When Berkshire Hathaway
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.
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
In addition, I looked at McDonald's
- Buffett's Subprime Bets
- The Death of Berkshire Hathaway?
- Charlie Munger's 10 Rules for Investment Success
The Motley Fool owns shares of Berkshire Hathaway, which is also a Stock Advisor and Inside Value pick. Home Depot is an Inside Value recommendation, too. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates hearing your comments, concerns, and complaints. The Motley Fool has a disclosure policy.