CHAPTER 5
Buy Good Companies at Fair Prices

Growth Rates

In GuruFocus's DCF calculator, we assume that in the next ten years a company will grow as fast as it did in the previous ten years. But this will most likely overestimate the growth of the company, especially if the company was growing quickly. Applying a 20 percent growth rate cap reduces overestimation. For example, Priceline averaged 40 percent per year in EPS growth over the past ten years. But for the past five years, the growth rate slowed to about 25 percent. It seems reasonable to assume that it will grow at about 20 percent per year in the next ten years.

For the terminal growth stage, the growth rate of 4 percent per year is probably too low for companies like Priceline. This may underestimate its intrinsic value; 4 percent per year is slightly higher than the long-term inflation rate.

The effect of the growth rate on the value of the business is illustrated in Table 5.1. We assume that the company is earning $1 per share now. Its terminal growth rate is 4 percent. The discount rate is 15 percent. The duration of both the growth period and terminal period is 10. At different growth rates, as reflected in the first column of the table, the value is displayed in the last column.

Obviously, at a higher growth rate, the stock is worth more. If a company grows at 25 percent per year for the first ten years, then grows 4 percent for the next ten, its stock is worth about 30 times its earnings, as we can see from the table. This coincides with Peter Lynch's rule of thumb that a fair P/E ratio for a company is roughly its growth rate. Of course, the fair value calculation result is affected by the discount rate. If the discount rate is 12 percent instead of 15 percent, the values move higher and Lynch's rule of thumb would seem conservative. During Lynch's years at Fidelity, the interest rate was in double digits. The higher discount rate was justified.

Number of Years for Growth and Terminal Stage

The number of years in the growth and terminal stages that are used for calculation can also vastly affect the calculation results. The reasonable assumption for the number of years varies from business to business. If you have teenaged children, like I do, you have surely noticed how they liked Aeropostale T-shirts. The adolescent T-shirt chain store was unstoppable, growing at 50 percent a year in the early 2000s. Then it hit a wall. Its revenue started to decline in the early 2010s and its stock has since lost more than 99 percent. If we use the DCF model to calculate its intrinsic value in the early 2000s, it would be too generous to assume that it has 20 years of life remaining.

Heard of “live fast, die young”? This saying seems also applicable to the life of businesses. Yet the opposite is also true!

Just as Buffett said, for a business that operates in a fast-changing industry, either no action, or acting too slowly, or acting incorrectly can cost it its life. The businesses that have a long life expectancy are the ones that can sell the same products and services 5, 10, or 20 years from the present. The required change in the business is minimal, and that provides the opportunity to keep improving in making and selling its products while building a network effect, brand recognition, taste habits, and addictions.

Consider Coca-Cola. For more than 100 years, the company has been selling essentially the same soft drink it introduced in the late nineteenth century. The assumption of ten years in the growth stage and another ten in the terminal stage would drastically underestimate the intrinsic value of the company. Curiously, in 1985, almost a century after its debut, Coca-Cola tried to make changes to its product and invented a new formula called “New Coke.” But then it found that Coke drinkers preferred the “good old days” and were opposed to the new taste. The company gave in and returned to the old formula. With this lesson behind it, Coca-Cola will probably stay with the same formula for at least another century.

The number of years used in the calculation is how the economic moat is reflected on the intrinsic value of a business. With a wide economic moat, a company can protect its territory and maintain its profitability for the long haul. The number of years used in the calculation needs to be greater.

Another example is See's Candy. For all the future cash flow the company would generate, Buffett paid $25 million in 1972. Table 5.2 uses the real earnings numbers for See's Candy's from 1972 to 1999,³ except for the years 1973 to 1975, when Berkshire didn't disclose the earnings numbers. Instead, I assumed linear growth from 1972 to 1976. All the earnings after 1972 are discounted to the year of the purchase, 1972, with the discount rate of 25 percent a year. The last column shows the cumulative discounted earnings of See's from 1972 to the year calculated.

The reason I used a steep 25 percent discount rate is that Buffett was concurrently growing the book value of Berkshire Hathaway at 25 percent a year. Therefore, by 1999, which is the last year that Berkshire reported See's revenue and earnings separately, See's had generated $55 million of pretax earnings in 1972 dollars. If I used a more generous 15 percent discount rate, for Buffett the earnings would be worth $114 million in 1972 dollars. If the discount rate is 12 percent, the cash flow is worth $154 million in 1972 dollars. After paying tax, it is still worth around $100 million. Thus, the $25 million Buffett paid for See's Candy in 1972, which he thought was expensive, was really less than 70 cents on the dollar after the tax payment. It was a bargain, considering the quality of See's business.

Nevertheless, See's life didn't stop in 1999. Just ask the Berkshire shareholders, who stood in long lines to buy the candies during shareholder meetings. To be honest, I find See's chocolates too sweet; I like the nuts and chews better. And those candies are expensive. I wouldn't buy them if I weren't a Berkshire shareholder. Yet See's continues to prosper. In the 15 years from 2000 through 2014, it generated more than $1 billion in pretax earnings for Berkshire Hathaway.⁴ The earnings are worth more than $500 million if discounted to year-2000 dollars with a discount rate of 12 percent. Buffett could still sell See's for $500 million in 2000, after generating all the cash flow and originally paying only $25 million. See's life didn't stop in 2014, either. Cash continues to flood in.

I have emphasized the application of the DCF model to Coca-Cola and See's Candy. The point is that the life expectancy of the business is a vital factor when considering buying a company. The companies that have the luxury of changing slowly can stay in business longer and are more valuable to their shareholders.

Is this why the turtle lives so long? I wonder, between the rabbit and the turtle, which one covers more distance during its lifetime.

The effect of the number of terminal years on the intrinsic value is reflected in the table below. Again, we assume that the company is earning $1 now. The discount rate is 12 percent. The growth stage lasted ten years and the growth rate was 12 percent. The terminal growth rate was 4 percent.

We can see that if we increase the number of terminal year growth from 10 to 20, the value of the stock is increased by about 20 percent. Further increase in the number of terminal years will not increase the value by much because of the discount, but a business with a longer life is definitely more valuable.

Discount Rate

I mentioned the effect of the discount rate briefly in the See's Candy calculation. Table 5.3 lists the discounted values for the $859 million pretax earnings that See's Candy earned from 1972 through 1999 at different discount rates if discounted to the year 1972, when Buffett bought See's. Clearly, the discount rate can also wildly affect the intrinsic value calculation.

So, what is a reasonable discount rate that an investor should use in the calculation of the intrinsic value of a stock? Academically, one should use the weighted average cost of capital (WACC) for the discount rate. But the reasonable discount rate is the rate of return you can achieve if you invest the money somewhere else. If you plan to invest in stocks, the discount rate should be the expected rate of return from a passive investment such as an index fund or ETF. That is why we used a 25 percent discount rate in the calculation for See's Candy—it is the rate of return Buffett was achieving with the book value of Berkshire Hathaway at the time. He could have put that $25 million somewhere else to achieve that kind of return.

If you also consider other options such as bonds, real estate, and so forth, the discount rate should be the rate of return you can expect from those investments plus a risk premium for investing in stocks. For instance, if you can get a risk-free return of 3 percent from a savings account, you should at least use a discount rate of 9 percent, with the additional 6 percent as the equity risk premium.

Therefore, the reasonable discount rate is highly dependent on the rate of return you can achieve from alternative investment options. In the current zero-interest environment, the possible returns from everything from bonds to real estate have declined. The discount rate should be reduced, too. Therefore, the values of stocks have increased. Stocks are traded at high valuations relative to historical levels, but this is probably justified by the current historically low interest rate.

For the example discussed in the previous section, the effect of the discount rate is illustrated in the table below. Both the growth and terminal stages lasted ten years and the growth rate was 12 percent. The terminal growth rate was 4 percent.

This is the effect of the interest rate on the discount rate. Buffett calls the interest rate gravity. When the gravity is lower, everything flies higher.

Excess Cash

When Buffett bought See's Candy, the price he paid was actually $35 million instead of $25 million. But See's had $10 million in cash that it did not need in its operations. Buffett did not count that cash into his cost. In estimating the intrinsic value of businesses, any excess cash should be added to the discounted earnings. These days, companies like Microsoft and Apple have a tremendous amount of cash that they don't need for their operations. This cash should be added to the total of future earnings to get a more accurate valuation.

GuruFocus's fair-value calculator has an item called “Tangible Book Value.” You can add portions or all of that to the calculation to compensate for the excess cash the company may have.

Earnings vs. FCF

If you look at the intrinsic value equation:

other than the growth rate and discount rate, intrinsic value is proportional to , which is the earnings for the past year. I haven't distinguished between earnings and free cash flow. The formula applies to both. Just replace with the earnings per share or free cash flow per share, whichever is preferred.

In GuruFocus's DCF calculator, we use earnings instead of free cash flow because our study found that historically the stock performance was more correlated to the earnings than to free cash flow. This finding was a little surprising because free cash flow is the real cash a business generates from its operations. But the free cash in any given year can be affected by the company's spending on property, plant, and equipment (PPE). For a company that is in steady operation, where the DCF model is applicable, the effect of the more random capital spending is smoothed out in earnings through the estimates of depreciation, depletion, and amortization (DDA).

An example is a company called Church & Dwight, which produces Arm & Hammer baking soda and Trojan condoms. Its EPS has been rising steadily, but its free cash flow is doing anything but. In some years, its free cash flow was negative because the company spent more cash on PPE those years. (See Figure 5.1.) Similar behavior was observed with Wal-Mart, which also has steady operations and earnings but fluctuating free cash flow.

In deciding which parameter to use for , be aware of the impact of the onetime effect. Earnings can be distorted by a onetime boost from selling businesses or a tax rebate, or a onetime impairment from write-downs of inventories or other assets. With free cash flow, it may be even more random, as management's decision on spending in the year can have a major impact. The normalized earnings over several years is a better number. GuruFocus uses earnings without nonrecurring items in the past 12 months as the default.

Margin of Safety

The margin of safety is defined as:

It is the difference between the intrinsic value and the price that investors are willing to pay relative to the intrinsic value.

A common question is how much margin of safety is enough for one to buy a stock. The answer is, not enough. The more it is, the better.

Although we have beautiful formulae that seem able to calculate the intrinsic value to any accuracy we want, in reality it is only as accurate as the parameters we input for discount rate, the growth rate, the lifetime of the business, and so on. They are affected by factors such as the long-term economic characteristics of the business, the management, and external issues such as future tax rate and inflation, among others. All are about the future, and they come with much uncertainty. The required margin of safety is dependent on the degree of confidence you have regarding these factors.

Furthermore, the intrinsic value of a company is never a fixed number. It changes all the time with the progress of business. A combination of good economic characteristics and capable management can grow the intrinsic value faster, whereas a business with poor economic characteristics can destroy value quickly. To verify this, consider how Buffett has grown the intrinsic value of Berkshire Hathaway while the business values of Sears, JC Penney, BlackBerry, and many other companies have eroded.

I have seen investors put too much belief in DCF calculations. Sometimes we receive questions from GuruFocus users such as why their calculation of the intrinsic value gets $60.01 per share while GuruFocus's DCF calculator gives $59.99 per share. With so many uncertainties in the calculation of intrinsic value, any result is simply an estimate, and the error is much higher than two cents on 60 dollars. The point of the calculation is to give investors a rough idea of where the intrinsic value lies. Remember what John Keynes said: “It is better to be roughly right than precisely wrong.”

I have also seen investors dismiss the DCF model completely. To its credit, DCF does give a quite reasonable valuation to the companies that have relatively consistent performance. We can see it from the recent acquisition decisions of Buffett. Berkshire Hathaway acquired BNSF Railway in 2010 for $100 per share, at the time the GuruFocus DCF model assigned an intrinsic value of $91. In 2012 Berkshire acquired Lubrizol Corp. for $135 per share while DCF calculated the value as $114 per share. In 2016 Berkshire acquired Precision Castparts Corp. at $250 per share, and DCF estimates that it was worth $249 per share.

Given the uncertainties with the DCF model, the higher margin of safety is obviously better. The stocks that can be purchased at higher discounts relative to their intrinsic values deliver higher returns to investors. The outperformance comes from the closure of the difference between the intrinsic values and the prices. We may also get higher returns from the deeper discounted price if we get the intrinsic value correct.

Of course, the market doesn't very often sell the stocks we want to buy at the prices we want to pay. As investors, we need to set ourselves an investment hurdle, as Donald Yacktman does with his investing. This hurdle can be the minimum difference between the price we want to pay and the value we will get. This hurdle is the margin of safety.