Warren Buffett values companies based on “Owner Earnings,” and I calculated valuations for Apple’s stock. Danielle Town’s & Phil Town’s Invested July chapter explains the 10 Cap / Owner Earnings and PayBack Time valuation equations so we can figure out a stock’s buy price.
The main lessons of this book stem from Charlie Munger’s 4th Principle of Investing: Pricing where we’re trying to value companies to determine a price that makes sense. There’s not an infinite price that we should pay for a company or a business.
These are Charlie’s principles summarized about companies we might like to buy:
-Meaning: We are capable of understanding it
-Moat: Intrinsic characteristics that give it a durable competitive advantage
-Management: with integrity and talent
-Margin of Safety (MOS): Buy at a price that makes sense and gives a MOS
The July chapter covers 2 of 3 of the Rule 1 valuation calculation methods that Phil Town created and which are featured in not only the Invested book, but also his prior New York Times bestsellers Rule #1 and PayBack Time. I apply the 10 Cap and PayBack Time equations to Apple’s stock fundamentals.
Like Danielle writes, we want to find a price that is not only reasonable, but wait until it is on sale beyond the reasonable price at which we can buy the stock so we have a reasonable MOS (50% off) built in.
The events of the Invested book take place in 2015, and back then Danielle was struggling to figure out how to value public companies so she could find a price to pay for stocks. She turned to her father Phil to show her the way.
10 Cap is based on Warren Buffett’s definition of “Owner Earnings,” a term he came up with. PayBack Time is based on Free Cash Flow. MOS as a valuation calculation is based on earnings, but we’ll cover that in the August chapter. Having these 3 valuation methods gives us a range to consider how much we’d like to pay for a stock so we make the best decision.
Danielle applies these valuation equations to examples in the book of a Lemonade stand, a Rental House, and Whole Foods before Amazon bought it.
In Warren Buffett’s 2013 Berkshire letter, he talked about how we went about buying his Nebraska farm and New York City real estate. The 10 Cap method comes from a real estate investing term called Capitalization rate or Cap rate for short.
Example: If you bought a rental property for $300K and over the first year received $30K in rent, that would be a 10% yield or a 10 Cap. In contrast, I’ve heard real estate in places like Vancouver, Canada is at a 2 Cap or 2% return nowadays.
Buffett loves using the 10 Cap as a simple and useful way to also value public company stocks.
In the 1986 Berkshire letter, Buffett defined Owner Earnings as “(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment.”
This chapter goes into the nitty gritty formulas that pull financial criteria from public companies’ 10-K filings that contain figures from their income statement and cash flow statement.
So I found Apple’s 10-K annual report from October 2020, and I share a table showing the financial numbers to arrive at a 10 Cap sale price for Apple to be $69.57 per share for right now. The current price of Apple is nowhere near this 10 Cap price if you notice.
It should be technically easier to find 10 Cap opportunities in the stock market than in real estate, because borrowing from another set of Buffett quotes: “Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is.”
Investors use PayBack Time to put a price on a company that they’re not going to sell for a long time. This means we want to figure out the amount of years it takes to get our whole purchase price back in terms of the company growing its free cash flows (FCF) at the “windage growth rate” of the company.
We estimate how much the company is growing on average and use that in compounding its FCF to reach a point at which we can take our money or initial capital out of the company.
Another way to think about this is the difference between public and private companies is based on how liquid they’re considered to be. Public company stocks on a stock market exchange are considered to be very liquid because people can trade in and out of them very quickly, which is really important to money managers.
But to people like Warren Buffett and Charlie Munger, they don’t need to be trading in and out as much. They’re totally happy with paying a private company price for a public company’s stock so that’s how we get an 8 Year PayBack Time (PBT) price. If we can get our money back in 8 years or sooner, that would be ideal.
The PBT equation looks at subtracting capital expenditures from net cash and then we grow this over 8 years and divide by shares outstanding for me to arrive at a PBT sale price of $68.41 per share at this time. If I use a lower windage growth rate, the price I should pay per share goes to an even lower amount.
All this means is if I want to buy Apple, I gotta wait until it’s on sale. Phil Town and Warren Buffett bought Apple when it was a 10 Cap back around 2015, so some of us may still be on the hunt until it goes on sale again!
I look forward to making more investor friends! Add me on Instagram: michellemarki
If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.