Warren Buffett’s Equity Bond Method Explained

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Warren Buffett’s Equity Bond Method Explained
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One of my favorite investing books of all time is Buffettology, by Mary Buffett and David Clark. In the book, the authors do an excellent job of explaining Warren Buffett’s quality investing style, and how he implemented his strategy for successful investing. They delve into both the qualitative and quantitative aspects of Buffett’s techniques when he is examining businesses to invest in.

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One of Warren’s favorite ways to calculate investment returns is by using the Equity Bond method. This method is far and away one of the best calculations when determining the future value of a stock.

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Imagine being able to know the price of a stock 3, 5, or even 10 years from now. Would that influence your decision to buy? Absolutely! The Equity Bond method allows you to see what your investment would be worth right now, as well as its potential future returns.

Let me show you how.

Explanation

So what is Warren Buffett’s Equity Bond? It’s a pretty simple method, really. Essentially, the Equity Bond is synonymous with earnings yield. Here is the mathematical formula:

Equity Bond

Earnings yield is simply the Earnings per Share (EPS) over the share price. For example, if a stock had a price of $100 and the EPS was $5.00, then the stock would have an earnings yield of 5%.

Why is this so important? It’s all about how Buffett views his investments. He isn’t looking for companies trading cheaply (like his mentor, Ben Graham) and selling them at fair value. As a quality investor, Buffett is looking for companies that can compound his original investment for years or decades to come.

Warren views the earnings yield of a stock the same as he would the yield of a bond, hence the name Equity Bond. The main difference between the Equity Bond and a normal bond is that the Equity Bond gets to appreciate the longer you hold it, whereas the normal bond has a fixed yield over time.

For example, would you rather own a stock with an earnings yield of 5% that appreciates every year, or a bond that was yielding a fixed 2%? The answer is pretty simple, right?

Characteristics of Ideal Companies

Obviously, not every company has great earnings yields, or else every business would be up for grabs. Even those companies that do have great earnings yields still need to have other important characteristics to make the investment worthwhile.

Here are some characteristics of ideal companies for the Equity Bond method:

  • Consistent increasing annual equity per share (or book value)
  • Higher than average Return on Equity (ROE) over long time periods (>15%)
  • An earnings yield more than the 10 year government bond (>1%)
  • A fair share price

Increasing Annual Book Value

Companies that have a consistent track record of increasing annual book value (also known as equity per share or shareholders equity) are the ideal candidates. Positive book value growth shows that a company and its management are increasing the equity base of the business without deteriorating shareholder value.

This is the foundation of our ideal company.

Return on Equity

Stocks that return higher than average Return on Equity (ROE) is the second characteristic of quality companies. Here is the formula for ROE:

Equity Bond

This equation can also be EPS / Equity per share for a per share calculation. A company that can increase shareholder equity, while simultaneously creating over 15% yearly return on that equity, is the key to finding a compounder.

Additionally, we prefer companies that retain most of their earnings and do not necessarily pay a dividend. This is not required, of course, as many companies do pay dividends. However, the theory behind this is that companies that are able to maintain a high ROE and do not pay a dividend can reinvest those earnings faster than one that does.

As the same with shareholder equity and book value, the key here is long consistent annual stretches of ROE’s that are above 15%. In order for the calculation to work, the company must be consistent in their returns.

Earnings Yield

Let me mention a quick caveat here. Over the past decade, we have had record low interest rates and bond yields. Therefore, it is easy to find companies that have an earnings yield above 1%.

I recommend finding companies with at least a 5% earnings yield in order to establish reasonable returns.

A Fair Price

No company is worth more than its fair value. Overpaying for a company can lead investors to mediocre, or even negative returns. This is why Warren Buffett and Charlie Munger talk so much about not overpaying for a company. The more you pay, the less your return will be.

Let me show you in an example of the Equity Bond method using Progressive Insurance (PGR) as an example.

Progressive Insurance Example

Progressive Insurance is an amazing company for this type of valuation method. Let’s take a look at some of PGR’s characteristics to see if it qualifies.

PGR Book Value per Share

PGR has compounded their book value (or shareholder’s equity) tremendously over the past decade, especially within the past five years. PGR grew book value over 211% in ten years, over 21% per year!

Equity Bond
Source: Finbox

PGR ROE

PGR has had a near perfect ROE track record, only dipping below 15% during a couple of quarters over the last decade. To make things even better, the ROE has skyrocketed the past three years, surpassing 30% ROE.

Equity Bond
Source: Finbox

PGR Earnings Yield

PGR is currently offering investors an 8% earnings yield (equity bond). This is an extremely attractive yield, especially with the 10 year treasury bond currently yielding less than 1%.

Equity Bond
Source: Finbox

Additionally, PGR’s earnings yield has stayed above 4% over the entire last decade. This is proof that PGR has created solid earnings over time.

We will get into the fair price portion later on into the valuation process.

Calculating the Return

Here are the required inputs we need for the Equity Bond calculation:

Equity per Share: Found on the Balance Sheet as Shareholders Equity. To calculate it, take this number and divide it by the number of shares outstanding.

PGR’s current equity per share is $30.06.

Earnings per Share: Found on the Income Statement. Always use diluted EPS numbers.

PGR’s diluted TTM EPS is $8.62.

Dividend Payout Ratio: This is a calculation that shows the percentage of earnings the company is paying out as dividends. Most platforms will calculate this for you, but you can find out the payout ratio by dividing cash paid for dividends (found in the Cash Flow Statement) by net income.

PGR’s current dividend payout ratio is 34%.

Share Price: Current share price of the company.

PGR’s current share price is 98.88.

Estimated Price to Earnings (P/E) ratio: P/E is simply calculated as share price over earnings per share. A standard P/E ratio is 15, but it may help to calculate the historical P/E ratio of the company you are analyzing. This serves as a final calculation to determine the assessed stock price and what our return would be after 10 years.

Equity Bond
Source: Finbox

We can see that PGR’s P/E has been consistently between 10 – 15 over the last decade. Let’s be conservative and use a P/E of 10 to assess the future stock price.

Equity Bond

After inputting all the numbers, let’s see what the output looks like.

buffett

The Magic of Compounding

According to our calculations, PGR has an ROE of 29%. We can see that PGR will pay $2.90 (or 34%) of its $8.62 in earnings as a dividend. This will allow the company to retain $5.72 (or 66%) of its earnings to its equity base, which will be $35.78 per share the following year.

Additionally, that $5.72 of retained earnings gets added to our own per share investment base of $98.88, bringing it to $104.57. We are essentially looking at our own investment of $98.88 per share as our own equity base, and PGR gets to reinvest our retained earnings, thus increasing our Equity Bond yield.

Essentially, since PGR’s earnings are likely to increase each year, so will our Equity Bond yield.

The Ever Expanding Coupon

Now the key to this calculation is the ability of PGR to maintain its 29% ROE over time, which will deliver returns to shareholders. If PGR can manage to maintain that 29% ROE the following year on $35.78 of equity per share, then we can assess next year’s earnings to be $10.26 per share.

If PGR maintains it’s 34% payout ratio, then it will pay out $3.46 as a dividend and add $6.80 to its equity base. Our own per share investment increases to $104.57 from the retained earnings, which increases our earnings yield to 9.8%.

As you can see, the beauty of this method is that the longer you hold, the greater your yield and returns will be. If we hold on to the stock for the next ten years, our equity bond would be yielding over 20% from our original purchase price of $98.88!

buffett

We can also calculate our average annual return after 10 years. According to our calculations, at year 10, PGR would have an estimated EPS of $49.14. If we take that EPS number and multiply it by our estimated P/E (10), we would have an estimated stock price of $491.38.

We can also account for the dividends we received over that time. Over the course of 10 years, we would receive $88.38 of total dividends. When we include the dividends into our calculation for annual returns, we come to an annual return rate of 19.3%!

Backtest

If you think this is too good to be true, let’s just run a little backtest. Ten years ago, PGR was trading for around $20.00 per share, adjusted for splits. It had equity per share of $8.09, EPS of 1.58, a dividend payout ratio of 25%, and a P/E of 12. Let’s input these into the calculator.

buffett

buffett

As we can see based on our results, PGR had an ROE of 20% and an earnings yield of almost 8%. While the numbers aren’t exactly how things played out in real life, the equity per share estimation at year 10 is $31.74; that’s pretty darn close!

Our estimated return is over 15% back in 2011, with an estimated stock price of $74.39, and $9.43 of dividends received. This is actually less than the current stock price of $98.88, so we technically undershot our actual returns. PGR was able to earn well over 20% ROE over the last decade, which helped boost returns even higher.

In fact, PGR did much better than our estimates. Its stock price ended up compounding over 400% in the last ten years. That equates to a 40% annual return!

buffett
Source: Finbox

A Fair Price

All of this compounding sounds incredible, and it is. But the thing to remember is that in order to have amazing returns, you still have to buy the company at a fair price. Overpaying for a stock can eat into your returns.

For instance, if we had paid for PGR at a P/E of around 20 today (which it was a few years ago), the current stock price would be around $172 per share. If we paid that much, our annual returns would be around 12%. While not terrible, it still is a big damper on potential returns.

This is why Warren Buffett and Charlie Munger talk so much about not overpaying for a company. The more you pay, the less your return will be.

Conclusion

The Equity Bond valuation method certainly is a unique method of valuation that I find very useful. It is one of my favorite methods to use, and I find it most beneficial when I want to calculate returns for those long term, buy and hold, high-quality stocks.

If you liked this method, I highly recommend you read Buffettology. The book takes this concept to much more detail than I did. Plus, you’ll learn other methods as well!

Article by Vintage Value Investing

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…
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