How Warren Buffett Determines the Price of a Stock

How Warren Buffett Determines the Price

Using Equity Share Value
	MCD	KO	DIS
Average ROE	21.1%	32.2%	9.1%
Average Annual Dividend Yield	3.0%	3.0%	0.9%
True Equity Rate of Growth of Shareholder's Equity	18.1%	29.2%	8.2%
Total Shares (in millions)	1,080	2,295	1,899
Total Equity (in millions)	15,458	31,003	37,519
Per Share Shareholders Equity Value	$ 14.31	$ 13.51	$ 19.76
N	10	10	10
I/Y	18.1%	29.2%	8.2%
PV	14.31	$ 13.51	$ 19.76
CPT FV - Future Per Share Value of Co's Shareholder's Equity	$ 75.82	$ 175.37	$ 43.30
Projected Future EPS	$ 16.03	$ 56.50	$ 3.94
Avg. 10 yr. P/E	20	23	25
Company's per share projected future 2020 trading price	$ 320.64	$ 1,299.60	$ 98.41
PV (company's current price)	$ 75.78	$ 65.22	$ 42.97
FV	320.64	$ 1,299.60	$ 98.41
N	10	10	10
CPT I/Y (This is the company's projected annual compounding rate of return.)	15.5%	34.9%	8.6%
Projected Future Trading Price of the Company's Stock	$ 320.64	$ 1,299.60	$ 98.41
Current Trading Price	$ 75.78	$ 65.22	$ 42.97

Explanation

First, any yield attributed to the payout of dividends is subtracted from the average, 10 year return on equity in order to reach the true rate of equity growth of shareholder’s equity or in other words, the true return on equity. The reasoning behind this calculation is to exclude dividends from our subsequent compounding calculations. We do not want to include dividends as they are paid out and play no part in the future compounding of our equity.

Next we find the total shares outstanding and total equity in the company off the balance sheet (easy to obtain from Morningstar.com) and divide the total equity by the shares outstanding in order to figure out the per share shareholder’s equity value. This figure is not necessarily the share price but it represents the amount of equity in the company each shareholder can technically claim per share.

Our next step is to determine future value of the company’s per share equity value, using the true rate of growth of our equity, and the current per share equity values, in this case, $14.31, $13.51 and $19.76 for McDonald’s, Coke and Disney respectively. These calculations can easily be computed using a handy-dandy, BAII Plus business calculator and plugging in, in the case of McDonald’s, 10 for N or the number of years, 18.1% for I/Y or the interest rate and $14.31 for the present value. Hit “compute”, “FV” to find the future value and you should get $320.64 for McDonald’s. What this tells us is that if McDonald’s continues to generate an average 18.1% return on equity, in 10 years the equity value per share should grow to $75.82. (See why predictability is so important? We could not count on any reliability going forward 10 years if some degree of consistency was not available in the historics.)

From this result, we can use the full 21% return on equity for McDonald’s, multiplied by the future $75.82 equity share value to determine that the company should have $16.03 in earnings per share. (Remember, the “return” portion of return on equity equates to earnings. By simply multiplying the historic average return on equity by the future per share equity value, we should be able to determine the future earnings per share. We then multiply this result by the average 10 year historic price to earnings ratio (again, Morningstar.com is invaluable) in order to determine the theoretical, future share price. If Price divided by earnings results in the P/E ratio, then using some simple algebra, solving for P should give us the price.

Price / Earnings = P/E Ratio

Price / $16.03 = 20

$16.03 (Price /$16.03) = 20 * $16.03

Price = $320.64

Breaking out our handy BA II Plus calculator again, we plug in the current price of MCD, at the time of this writing $75.78, $320.64 for the future value, 10 for N or the number of years, and compute the I/Y which gives us the company’s projected annual compounding rate of return. In McDonald’s case 15.52%.

Projected Future Trading Price: $320.64

Current Trading Price: $75.78

Projected Annual Compounding Rate of Return: 15.52%

Is This Good or Bad

You tell me. In a mutual fund I would expect to achieve ten to eleven percent a year over the long-haul, cds and t-bill are paying between three and five percent, my four-plex averages about a 10% rate of return. In my opinion, 15.52% is a great return. Coke and Disney have projected returns of 34.88% (whoa!!) and 8.64% respectively.

Is This Reliable?

You’ve seen the reasoning for picking companies that have reliable historic indicators: a consumer monopoly, staple brand, a strong track record of consistent earnings, consistently high return on equity. All roads lead to Rome and this case, they have lead us here and this is how Warren Buffett determines the future value of a stock and his expected rate of return.

It is always nice to have some verification though, especially in the “sounds too good to be true” 34.88% projected Coke return. Let us look at Warren’s second, validating valuation technique.