Warren Buffett provided a great illustration of what a long-term owner ought to be “cheering for” with regard to stock prices.
The example used IBM as a demonstration, and simultaneously added a future valuation component.
This article shows what IBM as an investment could look like with a higher multiple in the future.
In Berkshire Hathaway’s 2011 annual letter, Warren Buffett addressed the “irrational reaction” of many investors with regard to stock price. In particular Buffett was referring to companies that routinely repurchase shares. Many investors hope for higher prices. Yet the long-term owner, who also happens to be a net buyer, ought to be cheering for the opposite. The idea is that first you want a solid underlying earnings machine, but secondly you ought to be “rooting for” a stock price that underperforms. This enables the additional funds to retire more shares and create a springboard effect in the future.
Here’s an excerpt from Buffett’s letter using IBM (NYSE:IBM) as an example:
“Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?”
“I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.”
“Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.”
“If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1 ½ billion more than if the “high-price” repurchase scenario had taken place.”
“The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.”
“In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.”
Since that time profits have stagnated, but the company has indeed retired a large chuck of outstanding shares. The company went from having 1.16 billion common shares outstanding in 2011 to 991 million by the end of fiscal year 2014. And it was able to do so at lower, rather than higher prices – as a consequence, earnings-per-share have increased steadily as well.
In 2011 the company was earning nearly $15.9 billion. By 2014 this number had gone down to almost $15.8 billion. Yet earnings-per-share increased by almost 20% during the period. Its clear that share repurchases continue to have a strong influence on the per share metrics of the company.
Naturally this doesn’t singularly apply to IBM. The same concept holds for any company that is repurchasing shares. Take Wal-Mart (NYSE:WMT) as an example, which routinely retires a large chuck of shares each year. If you were a long-term owner, you’d much prefer for the company to buy out past partners at say $65 as compared to $85. Paying a premium to past shareholders doesn’t help those who stick around.
The natural realization in this story is easy to spot: lower prices in the intermediate-term can be beneficial rather than something to fear. In the long-term things more or less work out, but before that time comes a lot of things can happen. If the business keeps making money, a lower price is simply a better opportunity.
There is a secondary takeaway that’s not as easy to spot but just as tangible. Ordinarily you won’t find Buffett talking about specific valuations, but in this instance he did just that. He indicated that Berkshire’s earnings’ share in the “lower price” scenario would be $100 million greater. He went on to detail that at some later point, due to the increased earnings claim, these shares might be worth $1.5 billion more. He didn’t say it directly, but he might as well have: at some later point IBM could be trading at perhaps 15 times earnings.
Let’s take a look at what this multiple might mean for long-term owners. We’ll begin with a five-year period.
IBM has suggested a full-year operating earnings-per-share expectation between $15.75 and $16.50. Last year the company earned about $15.60, so this seems reasonable enough, especially when you consider the share repurchase program. From 2011 to 2014 total earnings actually decreased, but earnings-per-share increased by 6% annually. Let’s presume earnings-per-share can increase by 2% annually moving forward – hardly shooting for the moon.
Now granted if the company is barely growing you might question the higher earnings multiple, but let’s continue with the example to see what it looks like. If IBM were to grow its earnings-per-share by 2% annually, you would end the half a decade period with an EPS number of just over $17.20. At a 15 multiple, this would equate to a share price near $260. By itself, this represents annual gains over 12% per year.
Yet we’re not quite done yet. IBM presently pays a $1.30 quarterly dividend, or $5.20 on an annual basis. If the dividend grew by 2% annually (well below its historical average, and quite slow given the comparatively low payout ratio) you could collect perhaps $27 in dividend payments. If you add this to the anticipated price, you’d reach a total expected return of about 14.5% per year.
Interestingly, you don’t need a spectacular multiple for an investment in IBM to turn out OK (not that a 15 multiple is that spectacular). Even with a future multiple of 10, you’d expect 6% to 7% annual returns.
The same exercise can be completed over longer time periods. After 10 years, assuming the same growth, you might expect the company to turn out $19 in earnings-per-share. In addition, you’d stand to collect nearly $58 in dividend payments as well. Add it up, using the 15 multiple, and you come to a total value of $340 or an annual gain of 9%. With a multiple of say 11, you’d still expect returns of 6% per year – and that’s prior to thinking about reinvesting the now 3.5% yield.
And so the beat goes on. Buffett has a quote about setting expectations and finding investments: “I don’t try to jump over 7-foot bars, I look around for 1-foot bars that I can step over.” If you need a company to trade at 50 times earnings to work out, you’re trying to jump over a 7-foot bar. It’s possible, sure, but it might not be altogether prudent to expect.
Alternatively, if you need very little growth (or no company growth) and a P/E in the low teens to provide solid returns that’s looking for a lower bar to step over. Many people have ragged on the company for not providing great growth, but that’s just the thing: the low expectations, especially when coupled with a solid and growing dividend, allow for reasonable returns without spectacular business strides.
from Eli Inkrot.