of course, when we're investing, we will want the earnings per year to go up. Based on assumption 2, this means that the price will also go up. Conversely, if earnings go down, the market will also price the stock accordingly.

Let's say I want to get a returns of 15% per annum. Let's say the EPS (forward) is \$0.23, it will mean that I will have to buy at \$1.53 (0.23/0.15 = 1.53). If I pay:

\$2.00, my earnings yield becomes 11.5%
\$1.00, my earnings yield becomes 23.0%

In other words, the lower the price, the better the yield becomes. For me, I'll be happy with a earnings yield of 15%, which means a PE of 6.7 (1/0.15 = 6.7). If I buy a company with PE greater than 6 or 7, that will mean my earnings yield becomes lesser than 15%! That's an important realisation!

Of course, this is a simplistic case. What happens if the earnings keep on increasing? That will mean that my yield will increase and increase, even though the price of the stock remains the same! I finally understand why price is irrelevant, except when you're going to buy or sell, because earnings is what matters at the heart of this. But if we can assume assumption 2 to be true, then eventually the price of the stock will also increase as long as the earnings do too.

Okay, what happens when company gives out dividend? If profits earned are either put back into the business to let it grow or are given out to shareholders are dividend, it will only mean that when dividends are given out, future earnings will not grow to its greatest potential. Responsible companies that have no confidence of being able to maintain or generate higher earnings will give out dividends to shareholders. For those companies that can generate higher returns, why ask for dividends? Can shareholders generate returns higher than the ROE of the company themselves?

I'd rather let the company compound the earnings for me.

A few things must be put in place here.

1. Companies must be capable and responsible to handle the earnings efficiently. Otherwise, mismanagement of earnings into less worthy avenues will erode the value. Hence, an efficient, capable and candid management is crucial.

2. Inherent economics of the business must be sound. Some business/industry are just better than others.

3. Companies must have an economic moat so that their earnings will not be eroded by future and present competitors. This will ensure that earnings are high, consistent and growing.

This is going to be an exciting journey :)

musicwhiz said...

Hi LP,

Yes, those principles are mentioned in other books written on Buffett as well, and stand as important concepts with regards to value investing.

For me, still slowly reading through Phil Fisher's book. It's good that you have time to read so many books; in time you will become an excellent value investor.

la papillion said...

Hi mw,