“There is general agreement, at least among corporate finance theorists that the objective when making decisions in a business is to maximize value.”[i]
Alternative Objectives
- Maximize Market Share
- Profit Maximization Objectives
- Size/Revenue Objectives
Maximize Market Share
The bottom line in market share growth is that the management of the company values market share growth investments over investments that increase market share less.
Market Share: “The percentage of an industry or market’s total sales that is earned by a particular company over a specified time period.”[ii] Increases and decreases in market share is a sign of relative competiveness of a company’s products or services and allows a company to realize economies of scale: operational costs are fanned out over a greater breadth of revenue and ultimately, profitability should increase.
Profit Maximization Objectives
Profits can be measured thus, just as in maximizing the stock price, profit maximization is something that management can easily keep an eye on. The rationale behind profit maximization is that “higher profits translate into higher value in the long run” [iii] which is true in an earnings valuation model such as Warren Buffett’s:
How Warren Buffett Determines the Price
Now let us examine how the big chief determines price. Again, leading up to this point on our “Building a Small Business Warren Buffett Would Love the Flowchart, ™” we have defined a consumer monopoly company that generates strong and consistent earnings, with a high return on equity and the ability to retain earnings. At this point on the map we are concerned with the retained earnings adding value to the small business. (See Figure 5.1.)
Warren Buffett invests in businesses that, via the ability to consistently retain earnings at a high return on equity, will exponentially grow in value over time. In order to build a business that Warren Buffett would love, and create wealth, you must have the ability to increase the value of your business over time and use Warren Buffett’s methodology for determining price in order to measure your business’ value.
What follows is how Warren Buffett uses the return on equity of a business along with the current per share shareholder’s equity value in order to project a future trading price and rate of return. (See Table 5.5.)
Table 5.5 Determining Value Using Equity Share Value [table in text]
| | |||
| | 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 Shareholder’s 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 Company’s Shareholder's Equity | $ 75.82 | $ 175.37 | $ 43.30 |
| Projected Future EPS | $ 16.03 | $ 56.50 | $ 3.94 |
| Average 10-year 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 (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, since they are paid out and truly play no part in the future compounding of the equity.
Next, we find the total shares outstanding and total equity in the company from the balance sheet (easy to obtain from Morningstar.com for public companies) and divide the total equity by the number of shares outstanding in order to determine 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 that each shareholder can technically claim per share.
Our next step is to determine the 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 BAII Plus business calculator and by plugging in, in the case of McDonald’s, 10 for N or the number of years, 18.1 percent 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 percent 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 Mc-reliability going forward 10 years if some degree of consistency was not present in their history.)
From this result, we can use the full 21 percent return on equity for McDonald’s, multiplied by the future $75.82 equity share value, in order 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 for this information) 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 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 it is 15.52 percent.
Projected Future Trading Price: $320.64
Current Trading Price: $75.78
Projected Annual Compounding Rate of Return: 15.52%
Always remember as well that the price you pay determines your rate of return, similar to the old adage for buying a house: “You make your money when you buy.” Similar, yet different. So, if you waited to buy McDonald’s at a price of $65, then your rate of return would go up to 17.3 percent.
Is This Good or Bad?
You tell me. In a mutual fund I can expect to achieve a 10 to 11 percent return a year over the long haul. CDs and T-bills are paying between 3 and 5 percent, and my fourplex averages about a 10 percent rate of return. In my opinion, 15.52 percent is a great return. Coke and Disney have projected returns of 34.88 percent (whoa!) and 8.64 percent respectively.
Is This Reliable?
You’ve seen the reasoning for picking companies that have reliable historic indicators: a consumer monopoly; staple, invaluable branding; a strong track record of consistent earnings with a consistent high return on equity. All roads lead to Rome, and in this case, the roads have led us here (in a buggy with Warren Buffett in the passenger’s seat), 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 realm of “if it sounds too good to be true.” Coke has a 34.88 percent projected return—good golly! This sounds really great, but let us take a look at Buffett’s second valuation technique and see if we can get some corroboration around this spectacular return.
But first …
The problem lies in making short-term decisions that increase current profitability at the expense of long-term profitability. For example: if we own a taxi-cab company and forego the expense of changing the oil in order to ratchet up the near-term profitability. We may pocket more profit but down the road, those engines are going to blow up and cost us much more.
Size/Revenue Objectives
This is the Alexander the Great, “empire building” objective. The more the merrier, correct? Under this objective CEOs gobble up as much corporate real estate possible with no clear strategic imperative. Now, in the kingdom of Warren Buffett, when two consumer monopolies such as Fruit of the Loom and Russell Athletics marry, the combination can have synergistic, positive results.
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