Friday, March 28, 2014

10x Pretax Earnings! Case Studies: KO, BNI etc.

So, one of the great things about writing a blog is that I get feedback from some pretty intelligent people.  Most of us don't have a Munger to call, but a blog works well too.  If I say something wrong, I'm sure someone would jump in to point it out.

10% Pretax for Stocks Too?
Anyway, I have mentioned 10x pretax earnings or 10% pretax yield as Buffett's valuation measure numerous times here and more than once I've gotten a response saying that this hurdle is for private deals and not for pricing listed companies.  The argument, of course, is that if you buy a stock at 10% pretax earnings, you won't actually earn 10% pretax (due to the additional tax at the investee corporate level whereas in a wholly owned business, a 10% pretax return is actually a 10% pretax return).

It is true that when Buffett speaks of returns in the stock market, he uses GDP growth and dividend yields; earnings can't grow more than GDP and stock returns will reflect earnings growth over time plus whatever dividends you get.

Translating that into individual stocks, you will get earnings growth plus dividend yield equals expected return on the stock.

The only problem with this is that it doesn't tell you what the business is worth.  Would you pay 50x p/e for it?  20x?  The above calculation only works if valuation stays the same.

Anyway, my usual response to this is that many value investors (including Buffett) likes to analyze businesses based on what a rational businessperson would pay for the business in a private transaction.

So, if Buffett is willing to pay 10x pretax earnings for Wells Fargo in a private transaction to buy the whole thing, that is a valuation benchmark for me.  I know that this is not actually possible.  There are size and regulatory issues that will make this unlikely.  But in terms of valuing businesses, I think it is still a useful benchmark.

Is this how Buffett thinks about it? If he pays 10x pretax earnings for WFC stock, he will not necessarily earn a 10% pretax yield.  I don't know the answer to that question. Maybe that's a good annual meeting question.

But as long as I know that Buffett  would be totally happy to pay 10x pretax for the whole business, that's good enough for me regardless of whether that will actually happen.

Yes, you can argue that these "private business transaction" valuations are only valid when there is some chance of a private deal occurring.  But I only think of that when the private valuations don't make too much economic sense to me; valuations per eyeball or per POP valuations in the past, for example, or 40x EV/EBITDA for some media assets, or per acre land valuations etc.; just because some people are paying high prices doesn't mean anything unless there is a real prospect that what you are looking at will also be taken out at some point at the same high level.

Is 10x Pretax Reasonable? 
But 10x pretax earnings, even for listed companies, is not unreasonable at all.  You can translate that 10x pretax into a 15x after tax p/e ratio, and that wouldn't be far off from the 100 year or so long term average of U.S. listed businesses.   Since Buffett buys quality, above average businesses, paying 10x pretax is like paying an average price for an above average business.

So even if my view is wrong, it passes the rationality test; why not pay average prices for above average businesses?  And this is not dependent on market p/e or interest rates because you are using a long term average.  We are not increasing valuations due to decreased interest rates.

Case Studies
So, this discussion piqued my interest again so I decided to go back and look at some more of Buffett's big deals.  I use the term "case study", but it's far from it, really.  I'm only looking at one measure; pretax earnings yield or price to pretax profits.  So I apologize for the exaggerated terminology and to folks who come here looking for a 300 page paper on why Buffett bought something; you'll only see one line.  We all know how great the businesses he owns are, so there really is no need to look at that.

So, I looked at the 2005 purchase of Wells Fargo, Walmart and the recent IBM purchases, but what about some of the other older ones?

Again, since the Warren Buffet Library of Corporate Annual Reports doesn't exist yet, I can only look at some of them.

I got lucky and found a 1988 annual report of Coke, so that's good. Let's start there.

Below, let's take a quick look at Coke (KO), American Express (AXP) and Burlington Northern (BNI) (which a prominent value investing academic said was a crazy/insane deal or some such.  We'll see if it really was a bad price) and some others.

Coca Cola  (KO)
From the 1988 KO annual report:

Pretax earnings:   $1,582 million
Net earnings:        $1,045 million
EPS:   $2.85
Shares outstanding: 365 million
Year-end stock price:  $44.63

From the Berkshire Hathaway annual reports, the cost of KO was:

                     #shares owned           cost ('000)       cost/share (my calculation)
1988 AR       14,172,500                  $592,540       $41.81
1989 AR       23,350,000               $1,023,920       $43.85

So with $1,582 million in pretax profits and 365 million shares outstanding, that's $4.33/share in pretax earnings per share.

So it turns out he paid 9.7x pretax earnings as of 1988 and 10.1x pretax earnings as of the end of 1989.  

That's a pretty stunning discovery, even for me.  I think a lot of value investors were puzzled at what looked like a growth stock purchase by Buffett at the time, but it fits right in with the 10x pretax benchmark perfectly.  He didn't pay up because KO was a really high quality business; he paid what he normally pays.

American Express  (AXP)
So this one doesn't quite fit the mold, but let's take a quick look at it (it doesn't fit only because he didn't pay almost exactly 10x pretax earnings, but far less).

The 1994 annual report is the first time AXP showed up in the BRK letter so let's look at that and what he paid for it:

                        # of shares owned          cost  ('000)          cost/share (my calculation)
1994 AR         27,759,941                     $729,919             $26.29

By the way, I know that this is only an estimated cost per share of the stocks.  There may be some adjustments somewhere that might throw this off, but I don't think it would change things materially.

Thankfully, the SEC database goes back to 1994, so let's pull the relevant AXP figures from 1994:

Pretax earnings:  $1,891 million
EPS: $2.75
Shares outstanding:  496 million

So we don't even have to go very far with this one.  It looks like Buffett paid 9.6x net earnings for AXP.

Pretax earnings per share comes to $3.81/share, so he paid a 6.9x pretax earnings.

It looks like he got AXP really cheaply.   It got pretty cheap in 2009 too.

Moving on.

U.S. Bancorp (USB)
It looks like he started buying USB in 2006, but maybe earlier.  It shows up first in 2006 on the annual report.  He bought more in 2007.  This is from the annual reports:

                     #shares owned           cost ($mn)       cost/share (my calculation)
2006 AR       31,033,800                  $969                 $31.22
2007 AR       75,176,026                $2,417                $32.45

And here are the figures for USB in 2006 and 2007:

              Pretax          diluted (mn)                  Pretax
              earnings       shares outstanding        EPS
2006       $6,912         1,804                            $3.83
2007       $6,282         1,758                            $3.57

2013       $7,990         1,849                            $4.32

So in 2006, BRK was paying 8.2x pretax earings, and the total cost through 2007 comes to 9.1x pretax earnings of 2007.

And interestingly, BRK increased shares held in USB from 78 million in 2012 to 96 million at the end of 2013.  The pretax EPS of USB was $4.32 in 2013 and the stock traded in the range of 7.4 - 9.5x that figure throughout the year.

Burlington Northern (BNI)
So this is one of his other major purchases that made everyone scratch their heads.  There are two things to look at here; one purchase when he just bought the shares and then a second time when he bought out the whole company.  Let's take a look.

The first time BNI appeared in the annual report was 2007.  In 2006, he said there were two positions worth $1.6 billion that was not listed, so BNI was probably purchased in 2006 and other times too (could be some before and some after).

Here is what the 2007 BRK annual report showed:

                       # of shares owned          cost  ($mn)          cost/share (my calculation)
2007 AR         60,828,818                     $4,731                  $77.78

And these are the figures for BNI for 2006 and 2007:

                                                   2006               2007
EPS:                                           $5.11              $5.10
Pretax earnings:                         $2.96 bn         $3.0 bn
diluted shares outstanding:           370 mn        359 mn
Pretax EPS:                                $8.11             $8.25

So from this, it looks like Buffett was paying 9.4x - 9.6x pretax earnings per share.  Voila!

And then of course, BRK bought the whole thing in late 2009 (on an announcement basis).  The offer price was $100, so let's see what the BNI figures were for 2009.  Even though the figures haven't come out yet when the announcement was made, most of the year was over, so they would have known pretty much what the earnings were going to be.

Here it is:

BNI 2009
EPS:   $6.08
Pretax earnings:  $3,368 mn
Diluted shares outstanding:  348 million
Pretax EPS:   $9.68

So at $100/share, Buffett paid 10.3x pretax EPS of BNI.

A lot of people thought Buffett overpaid, but it turns out he just paid what he always seems to pay.  I know, I know.  What about capex, maintanence capex / depreciation and all that?   Yes, that was the argument back then.  I don't know.  I'm just looking at this and noticing a pattern.  I don't have all the answers!

BNI Tangent
What's a blog post here without a tangent?  As I was doing this stuff, I just took a quick look at the famous 'projections' of BNI that was included in the merger proxy.  Buffett has said that he ignores these management projections, but these are often done by management / investment bankers in mergers so they can do their cash flow discount model analysis and whatnot.

So here are the various projections for BNI from the proxy dated December 2009:

2010 Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,994  $16,601  $17,611  $18,667  $19,418  6.7
Freight revenue w/o fuel
  12,372  12,830  14,063  15,014  15,834  16,558  6.0
Operating income
  3,204  3,421  4,336  4,921  5,360  5,745  12.4
  4,737  5,052  6,056  6,746  7,313  7,825  10.6
Net income
  1,631  1,717  2,224  2,476  2,663  2,831  11.7
Earnings per share
  4.77  5.04  6.88  8.41  9.71  10.96  18.1
2011 Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,254  $15,436  $16,629  $17,839  $18,877  6.1
Freight revenue w/o fuel
  12,372  12,424  13,345  14,291  15,244  16,044  5.3
Operating income
  3,204  3,092  3,638  4,241  4,775  5,209  10.2
  4,737  4,723  5,357  6,063  6,724  7,283  9.0
Net income
  1,631  1,515  1,842  2,149  2,386  2,572  9.5
Earnings per share
  4.77  4.41  5.43  6.74  8.10  9.35  14.4
No Recovery Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $14,012  $14,410  $14,622  $14,844  $15,069  1.5
Freight revenue w/o fuel
  12,372  12,377  12,736  12,953  13,176  13,401  1.6
Operating income
  3,204  3,010  3,224  3,324  3,314  3,310  0.7
  4,737  4,639  4,939  5,138  5,249  5,363  2.5
Net income
  1,631  1,465  1,607  1,660  1,631  1,610  (0.3%) 
Earnings per share
  4.77  4.27  4.65  4.87  4.94  5.07  1.2
Deeper Recession Case

  2009E  2010E  2011E  2012E  2013E  2014E  CAGR
  (In millions, except per share and percentage data)
Total revenue
  $14,013  $13,544  $13,618  $14,000  $14,283  $14,756  1.0
Freight revenue w/o fuel
  12,372  12,107  12,147  12,351  12,632  12,929  0.9
Operating income
  3,204  2,759  2,728  2,778  2,841  2,898  (2.0%) 
  4,737  4,387  4,440  4,588  4,770  4,943  0.9
Net income
  1,631  1,310  1,295  1,326  1,369  1,399  (3.0%) 
Earnings per share
  4.77  3.82  3.74  3.80  3.89  4.05  (3.2%) 

And check this out.  These are the figures for 2013 that BNI actually booked (from the BNI 10-K):

BNI 2013 Results
Revenues:             $22,014 million
Operating income:  $6,667 million
Pretax income:        $5,928 million
Net income:             $3,793 million

The most bullish projection in 2009 was for operating income of $5,360 million and net income of $2,663 million.  Operating income came in 24% higher and net came in 42% higher!

OK, so here's one more acquisition.  This name might not give BRK holders a warm and fuzzy feeling (due to the Sokol incident), but it is a major acquisition so it is a relevant data point.

BRK bought Lubrizol in 2011 for $135/share.

For the 2010 year, here are some figures for Lubrizol:

EPS:  $10.64
Pretax earnings:  $1.00 billion
Diluted shares outstanding:  68.8 million
Pretax EPS:  $14.53

So a $135/share purchase is 9.3x pretax EPS.

So let's just recap all of this stuff I said in the last post (part 5) and this one.

These are the multiples to pretax earnings Buffett paid in these big deals:

KO in 1988/89:    10.1x
AXP in 1994:         6.9x
WMT in 2005:      10.3 - 12.9x (range of stock price in2005)
WFC in 2005:         9x
USB in 2006/2007:  9.1x
USB in 2013:  7.4 - 9.5x (range of stock price in 2013)
BNI stock purchase: 9.5x
BNI acquisition:  10.3x
Lubrizol:   9.3x
IBM:  9.7x

I exclude Heinz here as it is a different situation and I think he said he wouldn't have done the deal without 3G.  I may be missing some here as I didn't intend this to be comprehensive by any means, but just looked quickly at some of the large purchases he has made over the years and it is very interesting.

It's amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that.

Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying.

And yes, right now I'm the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it's really interesting.

Of course, this actually makes no sense as every company has different capital needs (free cash flow / owner earnings etc.)  Of course, what Buffett calls "owner earnings" are more important than pretax profits.  This was one of the arguments about the BNI deal.

And it is silly to think you can price anything and everything at 10x pretax profits.  Buffett obviously looks at everything else and has a deep understanding of the various businesses and is only willing to pay this amount for the very best businesses out there.

Why he says he will pay 9-10x pretax earnings (OK, for private deals) and yet seems to go out and pay 9-10x pretax earnings on stocks is a good and valid question.

It's amazing, though, isn't it?  Even if it is an odd coincidence.

But I don't think 10x pretax earnings for a stock is a bad price if it's a high quality business that can grow over time etc...  (But you still have to answer the question how much growth there will be and how much a shareholder can expect to get back.)


  1. Hi, your blog has been a great read since for the past couple of years I've come to love companies & investors that you write about.

    As for the article, this is a great find. For Buffett of course there has almost always been the problem of size+quality combination, which makes stock purchases made at great valuation harder than for someone handling <100m portfolio.

    It's too consistent to be a coincidence in my opinion: Buffett has always come to a conclusion that purchase of the business at that particular price makes sense.

    I haven't done any research on Buffett (though I'm currently reading snowball and enjoying it a lot) so I'm surprised because I always thought that Buffett bought all those businesses with cheaper valuation. I'm not saying that he paid too big of a price, but I sort of had an image where he got them super-cheap (excluding AXP).

  2. Buffett bought a lot of these companies when they were growing at 10%+ rates for 5yrs or so. You have to take the growth rate into account since I'm sure he uses that for his margin of safety. Still a great post, I'm actually taken by surprise that KO was trading at 10x pretax earnings lol. BNI was an easy case since he bought at the bottom of their earnings cycle and had his eye on oil shipment from the Bakken so that was an easy layup.

    I think you should make a post and explore the idea of what would Buffett and Munger buy if they had to start over with $1 million or whatever. It's interesting to see that early Berkshire was loaded up with broadcast and newspaper companies since he liked the economics and the price was right. Today I have a feeling he would really load up on banks even after the run up.

    1. Yes, growth is important. I don't think he would buy anything without growth potential (except for special situations). But it's interesting because surely all of these companies had different return on capital and growth profiles at the time of purchase.

      As for what Buffett would do with $1 million is a great question. VIC is full of ideas like that (Stock Market Genius-type ideas).

    2. Was oil shipment by rail an easy layup? I disagree and think that was just a pleasant surprise for BNSF and Berkshire.

    3. BNSF was just a play on the fact that oil will continue to go up for the next century as we run out of it. Technology discovering a ton more energy isn't helping him. And of course when we discover fusion energy, that will basically destroy the thesis. But the investment will have done really well up until that point!

    4. I think Josh has this one right. Too much of what we think about past Buffett investments is colored by hindsight bias, pure and simple.

      He bought BNSF as he could do so for a major discount to replacement cost, and saw that the rail industry after decades of misery, had its dynamics change for generally favorable demand economics.

      The rise of Bakken (or any other oddly located oil production field that would revert oil transportation from pipelines to 1800s method of using rail cars) was hardly viewed as very likely in 2009. Clearly Buffett got the upside on this one. You may view it as the opposite side of the same coin as his investment in TXU bonds. In ~2007/2008 it hardly seemed likely that a natural gas shale revolution would occur with nat gas wrecking the economics for base load generating coal power plants, though it did.

  3. Buffett's criteria are well-known among value investors, but I think this is a great explanation of the fourth:

    1) undersand the business
    2) favorable long term prospects
    3) operated by honest, competent people
    4) available at an attractive price

    If you substitute 4) for "priced at less than 10x pre-tax earnings" that's not a bad checklist to use in filtering companies to invest in!

  4. Another recent sizable purchase that also meets this test is Exxon (XOM). Thanks for your insightful blogs.

  5. Not sure how this might factor into the cost but Buffett did sell short puts in BNI before ultimately purchasing. Perhaps BNI was close to the 10x rule and getting some put premiums helped meet his rule.

  6. You should check at what multiple Buffett paid for those stocks relative to the multiple ranges they would typical trade in. I bet Buffett was bottom ticking the multiples, or catching them when they broke through the typical range to the downside. It doesn't really matter if one pays 8x, 9x, 10x or 11x for a long term growth investment. Lower is better, but you don't want to get too greedy waiting for some multiple that it has never traded at before.

  7. A conservative investor may prefer the "rational private buyer" valuation as an upper limit, rather than as the default benchmark. Many companies would be worth more, subjectively, if the prospective buyer could count on shared business perspectives between the board of directors, management, and the investor class. Yet, appreciating, and accounting for, conflicting interests is part of the game of investing. Furthermore, the "rational private buyer" class includes actors with structural advantages, such as private equity credit relationships. Private equity purchases skew valuations because management secures their equity by repatriating cash via leveraging the company at rates that are based upon the overall client relationships between the PE firm and its creditors. Such transactions are market prices, and thus valid, but they represent pathways that sometimes skew upwards.

    It would be interesting to know whether Buffett imagines a general class of "rational private buyers", or if he specifies idealized candidates for any given security. For example, Safeways recently undertook a successful series of sales to Sobeys and Cerebrus, achieving healthy valuations that may be excessive to a buyer outside of the Canadian retail structure or the PE structure. But would Buffett have imagined the incentives of those interests, and thus adjusted his valuation from their perspective? Or would he have incorporated them as potential pathways with some probability of occurence?

    1. Good points. Thanks for pointing that out. So I should fine tune my comment about rational private buyers. This 9-10x pretax is not the price that a "rational private buyer" would buy in the conventinal sense (as you say, private equity or merger partner), but it's the price that Buffett himself would pay. And Buffett himself would only pay a discount to what he thinks something is worth, so I don't think it's stretching it or reaching to say that at least in the above stocks, he feels that those businesses are worth much more than 10x pretax profits.

      Make of that what you will. The facts are there, his comments are known, so I'm just connecting the dots in a rational way.

      Thanks for commenting.

    2. So to sum up the difference between the two:

      Rational private buyer price: value investors want to buy something at a discount to it

      9-10x pretax profits (for Buffett quality stock): price Buffett is willing to pay, which is a discount to what he thinks it's worth.

  8. Very good series on Buffett. Thanks
    I put links to your website to mine.

  9. Thank you again!

    I would like to add, that in 2007 Buffett bought almost 9 percent of the KFT at an average cost of 33,2 USD per share. Kraft's 2006-2007 net EPS was 1.73-1.56, pretax EPS was about 2.23 in the both years. So it seems multiple in this case was 14.4x. Perhaps one could say that at that time margins and earnings were depressed and using pretax EPS of say year 2003, which was about 3 USD, one would get to the 10.7 multiple, however later EPS temporarily would become even lower. At the same time this is kind of the business, which is a little bit different from banks (with leverage) or utilities (regulated, capital intensive) and I think he paid more than 13 pretax for J&J in 2006-2007 and again earlier even more fore BUD. So if you look only at these "very wonderful" and "very predictable" businesses, it seems that price Buffett was willing to pay, was even higher?

    Now for the tangent: it appears that AXP price really was an outlier, but it seems, that at the time the company was more than just "unloved", just see this: "More recently the tarnished American Express card has been losing market share to Visa and MasterCard as Amex's principal consumer benefit--prestige--becomes a tougher sell. And the company's international business, say analysts, is in the doldrums." And Buffett himself, after being quite for some time about his rationale, later wrote in 1997 report "Our Percs were due to convert into common stock in August 1994, and in the month before I was mulling whether to sell upon conversion. One reason to hold was Amex's outstanding CEO, Harvey Golub, who seemed likely to maximize whatever potential the company had (a supposition that has since been proved -- in spades). But the size of that potential was in question: Amex faced relentless competition from a multitude of card-issuers, led by Visa. Weighing the arguments, I leaned toward sale. Here's where I got lucky. During that month of decision, I played golf at Prouts Neck, Maine with Frank Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge of the card business. So from the first tee on I was quizzing him about the industry. By the time we reached the second green, Frank had convinced me that Amex's corporate card was a terrific franchise, and I had decided not to sell. On the back nine I turned buyer, and in a few months Berkshire owned 10% of the company." So boy, it seems that at that time AXP future was looking really scary (in this light current IBM problems looks like peanuts?), so perhaps this 7x multiple could even be put into distressed category?


    1. Thanks for that. Yeah, I almost forgot about KFT and JNJ. I know Buffett didn't like KFT after all and dumped it. He probably made money on it, but I don't think it was one of his big winners by any means, and neither was JNJ, I don't think. I did remember BUD but didn't see the old filings so didn't figure that one out, but either way he didn't own it for too long as it was taken out.

      So maybe the ones where he paid more than 10x pretax were mistakes... I don't know.

      Thanks for the background on AXP. I don't think there is any lower limit on price if he wants something, so yes, if something is unloved and cheap, that's obiously great for Buffett...

  10. Thank you for these articles. What do you think about ARO? It has no moat. However 10 year ROE 37% and ROIC with a small debt. 48% free cash flow yield. 14% Operating margins and 29.23 % short interest I am keeping an eye. Please let me know your thoughts. Thanks again.

    1. Oh, these teen retailers are so unpredictable... in fashion one day, out the next... I have no particular insight there...

    2. Fair enough. How about CHRW Average for 10 year period 30.17% ROE/ROIC avg, 12% growth in 10 years, Free cash flow yield 5%; net profit 348 millions/per year. No big short, currently one is based on ROE one is paying 2.7 times book value (9.33). providing us logistics services for truck to ship logistics, third party logistics company. Company provides freight transportation services and logistics solutions. It seems to have some moat as it find cheaper transportation service thus a niche.

    3. I've looked at it a long time ago but not recently so really have no opinion of it. It has been a well-regarded business, though. I don't know what's going on there these days, though...

    4. I am short CHRW, it had a moat in the 1980s and 1990s, now there are so many competitors attacking pricing in the truck brokerage/logistics market. It is a once good business whose economics are deteriorating.

  11. Another interesting point, I believe I read somewhere that Ian Cumming and Joe Steinberg of Leucaida liked to buy assets for a min. 15% pre-tax yield, although these are primarily distressed/lower quality assets.

    1. Yes, they did say that at an annual meeting I was at; I posted about that here.

  12. What about the fact that he wanted safe, predictable business (his "inevitables") to "safely" exploit his investment leverage?

    1. Good question. He did answer someone's question "how do you do well in the stock market?" by saying "don't buy crappy businesses". He didn't say, "well, you can buy crappy businesses, but if you are investing assets of an insurance company, then you have to be more careful so you should buy higher quality companies".

      So I think he wants to invest in predictable, safe businesses either way. Again the exception would be special situations. He realized over the years that picking up cigar butts is fine and dandy, but if you find a great business with growth potential and you pay a reasonable price for it (instead of a cigar butt-like price), your returns can be quite good. If you buy crappy business on the cheap (like the originai Berkshire Hathaway purchase), then the business might be so bad the 'cheap' part doesn't even matter. Of course BRK worked out well because of what he did with it, but if that was a passive investment, it would have been a total disaster.

  13. Why use pretax earnings instead of after tax earnings?

    1. People use pretax earnings as sometimes tax rates can change for various reasons. Pretax earnings just eliminates one variable that might distort the operating trend of a company.

    2. Great post. I'm a bit late to the party. A pre-tax current earnings yield of 10% makes it more comparable to a bond consistent with what Mary Buffett claims to be his view of a stock as an "equity-bond." Of course 10% is just his starting point and represents a safe margin above investment grade current yields. The kicker as noted above is his expectation that these owner earning "coupons" will grow over time for businesses with wide moats. Similarly and of note: 10% comes up conspicuously in his examples on investing from this years Chairman's Letter i.e. the farm had a 10% normalized return and the NY real estate's "unleveraged current yield from the property was about 10%." I look forward to reading more of your wonderful contributions.

  14. Hi kk,

    How will you relate this to the 15% hurdle rate that Buffett said numerous time in the past?

    1. That's a very good question. My guess is that he uses 10x pretax as a minimum hurdle but is not actually the expected return on an investment. Don't forget, he doesn't like to invest without growth opportunity.

      Anyway, 10% pretax yield does not equal 10% expected return.

      Look at WFC as an example. If he pays 10x pretax earnings, his return can be higher. If ROE is, say, 15% and dividend payout is 50% and the stock trades at 1.7x book value, his expected return might be 7.5% earnings growth (50% retention x 15% ROE) plus a dividend yield of 4.4% (7.5% divided by 1.7x book) for a total return of 11.9%.

      So his 10x pretax might be his minimum return (assuming no earnings growth at all) while he hopes for better return from increased earnings over time.

      He has said in the past that his favorite holding period is forever, and that stock prices will ultimately reflect earnings, if he expects to earn 15% on anything, then earnings must grow, over time, 15%. If that's per share, then this can of course be boosted by share repurchases etc...

    2. Oh, and by the way, the above growth rate/expected return is after tax (ROE is based on 'net' income, not pretax). So you can argue that the 12% or so expected return is after-tax (of course, not after tax net to BRK, but after tax nonetheless at the investee level). So if Buffett wants to make 15% pretax, that is like 9-10% after tax. So the above 12% expected return on WFC exceeds an expected return of 15% pretax.

      But then, yes, there is another layer of tax that BRK will have to pay both on the dividends it receives and the capital gains on the stock appreciation so the above is just one way of looking at it, and just one way to reconcile the 10x pretax price he is willing to pay versus his expected return.

  15. you outdone yourself. great blog.

  16. Does this test also check with when he does Berk buybacks at 1.2 x book? Thank you for the good lesson.

    1. Actually, that's a very good question. I haven't circled all of this back to repurchases at 1.2x book. That's a good point. But if you know what the two column valuation method is, then you can use 10x pretax earnings of the non-insurance (exclude investments) business to see what Buffett thinks is the intrinsic value (or actually, 10x pretax is what he would pay, not what he thinks is IV).

    2. For what it's worth, equity of the insurance companies (not counting the equity of the non-insurance subsidiaries) + Float + 10x Pretax non-insurance earnings is pretty close to the current price (119 / B Share), or about 1.3x book.

  17. 10x Pretax EV or Marketcap??

    1. Market cap. Pretax income is after interest expense, so market cap is good to compare. If you're looking at operating earnings or EBIT, then you should use EV as it is before interest.

  18. Hi KK,

    Thanks for the article.

    How did you get the old KO annual report? I don't work in the finance industry, but do financial companies keep old annual reports? (I remember reading that Eddie Lampert read old annual reports of companies that Buffett invested in).

    How do you think I can get old annual reports of TCI? (John Malone's company).

    1. I just happened to find it on the internet (googled coke annual report). I don't know how you can get old annual reports, especially for companies that don't exist anymore; that's why I think it's a good idea for a library of such things to exist online somewhere...

    2. You could just ask the company IR to email it to you. I'm sure companies have all the annual reports they have published.

  19. Very interesting article, the KO prices in 1988 really surprised me!
    For fun I ran through this with a few other companies today.(Pretax earnings/share)

    Year 2013 2012 2011 2010
    KO 2.55 2.58 2.47

    WMT 7.59 7.02 6.41

    IBM 17.7 18.95 17.3

    DTV 8.12 6.9 5.3

    COST 6.93 6.29 5.38

    DVA n/a 10.22 9.50 7.19

    unfortunately I think the formatting will be off, but hopefully you can see it. Perhaps this is part of the reason WEB doesn't think stocks are crazy overvalued?

  20. sorry this is a stupid question when yo refer to pre-tax earning are you refering to EBIT - T? or EBT? or Net inome + tax?

  21. Charlie Munger at the 2010 Wesco Meeting:

    Q (Ottawa): WEB says he expects a “reasonable return” on BNSF. What percentage or range of percentages is reasonable? Also, any books you’ve read in the past year and recommend?

    A: Berkshire is looking at opportunity costs. We spent 6% of shares outstanding to acquire BNSF. We were getting low returns on cash, and we paid low rates on the money borrowed to do the deal. It’s a better deal for Burlington shareholders, but that doesn’t mean it’s a bad deal for Berkshire shareholders. Bringing in Matt Rose, who’s quite young, is a huge plus. Though not an iron rule, we hope to make, say, 10% pretax long term when buying with equity. But this was part equity, part debt. Stocks generally will probably do worse that 10% pretax; this isn’t an environment you should be happy about. We might be wrong about getting 10%, too.

  22. I have been reading your blog for some time now. What amazes me is that you still have not publish a book. You can do it this way that is thought provoking in which you could use real examples of companies as above with. I will be the first in line to buy it. Great article

  23. I was trying to use this today. Actually, I was trying to use this AND a version of the magic formula to see if good candidates for one are also good for the other. I am having trouble applying the idea of EBIT. For instance, AAPL shows up on the magic formula but when I look for EBIT, I am faced with ttm or rolling 12 month or a quarter X4. Doing this for AAPL is one thing, then I tried it on MU and because their ttm is so different from the next year due to the Elpida acquisition I don't have any way to guesstimate their EBIT. For them each quarter is VERY inconsistent so quarter X4 makes no sense. Also, what to do with the Cash AAPL has. Does it deserve a place in the per share price of AAPL? Could I apply it towards reducing float? Likely I am making this more difficult than it has to be.... It seemed so simple reading it - more credit to the author now that I have tried to do it myself.

    1. Hi,
      For AAPL, trailing four quarters is probably a good idea as sales may be bigger in the Sep-Dec quarter. And yes, you can take out the cash and investments. Usually, you want to take out the interest income/investment income too if you deduct the cash from the market cap, but since interest rates are so low it might not make too much of a difference.

      For MU, it's true that mergers/acquisitions make things difficult to do comparisons. If you look for a presentation, companies often give guidance for the next year so you can look for that sort of information too.

  24. Brooklyn Investor

    Many thanks for your recent flurry of posts on Berskhire, market timing, and the 10% pre-tax earnings yield. Your posts prompted me to go back and re-read the original Buffett Partnership letters. It is amazing how you can see Buffett's transformation from Graham and Dodd (doing "work outs", etc.) to Munger-style buying great companies at a reasonable price. I believe Munger and Buffett were introduced just before the '60s, so it makes sense to see the change occur during the life of the Buffett Partnership.

    At the same time, I was reading a post over at Value Investing World ( where India's answer to Bruce Greenwald, Sanjay B, talked about the effort required to do Dodd and Graham style investing. He was speaking from decades of experience:

    "I have absolutely enjoyed practicing all these styles of value investing. Over the years, I also learnt…about the idea of returns per unit of stress.
    You can make a lot of money by being an activist investor, which I’ve done in the past. But it’s stressful. You can make a lot of money by shorting over-valued stocks of companies run by promotional and fraudulent managements. But it’s stressful…I found that investing in moats is not stressful. It involves a slow and more meaningful understanding of how a business creates value over the very long term. And boy does it work!
    Moats are internal compounding machines. History shows that you get rich by just sitting on them because they do all the hard work for you. And I realized that over the years. Just as Mr. Buffett did when he too moved from classic Graham-and-Dodd to moats."

    That seemed reminiscent of what Buffett said when giving the reason for winding up his partnership:

    "When I started the partnership I set the motor that regulated the treadmill at "ten points better than the Dow". I was younger, poorer and probably more competitive….Elementary self-analysis tells me that I will not be capable of less than all-out effort to achieve a publicly proclaimed goal to people who have entrusted their capital to me. All-out effort makes progressively less sense…An example of the latter might be the continued investment in a satisfactory (but far from spectacular) controlled business where I liked the people and the nature of the business even though alternative investments offered an expected higher rate of return. More money would be made buying businesses at attractive prices, then reselling them."

    The end result was a sort of epiphany that it would be so much easier to just buy and hold compounders that were selling at reasonable prices rather than all the effort required in cigar-butt investing. One might give up a few percentage points of return a year, but one's sense of well being should be improved tremendously by partnering with great businesses. Add to that the fact that you can invest large amounts in wide-moat companies without worry. Whereas, with Graham and Dodd, I feel you need a larger basket which means more things to monitor (read: worry about). That does not mean that Graham and Dodd has not place in investing, it simply means that it is probably somewhere you look if you cannot find enough compounders (even Buffett recently gave Irish banks a go).

    Finally, having read warnings by Seth Klarman and other respected investors, I was left thinking I should sit with cash on the sidelines and wait. However, that IS market timing as you suggest. The better way to operate is simply to see if there are any great businesses selling at fair prices -- and, as you pointed out, Wells Fargo is just sitting there at the moment. Doesn't matter what markets or market prices do for the next few years. WFC will continue to grow earnings.

    In short, "thanks" for the great work you do -- please keep it up if for no other reason than you are a great teacher to real people out there who can benefit enormously from it.

    Here's to Brooklyn ...

    1. Thanks for the comment.

      Yes, a lot of respected investors are warning of market levels for sure. But don't forget that if what you own is reasonably priced and generates a lot of cash flows, they will benefit from lower prices. Think of why Buffett is totally comfortable 99% invested in BRK (well, his 1% is enough to live so that's part of it too); if the market goes down, he has all that cash coming into BRK to put to work so he is happy.

      The same is true with many companies. So depending on what you own, even if you are "fully invested", you aren't, really.

      This is not to say, of course, that everyone should always be fully invested at all times. This is not true either; one should just be invested enough that a 50% drop wouldn't overly upset them etc...

  25. I think you are right on the money. Here is a quote from p.16 of Berkshire's 2002 annual report: "Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate into 6 1/2 - 7% after corporate tax), we will sit on the sidelines."

  26. Hi, great post you have there. Very interesting. Do you happen to know how and where did Warren Buffett get his magic "10%" pre-tax return investment requirement from? I suspected that there should be a common sense guide for this particular required return number which he used all these years. Was it from AAA/AA/A/BBB bonds yield? Was it 10/20/30 years duration? And did he Normalized the long term average yield from that bond yield? If yes, was it Normalized for 10/20/30 years cyclicality? Your insights on this would be appreciated. Thank you.

    1. Hi, I don't know, but I think 10% has been sort of a reasonable rate of return over time in equities. Also, keep in mind that 10x pretax is list 15x after tax profits and stocks have traded at 14-15x p/e over time. So it sort of feels like Buffett is willing to pay an average price for an above average business, which makes a lot of sense. If his targets are better than average, then an average price is very reasonable.

    2. I think Buffett starts with a 6.5% hurdle rate or the 10yr Treasury yield if it is greater than 6.5%. He uses 6.5% because it is the long-term average. He uses the average because his holding period is forever so he doesn't assume that rates will stay low over his holding period. He's just trying to match the risk free rate (or the 6.5% hurdle rate when rates are low) and then let the business handle the rest. A 6.5% yield translates to ~10% pre-tax yield based on the old 35% tax rate.

  27. Hi kk,

    Very interesting article, but I'm trying to understand something here. Say for the KO example above, the shares outstanding was actually 450 million shares and the pre-tax income was still $1,582 million. This would now give you a $3.52 pre-tax EPS. So, with a stock price of $44.63 and a $3.52 pre-tax EPS the multiple would be an even lower 7.88x. How does this make sense? Doesn't the increased shares outstanding decrease each shareholder's ownership? If the company were buying back stock, the multiple would in turn be much higher due to the lower shares outstanding. Hope this makes sense.

    1. Hi, if t he shares outstanding was 450 mn shares, then the pretax p/e would be 12.7x, not 7.88.

    2. Shit, I see what I did. Yea makes sense, horrible mistake there. So say a company is trading around the 10x multiple but it has a wonderful history of growth (16% 10-year average growth in revenue, 25% 10-year average growth in EBIT, and 28% 10-year average growth in Net Income). How would you take into account the growth rate for a company like this? I feel like on the surface, this combination makes it a no-brainer as a long-term holding at a fair price. Obviously it depends on other factors too, like its revenue drivers, economic moat, management, etc.

  28. Hi, enjoy your blog. Wondering if you've taken stab at applying this methodology to DE given Buffett's recent stock purchase? Just a quick eyeball of 10yr avg and 2015E, doesn't seem too far off from concept above.

    1. Sorry for the late response... I saw this but forgot to respond. I haven't looked at DE closely, but I wouldn't be surprised at all if it came close to 10x pretax. I just flipped through some corporate presentations and I can see why Buffett would like this. DE is a really good company and their equipment is really helping increase crop yields (GPS etc.) so it is definitely an interesting play.

      The timing is interesting as we are coming off of a great time for farmers in the U.S. (due to higher farmland prices) and we are likely looking at a few years of diminishing farmer balance sheets etc...

      But if you look at it like Buffett does, what they can earn over time, then it looks pretty interesting if DE hits those 'mid-cycle' goals they talk about.

  29. How do I find "pre-tax earnings"?

    1. Hi, pretax earnings is the item in the income statement that usually comes before income tax. You have operating earnings, interest income/expense, pretax income, income tax and then net income or something like that. You can google it and you'll find plenty of simple income statement/balance sheet definitions/examples.

  30. Thank you KK

    So, basically, to get to pre-tax income, the only item that we would deduct from operating income is interest expense. All other items such as depreciation, cap-ex etc need not to be part of it. Correct? I guess WB uses it because it is less manipulated than other numbers such as net income.

    1. Depreciation is deducted but capex is a cash flow item. The best way to go about this is to just go get a 10-K of a company (simple company is better) and then go through the income statement line by line. If there is something you don't understand, just google it. There is a lot of info on the internet explaining basic accounting. So I would just go do that. It's much faster that way.

    2. Buffett says depreciation is a real expense so he keeps it in his calculation for multiples (pre-tax / purchase price).

  31. Thanks KK
    I would guess 10xPTE is not for all qualitatively eligible purchases. I guess he would use 8xPTE for high cap-ex such as XOM but will be willing to pay higher for businesses with monopoly position as he mentioned in discussion about 1992 letter about cable TV stations & local newspapers franchise.

    Based on 10xPTE, if WB were an outsider & were to buy BRK-A, he would buy at
    140,123 (investments) + 108470 (=10x10847) == 248593 per A share (at Dec 2014 end)

    So, BRK is cheap even by WB criteria

  32. MCD purchase 1996

    Price paid $41.96

    Pre-tax earning 3331-365 = 2966
    Net income 1573
    PE range for that year 19-25, price range 41-54

    Multiple of pre-tax earning paid=
    1573x19/2966 = 10.07

  33. KK,

    Thank you for sharing your time and thoughts. For those of us who are just starting and do not have 7 or more figures (yet! :) could you write a post or a few words about small or micro caps and how you'd go about finding them? Many thanks!

    1. Hi,

      I don't know about small and micro caps too much. There was a time I spent a lot of time looking for them, but I would often find things that I couldn't evaluate unless I met management, but that wasn't in the cards for me. It is hard to find information on microcaps, I find. For example, if you wanted to evaluate COST, it's easy. There are a lot of public filings, long history, lots of articles in the news about the people, stores etc. You can actually go to the stores etc. But for microcaps, it's hard to find information about the business other than the usually limited filings.

      That doesn't mean you can't find interesting things in that space. I'm no specialist in the area, but I used to really enjoy going through Walker's manual, for example. It was like a S&P stock guide but for microcaps.

      Also, going through ideas at VIC (Value Investors Club) you can often find microcap ideas. Also look at the holdings of microcap mutual funds. You can screen stocks based on market cap and low valuation etc. There are a lot of things you can do.

      Anyway, good luck!

    2. Hi,

      Thanks. I've been thinking awhile about your reply and you are right of course. I guess one can also call or send emails (I've sent to a few IR and always get a reply) but still the difficult part would be to figure out which questions to ask, especially qualitative ones. While with the big mcaps the questions are all around and can be even passively absorbed over time if you read enough.

  34. Do you have a similar analysis for the private deals? ie. companies he bought that are not publicly traded?

  35. Hello

    Have you looked at Buffett"s price paid for Precision Castparts? Exceeded his 10x pre-tax price. Any thoughts on that? Charlie has hinted that they might look for places to put more capital to work at slightly lower rates (e.g., MidAmerican).


    1. Hi,
      Yes, it looks a little expensive. This 10x pretax is no hard rule or anything. Just an observation. I don't expect all deals to fit; there are a lot of other things to consider.

  36. KK, thanks for this blog post.

    Do you know how Buffett values insurance companies, such as GEICO? Is it mainly based on EV/EBIT or on book value?

    I have read some internet articles saying that the way to value insurance companies is P/B and ROIC.


    1. Hi,

      I forget which year, but Buffett did explain his valuation of GEICO not too long ago; I think it was in reference to the value of goodwill. He doesn't look at insurance companies on P/B or any conventional measure like that, but he looks at the value of float and some multiple of underwriting profit if the insurance operation itself (excluding investments) is consistently profitable. He sees float as good as equity.

    2. Thankyou for your prompt reply

      I was thinking about this in terms of his recent stake in ASX:IAG. He took a 3.7% stake at $5.57. He also got a sweetener - 20% of insurance premiums and pays out 20% of insurance costs. Since IAG has combined ratios <100% on average, this works out better for him than current shareholders and will probably reduce EPS.

      My interest in the company was his stamp of approval on the management team.

      Do you think the stock is attractive?

      According to gurufocus the EV/EBIT is about 6. The ROE is about 17%. Despite this book value has stayed flat for a decade, I think because of the company's preference for a 100% payout ratio. (This is common in Australia - people invest for income not thinking about growth from high ROE companies). P/B is 2.

      Do you think these numbers are attractive?

      On the one hand the "owner earnings" calculation is <10.
      On the other hand book value has 0% CAGR and the P/b is 2.

    3. Sorry the EV/EBIT was based on data for year ending Dec 14. The annual report results which include up to Jun 15 are as follows:

      EBIT 1,570
      Shares 2,416
      LTD 1,375
      Cash/cash equiv 447

      EV for SP $5.50 = 14,216m

      EV/EBIT = 9.05

      ROIC 18%

      Still at 9x it looks good.

  37. I am new to your website. Per Gurufocus, 2006, 2007 & 2013 Pretax income figures for USB are 6863,6207 & 7764. These figures are listed under income statement and you do not need to do any calculations. The data for 2010-2014 is available for free and no membership is required. These differ from the pretax earnings you show above. I appreciate you response as to why Gurufocus figures differ from the figures you show above. Thanks in advance.

    1. Hi, that's a good observation. The difference is the tax-equivalent adjustment. USB reports interest income on a tax-equivalent basis (which shows a larger number than actual as you are converting tax-free yield to tax-equivalent yield. There is a number in the income statement that adjusts this back down and that adjusted figure is what Gurofocus is using. It's only 3% so doesn't change the above argument much.

  38. Also, the 2013 IBM pretax per share shown above is 17.7. Gurufocus pretax/share for IBM for 2013 is 20244/1103=18.35. Except for 2013 IBM figure of 17.7, other figures shown above are pretty close to what I calculate using Gurufocus. Any idea why this one figure differs? Thanks.

    1. Hi, why not take a peak at the 10k and try to figure it out yourself? It's always good to go to the source and see where people get numbers. Very often, numbers will vary according to data source for many reasons.

      If you need help, I'll be glad to point you in the right direction. Trust me, you will learn a lot by trying to figure this out (and it's not that hard!).

  39. Per the 10K, the 2013 pretax is 19,524 and this will give a pretax/share of 17.7 as you have correctly shown above. There are several discrepancies between the two sources (10K and Gurufocus)such as all important total revenue that would explain the difference in the 2013 pretax figures. You have been very helpful. Thanks.

  40. Found this in Tweedy paper

    << Intrinsic
    value for industrial companies was defined as 10x EBIT (i.e., earnings before deducting interest
    and taxes), plus cash, less interest bearing debt and preferred stock, divided by outstanding
    shares. In recent years, we have observed many corporate acquisitions of companies at a valuation
    equal to about 10x EBIT. An acquisition valuation of 10x EBIT provides an acquirer with a 10%
    pre-tax return on the total purchase price including any assumption or pay-down of the acquired
    company’s debt.>>


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