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Here is a short technical note Warren Buffet's 1981 formula. I came across this from the Money Magazine, June 2009 issue. Hence I do not guarantee that Money Magazine's content is correct or even if this is truly a formula used by Warren Buffet. However, after analysing the formula for myself, I see the merit of it. In fact I will be including this so called Buffet's 1981 formula in my future article which explains my 3-fold Valuation method to decide on buying stocks.
The Buffet's 1981 formula is this:
Value = (ROE / Required Return) x Equity Per Share
where
ROE = Rate of Return of the Company of interest (in %). This can be calculated using Net Profit After Tax divided by Total Equity.
Required Return = Pre-tax required rate (in %) that you would like to get for your investment. For example you may wish to use a long term deposit or long term government bond rate for this.
Equity Per Share = the Equity of a company divided by the total number of shares. These figures can be obtained from the company's annual reports.
This is a quick and simple way to value a company, to see if the company is priced more or less than it is of value to you. Your input comes into the Required Return where you can choose how much you expect from this investment.
Then the formula will produce the value of the company per share. Simply compare this with the current price to see if it is over or under priced. Using this model, a company that can generate a higher return on equity is worth more than one that cannot. Also a company that generates a high ROE and is able to retain all of its earnings and continue to make higher returns, is worth more than a business with the same ROE but forced to pay most of its earnings out as dividends.
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4 comments:
Interesting post. I noticed that Total Equity gets used twice in the formula, so I figured out a way to simplify it for quicker calculation, see below:
Value = (ROE / Required Return) x Equity Per Share
= ((Net Profit After Tax / Total Equity) / Required Return (i.e.long term government bond rate)) x (Total Equity / Shares Outstanding)
= ((Net Profit After Tax / Total Equity) x (Total Equity / Shares Outstanding)) / long term government bond rate
= (Net Profit After Tax / Shares Outstanding) / long term government bond rate (in decimals i.e. 0.0453)
This way you only have to know 3 things that are easy to lookup: Net Profit After Tax, Shares Outstanding & long term government bond rate.
Thanks Dave,
Very good observation there. Your formula is more convenient to use since the quantities are readily obtained from financial reports.
Cheers!
www.investutils.com has a good tool for buffett and Graham intrinsic value formula calculations.
Hello,
Thanks for this post. I have a couple points.
First, I'd like to say something about Dave's post above. While the algebra is lovely and thoughtful, it's important to keep in mind that ROE must be calculated with the year's average equity in mind. So, if you need the average equity of a company from 2010, you need to average the end-of-year equities of both 2010 and 2009. Thus, if true ROE is calculated with a year's average ROE and the latter half of the equation is measuring the most current equity, you cannot do any algebraic cancellations like Dave suggests.
Secondly, I tried this formula out on a deal that Buffett described in this interview: http://www.youtube.com/watch?v=Lc791is6X0o.
He said that when he bought shares of PTR (circa March 2003), he valued the company around 100 billion while it was selling for around 35 billion in the market. If he was only looking at PTR's 2003 annual report, he saw only 2002, 2001, and 2000 income and balance statements. On this statement was the current information: 2002 Net Income=5,668; 2001 Net Income=5655; 2002 equity=47,374; 2001 equity=44,797; 2000 equity = 36,412. The average bond rate during those same three years was around 6%. All this in the equation: ((2002 Net Income/((2002+2001 equity)/2)+2002 Net Income/((2002+2001 equity)/2))/2)/(Bond rate)*2002 equity=
103535.51 billion.
So it looks like this equation isn't far off from how Buffett calculates intrinsic value - if indeed he takes the average bond yield over the period of his ROE calculations.
Buffett also said he sold the company back into the market when he and Munger thought PTR was selling at its intrinsic value - 275 bil.(http://tinyurl.com/6bdxl9m). Using the same equation, using the average ROEs from 2006 back to 2001, a valuation of 275 bil. would only work if the bond price was around 6.2% - which it wasn't. So, it seems as though there was more thought put into the matter by Munger and Buffett.
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