Finance Lecture

What’s a good business, what’s a mediocre business, what’s bad

business and why?

“Time is a friend of the good business and the enemy of the mediocre”. - Warren Buffett

Measures of Economic Performance

Growth in revenues?Market share?

Growth in Profits?Growth EPS?Profit Margin?

Capital Efficiency?Return on Capital?

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The Case of Five Companies

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Relation between returns on capital, dividend policy, and

stockholder returns

Key Principle # 1

Assets are worth more than book value when they are

expected to earn a return on capital employed which is more

than market rates of return.And Vice Versa...

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Key Principle # 2

Assets lodged in the hands of a manager who thinks and acts in the interests of the owners are worth more than identical

assets lodged in the hands of a self-interested manager.

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Key Principle # 3

All growth is not good. There is good growth and there is bad growth. Good growth creates value. Bad growth destroys it.

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Key Principle # 4

Some businesses can grow WITHOUT requiring any

incremental capital. They are a very special class of businesses

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Key Principle # 5

None of these, in isolation, are accurate measures of the greatness of a business: Growth in revenues,

Market share, Growth in Profits, Growth EPS, Profit Margin, Capital

Efficiency, Return on Capital

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Key Principle # 6

Price, like Love, Changes Everything*

* Conditions Apply

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“Most companies define “record” earnings as a new high in earnings per share. Since

businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance

combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.”

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“After all, even a totally dormant savings account will produce steadily rising interest

earnings each year because of compounding.”

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“The primary test of managerial economic performance is the achievement of a high earnings

rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per

share.”

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“In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial

analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes

in that figure.”

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Buffett on Best Businesses

“Leaving the question of price aside, the best business to own is one that over an

extended period can employ large amounts of incremental capital at very

high rates of return”

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“The worst business to own is one that must, or will, do the opposite - that is,

consistently employ ever-greater amounts of capital at very low rates of return.”

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“The business is wonderful if it gives you more and more money every year without putting up anything – or by putting up very little. And we have some businesses like that. A business is

also wonderful if it takes money, but where the rate at which you re-invest the money is very

satisfactory.”16

Scott-Fetzer

Berkshire purchased Scott Fetzer at the beginning of 1986. At the time, the company

was a collection of 22 businesses

Acquisition cost: $315.2 million for Scott Fetzer, against book value of $172.6

million.

“The $142.6 million premium we handed over indicated our belief that the company's

intrinsic value was close to double its book value.”

What’s Causing This???

Earnings per share = Asset turnover x Return on sales x leverage x Book value per share

EPS=(Sales/Assets) x (Net Income/Sales) x (Assets/Net worth) x (Net worth/Shares

outstanding)

Why is time a friend of the wonderful business?

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“Time is a friend of the good business and the enemy of the mediocre”

Why?Importance of Earnings Retention

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Return on Capital, Growth Recommended dividend policy

A Low return, high growth potential High

B Low return, low growth potential High

C High return, high growth potential Low

D High return, low growth potential High

“Because it had excess cash when our deal was made, Scott Fetzer was able to pay Berkshire dividends of $125 million in

1986, though it earned only $40.3 million.

“Scott Fetzer’s earnings have increased steadily since we bought it, but book value

has not grown commensurately. Consequently, return on equity, which

was exceptional at the time of our purchase, has now become truly

extraordinary.”

“Just how extraordinary is illustrated by comparing Scott Fetzer's performance to that of the Fortune 500, a group it would

qualify for if it were a stand-alone company.

“Had Scott Fetzer been on the 1993 500 list the company's return on equity would have ranked 4th. But the top three companies in return on

equity were Insilco, LTV and Gaylord Container, each of which emerged from bankruptcy in 1993 and none of which achieved meaningful earnings

that year except for those they realized when they were accorded debt forgiveness in

bankruptcy proceedings.

“Leaving aside such non-operating windfalls, Scott Fetzer's return on equity would have ranked it first on the Fortune 500, well ahead of number two. Indeed, Scott Fetzer's return on equity was

double that of the company ranking tenth.”

Steven Penman

Value = Book Value + Speculative Value

Speculative Value could by +ve or -ve

Why would speculative value be +ve?

Why would speculative value be -ve?

Buffett uses the concept of “Economic Earnings” instead of “Free Cash Flow”

Buffett’s Equation:

Value of Firm = Value of Net Tangible Assets + Economic Goodwill

“Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on

such assets considerably in excess of market rates of return. The capitalized value of this excess return is

Economic Goodwill.”

Reverse Engineering:By plugging stock price on left hand side, we can derive

the value of speculative growth.


“The worst business of all is the one that grows a lot, where you’re forced to grow just

to stay in the game at all and where you’re re-investing the capital at a very low rate of

return.”

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Graham’s “Frozen Corporation”

A company whose charter prohibited it from ever paying out anything to its owners or ever being liquidated or sold.

And Graham’s question was, “What is such an enterprise worth?”

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Graham’s “Frozen Corporation”

“I do think that it’s an interesting case because I think there is a class of business where the eventual “cash back” part of the equation tends to be an illusion. There are businesses like that – where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.”

Shareholder: Did you have a particular business or investment experience early in

your career which convinced you it was preferable to invest in high quality

businesses? Or was it simply a matter of analyzing the effect of owning a high quality

growing company over a long term?

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”You should seek businesses that just drown in money if they just pause for breath…”

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Models for Business Success

Questions to ask:Why is this company earning high returns on

capital?Answer lies in the the du-pont formula

High margins and high capital turnover (low capital intensity)- ITC’s tobacco business

High margins and low capital turnover (high capital intensity e.g. shipping)

Low margins and high capital turnover e.g. Wal-martBut see what happened to IBP

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Models for Business SuccessQuestions to ask:

What models combine to produce its extraordinary profitability and/or scale?

Why would it continue?How long can it last?

Is this a fluke, a short-lived first mover advantage, or is it likely to last very long?

What forces will cause these results to stop occurring? [backward thinking]

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Moats

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Moats

“What we’re trying to find is a business that for one reason or another – because it’s the low cost

provider in some area, because it has a natural franchise due to its service capabilities, because of its

position in the consumer’s mind, because of a technological advantage or any kind of reason at all –

has this moat around it.

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Moats

“However all moats are subject to attack in a capitalistic system. If you have a big castle out there,

people are going to try to figure out how to get to it. And most moats

aren’t worth a damn in capitalism.”

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Moats

“And we try to figure out why the castle is still standing and what’s

going to keep it standing or cause it not to be standing five, ten, or twenty

years from now. What are the key factors? How permanent are they?

And how much do they depend on the genius of the lord in the castle?”

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The Franchise-Business Continuum

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Strong FranchiseWeak Franchise/Strong BusinessWeak Business

Buffett on Franchise Value

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What to look for in a great business?

A high return on capital (not contributed by a very low margin operation where margins

could fall as happened in IBP) which is sustainable - pricing power, low cost

advantage etc.Ability to deploy incremental capital at high rates of return i.e. growth prospects. (Why

this ability is crucial?)Ability to self-fund growth (How important is

dilution?)51

What to look for in a bad business?

A low return on capital

Growth (what does high growth do to bad business?)

Inability to self-fund growth (with consequential effects on quality of balance

sheet)

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“Time is a friend of the good business and the enemy of the mediocre”. - Warren Buffett

"If a business earns 18% on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with

one hell of a result." - Charlie Munger

Finance Lecture

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