Is 12.5 Buffett's Magic Number?

When Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) chairman Warren Buffett negotiates with the owner of a business he wants to buy, he has to figure out how much to pay for the company. After reading all of Berkshire's annual shareholder letters, I'd say the multiple Buffett typically looks to pay is around 12.5 times trailing earnings. Here's why I think that's the magic number.

A fair price
In most business sales, after the buyer signs on the dotted line, the seller hands over the keys, heads to the Caribbean, and lets the buyer figure out what to do next. In this situation, the buyer has an incentive to pay as low a price as possible, while the seller wants to get as high a price as possible.

Buffett's business transactions are more like marriages. After selling his or her business to Buffett, the owner usually stays on and runs the company, and almost nothing changes.

As a result, it is extremely critical that Buffett pays the owner a fair price. After all, Buffett can't rip off the guy whom he expects to run his newly bought business for the next 20 years. Nor can he overpay, because that wouldn't benefit Berkshire shareholders. Thus, he has to pay a price that both parties can be happy with over the long term.

Why 12.5?
The businesses Buffett buys tend to be extremely stable and offer a high return on capital. Thus, most of the earnings head directly to free cash flow, and the business can often grow without adding any additional capital. In his 1991 annual letter, Buffett noted:

Ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million.

In other words, a company with an extremely wide moat, which can grow earnings around 6% every year with minimal additional reinvestment, would be worth 25 times earnings. Thus, paying 12.5 times that price would be equivalent to buying a dollar for 50 cents and would provide an 8% free cash flow yield (invert 12.5) that should compound over time.

The rule of 12.5
Investors should keep a sharp eye out for high-quality, wide-moat companies trading around or below 12.5 times normalized earnings. For example, Buffett paid 12.5 times earnings for one of his first big scores, See's Candy. See's much larger competitor, Hershey (NYSE: HSY  ) , earned nearly $600 million in 2004 and currently trades at a $9.5 billion market cap. Thus, although they're not there yet, Hershey's shares could hit the magic 12.5 number in the future.

In addition, I looked at McDonald's (NYSE: MCD  ) back in 2003, right before the shares quadrupled in value. If investors had bought shares back then, they'd have been paying about 13 times trailing earnings -- not too far from 12.5. Some other very high-quality companies that trade near 12.5 times earnings are American Express (NYSE: AXP  ) at 15 times earnings, Lowe's (NYSE: LOW  ) at 11.5, and Inside Value recommendation Home Depot (NYSE: HD  ) at 11. The future may be bright for these companies, so it may be wise to follow them.

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