Warren Buffett's Initial Rate of Return on a Stock, Initial Rate of Return on a Business

If you buy a stock for $100 and it has net per share earnings of $10, your initial rate of return is 10%. The same calculation holds true for a small business: if you purchase a small business for $100,000 and it has average yearly earnings of $10,000, your initial rate of return is 10%.

Now, will these rates of return continue? It all comes back to the predictability of earnings and Warren Buffett has found that the businesses with the highest levels of predictability are the ones with a consistent earnings track record.

This …				Not This …
Year	EPS			Year	EPS
1999	$1.30			2001	($0.36)
2000	$1.48			2002	$0.04
2001	$1.60			2003	$0.58
2002	$1.23			2004	$0.00
2003	$1.77			2005	$0.96
2004	$2.00			2006	$4.04
2005	$2.04			2007	$0.40
2006	$2.16			2008	$0.57
2007	$2.57			2009	$1.95
2008	$2.49			2010	$3.85
2009	$2.93			2011	$7.88

Additionally, Warren Buffett invests in companies with the ability to grow their earnings. Thus, in the world of Warren Buffett, the initial rate of return is growing based on the company’s earnings growth rate. This can be found by using a historic earnings number as a present value, a current earnings number for a future value, the number of years in between and by solving for the interest rate.

For example, in 2000 and 2010 McDonald’s had earnings per share of $1.46 and $4.58 respectively. The inputs in our handy, dandy BAII Plus financial calculator are as follows:

PV = $1.46

FV = $4.58

N = 10

CPT I/Y = 12.11

Thus, on average, the 10 year historic earnings for McDonald’s have grown at a rate of 12.11%. What this means is that with McDonald’s at a current price of $81.14 and recent earnings per share of $4.58, if the stock were purchased today, the initial rate of return will be 6% ($4.58/$81.14) and this rate of return, in theory, will be growing, at 12.11% a year. So, by the end of year 1, the earnings should grow to $4.85. At the end of year 2, $5.15, year 3, $5.45, so on and so forth. So, by the end of year three, the rate of return on the initial investment will be 7%. ($5.45 / $81.14).

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