Introduction and summary:
In an article a few weeks back I wrote an article about the logic behind buying shares in quality companies, given that they are trading at fair multiples. Warren Buffett and Charlie Munger are, not surprisingly, correct in saying that it’s far better to buy a wonderful company at a fair price than buying a fair company at a wonderful price.
But what is a fair price and how much should you be willing to pay for a quality company? Quality companies should trade at higher multiples, but how much to allow for a margin of safety?
Given a few assumptions it turns out you can justify buying a good and durable business at pretty rich valuations. In this article I go into greater detail how much you can actually pay and still make good returns over two decades. I have as usual provided a Google Sheet to show my calculations.
A good and durable business:
I believe that a business that has shown good returns on equity and capital over many decades most likely has a pretty durable business model. I’m careful of using the word “moat” because I think it’s a bit misused. Still, given that the past is any indication of the future, we can calculate the maximum you can pay for a business and to allow for acceptable returns.
In the calculations I have used return on equity (ROE) as a proxy for quality. I simply assume a company that has shown high and persistent ROE is a quality company and that it can continue returning high returns. That is of course a very big IF. (I could have used other metrics like ROIC, but at the end of the day this article serves only as an illustration.)
A mathematical example of how much you can pay for a quality company
Assuming you buy a quality company, what is a fair price? Actually, quite high if you get all the assumptions correct. These are the assumptions I’m using in this article:
- Our quality company has shown consistent ROE of 18%. We assume this to continue.
- Currently the company trades at 25 times earnings.
- It can reinvest the retained earnings at the same ROE. (Unlikely in the real world, we’ll adjust for this at the end.)
- “The market” returns about 10% on equity and trades at 19 times earnings.
Thus, the market already value the quality company much higher than the “market”, presumably due to its higher expected future returns and earnings.
If your time horizon is nineteen years, how much can you pay for the quality company and still manage to return the same as the market, ie, 10% annually? To allow for some kind of margin of safety we assume the earnings multiple drops to 19 at the end of the period.
The stock still returns a very respectable 16.3% return (you can play with numbers in my sheet). Not bad! Perhaps more interestingly is to calculate how much you can pay for the earnings and still make a 10% return (as the market).
It turns out you would have generated a 10% return even if the earnings multiple was 65 at the start! The reason is of course due to the compounding effect and high marginal returns on retained earnings.
Many dividend investors don’t invest in Berkshire Hathaway because it doesn’t pay a regular dividend. But the lack of a dividend is the exact reason why Berkshire has managed to compound so well!
What happens when cash is returned to shareholders?
Unfortunately, the example above is unlikely to happen in the real world: A company can’t just endlessly retain earnings and compound at the same rate as before. Sooner or later the marginal rate of return plummets and the company needs to return cash back to shareholders either via dividends or buybacks. This complicates our model, but this is of course a much more likely scenario.
Let’s continue using the same example from above but now change the assumptions:
- 65% of earnings are paid out as dividends.
- Dividends are reinvested at year’s end.
- Because dividends are reinvested, I calculated a gradually dropping PE ratio (to consider the price of the reinvested dividends and lower PE ratio at the end of the period).
- No dividend taxes considered.
As expected, the dividend distributions lower the annual returns because you reinvest at higher multiples and prices, just as I covered in this article about external and internal compounding.
What happens? The CAGR drops significantly:
- If PE starts at 35, then CAGR drops to about 5%.
- Even with a PE of 25 at the start you only manage 7.5% return, below “the market’s” 10% return.
Why is this? It’s because you reinvest so much of the earnings at an unfavorable price. The more internal compounding, the better. Even though the company returns 18% of equity every year, you reinvest your equity at much lower rates.
I hope it’s no surprise for readers of this blog that returns suffer when you DRIP. You can pay a lot for a good business, but as soon as distributions surpass 50% the marginal rate of return from the reinvestment/dividend has problems to recoup the steep price you pay for those earnings.
Before you do any investments I believe it makes a lot of sense to run some simple calculations like I have done in this article.