How to Think Like Benjamin Graham and Invest Like Warren Buffett
by Lawrence A. Cunningham
Chapter 6 - Apple Trees and Experience
If market price is the last thing an investor or manager should look
at in determining the value of a business or an ownership interest
in it, the first thing to consider is its fundamental economic characteristics.
There are so many approaches to appraising those fundamentals
that many people use the relatively lazy metric of market
price as a guideline in valuation, but that is a mistake. Of all the
approaches to appraising business value, just a few do virtually all
the hardwork, and those are the ones you need. A parable will
illustrate the basics, and the rest of this part will fill in the details.
Story of an Old man and his tree
Once there was a wise old man who owned an apple tree. It was a
fine tree, and with little care it produced a crop of apples each year
which he sold or $100. The man wanted to retire to a new climate,
and he decided to sell the tree.He placed an advertisement in the business
opportunities section of The Wall Street Journal to sell the tree for “the best offer.”
The first person to respond to the ad offered to pay $50, which, he
said, was what he could get for selling the apple tree for firewood
after he cut it down. “You don’t know what you are talking about,”
the old man chastised. “You are offering to pay only the salvage value
of this tree.You can’t see that my tree is worth far more than 50 bucks.
The next person who visited the old man offered to pay $100 for
the tree. “For that,” she opined, “is what I would be able to get for
selling this year’s crop of fruit, which is about to mature.” “You are
not as out of your depth as the first one,” responded the old man.
“At least you see that this tree has more value as a producer of apples
than it would as a source of firewood. But $100 is not the right price.
You are not considering the value of next year’s crop of apples or
that of the years after. Please take your $100 and go elsewhere.”
The third person to come along was a young man who had just
dropped out of business school. “I am going to sell apples on the
Internet,” he said. “I figure that the tree should live for at least
another 15 years. If I sell the apples for $100 a year, that will total
$1,500. I offer you $1,500 for your tree.” “Oh, no, dot-commer,” lamented the
man, “you’re even more ill informed about reality than
the others I’ve spoken with.” “Surely the $100 you would earn by selling the apples from the
tree 15 years from now cannot be worth $100 to you today. In fact,
if you placed$41.73 today in a bank account paying 6% interest,
compounded annually, that small sum would grow to $100 at the end
of 15 years. So the present value of $100 worth of apples 15 years
from now, assuming an interest rate of 6%, is only $41.73 not $100.
Pray,” advised the beneficent old man, “take your $1,500 and invest
it safely in high-grade corporate bonds and go back to business
school and learn something about finance.”
Before long there came a wealthy physician who said, “I don’t
know much about apple trees, but I know what I like. I’ll pay the
market price for it. The last fellow was willing to pay you $1,500 for
the tree, and so it must be worth that.” “Doctor,” advisedthe oldman, “you should get yourself a knowledgeable investment adviser. If there were truly a market in which
apple trees were traded with some regularity, the prices at which
they were sold might tell you something about their value. But not
only is there no such market, even if there were, taking its price as
the value is just mimicking the stupidity of that last knucklehead or
the others before him. Please take your money and buy a vacation
home.”
The next would-be buyer was an accounting student. When the
old man asked, “What price are you willing to give me?” the student
first demanded to see the old man’s books. The old man had kept
careful records and gladly brought them out.
After examining them, the accounting student said, “Your books
show that you paid$75 for this tree ten years ago. Furthermore, you
have made no deductions for depreciation. I do not know if that
conforms with generally accepted accounting principles, but assuming
that it does, the book value of your tree is $75. I will pay that.”
“Ah, you students know so much and yet so little,” chided the
old man. “It is true that the book value of my tree is $75, but any
fool can see that it is worth far more than that. You had best go back
to school and see if you can find a book that shows you how to use
your numbers to better effect.”
The final prospect to visit the old man was a young stockbroker who
had recently graduated from business school. Eager to test her new
skills, she too asked to examine the books. After several hours she
came back to the old man and said she was prepared to make an
offer that valued the tree on the basis of the capitalization of its
earnings. For the first time the old man’s interest was piqued, and
he asked her to go on.
The young woman explained that while the apples were sold for
$100 last year, that figure did not represent the profits realized from
the tree. There were expenses attendant to the tree, such as the cost
of fertilizer, pruning, tools, picking apples, and carting them to town
and selling them. Somebody had to do those things, and a portion of the salaries
paid to those persons ought to be charged against the revenues from
the tree. Moreover, the purchase price, or cost, of the tree was an
expense. A portion of the cost is taken into account each year of the
tree’s useful life. Finally, there were taxes. She concluded that the
profit from the tree was $50 last year.
“Wow!” The old man blushed. “I thought I made $100 off that
tree.”
“That’s because you failed to match expenses with revenues, in
accordance with generally accepted accounting principles,” she explained.
“You don’t actually have to write a check to be charged with
what accountants consider to be your expenses. For example, you
bought a station wagon some time ago and used it part of the time
to cart apples to market. The wagon will last a while, and each year
some of the original cost has to be matched against revenues. A
portion of the amount has to be spread out over the next several
years even though you expended it all at one time. Accountants call
that depreciation. I’ll bet you never figured that in your calculation
of profits.”
“I’ll bet you’re right,” he replied. “Tell me more.”
“I also went back into the books for a few years and saw that in
some years the tree produced fewer apples than it did in other years,
the prices varied, and the costs were not exactly the same each year.
Taking an average of only the last three years, I came up with a
figure of $45 as a fair sample of the tree’s earnings. But that is only
half of what we have to do to figure the value.”
“What’s the other half?” he asked.
“The tricky part,” she told him. “We now have to figure the value
to me of owning a tree that will produce average annual earnings of
$45 a year. If I believed that the tree was a ‘one-year wonder,’ I would
say 100% of its value—as a going business—was represented by one
year’s earnings.”
“But if we agree that the tree is more like a corporation in that
it will continue to produce earnings year after year, the key is to
figure out an appropriate rate of return. In other words, I will be
investing my capital in the tree, and I need to compute the value to
me of an investment that will produce $45 a year in income. We can
call that amount the capitalized value of the tree.”
“Do you have something in mind?” he asked.
“I’m getting there. If this tree produced entirely steady and predictable
earnings each year, it would be like a U.S. Treasury bond.
But its earnings are not guaranteed, so we have to take into account
risks and uncertainty . If the risk of its ruin was high, I would insist
that a single year’s earnings represent a higher percentage of the
value of the tree. After all, apples could become a glut on the market
one day and you would have to cut the price, thus increasing the
costs of selling them.”
“Or,” she continued, “some doctor could discover a link between
eating an apple a day and heart disease. A drought could cut the
yield of the tree. Or the tree could become diseased and die. These
are all risks. And we don’t even know whether the costs we are sure
to incur will be worth incurring.”
“You are a gloomy one,” reflected the old man. “There could also
be a shortage of apples on the market, and the price of apples could
rise. If you think about it, it is even possible that I have been selling
the apples at prices below what people would be willing to pay and
that you could raise the price without reducing your sales. Also,
there are treatments, you know, that could be applied to increase
the yield of the tree. This tree could help spawn a whole orchard.
Any of these would increase earnings.”
“The earnings also could be increased by lowering costs of the
sort you mentioned,” the old man continued. “Costs can be reduced
by speeding the time from fruition to sale, managing extensions of
credit better, and minimizing losses from bad apples. Cutting costs
boosts the relationship between overall sales and net earnings or, as
the financial types say, the tree’s profit margin. And that in turn
would boost the return on your investment.”
“I am aware of all that,” she assured him. “The fact is, we are
talking about risk. And investment analysis is a cold business. We
don’t know with certainty what’s going to happen. You want your
money now, and I’m supposed to live with the risk.
“That’s fine with me, but then I have to look through a cloudy
crystal ball, and not with 20/20 hindsight. And my resources are
limited. I have to choose between your tree and the strawberry patch
down the road. I cannot buy both, and the purchase of your tree
will deprive me of alternative investments. That means I have to
compare the opportunities and the risks.
“To determine a proper rate of return,” she continued, “I looked
at investment opportunities comparable to the apple tree, particularly
in the agribusiness industry, where these factors have been
taken into account. I then adjusted my findings based on how the
things we discussed worked out with your tree. Based on those judgments,
I figure that 20% is an appropriate rate of return for the tree.
“In other words,” she concluded, “assuming that the average
earnings from the tree over the last three years (which seems to be
a representative period) are indicative of the return I will receive, I
am prepared to pay a price for the tree that will give me a 20% return
on my investment. I am not willing to accept any lower rate of return
because I don’t have to; I can always buy the strawberry patch instead.
Now, to figure the price, we simply divide $45 of earnings per
year by the 20% return I am insisting on.”
“Long division was never my strong suit. Is there a simpler way
of doing the figuring?” he asked hopefully.
“There is,” she assured him. “We can use an approach we Wall
Street types prefer, called the price-earnings (or P/E) ratio. To compute
the ratio, just divide 100 by the rate of return we are seeking.
If I were willing to settle for an 8% return, that would be 100 divided
by 8, which equals 12.5. So we’d use a P/E ratio of 12.5 to 1. But
since I want to earn 20% on my investment, I divided 100 by 20 and
came up with a P/E ratio of 5:1. In other words, I am willing to pay
five times the tree’s estimated annual earnings. Multiplying $45 by
5, I get a value of $225. That’s my offer.”
The old man sat back and said he greatly appreciated the lesson.
He would have to think about her offer, and he asked if she could
come by the next day.
When the young woman returned, she found the old man emerging
from behind a sea of work sheets, small print columns of numbers,
and a calculator. “Delighted to see you,” he said, enthralled. “I think
we can do business.
“It’s easy to see how you Wall Street smarts make so much
money, buying people’s property for less than its true value. I think
I can get you to agree that my tree is worth more than you figured.”
“I’m open-minded,” she assured him.
“The $45 number you came up with yesterday was something
you called profits, or earnings that I earned in the past. I’m not so
sure it tells you anything that important.”
“Of course it does,” she protested. “Profits measure efficiency
and economic utility.”
“Fair enough,” he mused, “but it sure doesn’t tell you how much
money you’re getting. I looked in my safe yesterday after you left
and saw some stock certificates I own that never paid a dividend to
me. And I kept getting reports each year telling me how great the
earnings were. Now I know that the earnings increased the value of
my stocks, but without any dividends I couldn’t spend them. It’s just
the opposite with the tree. “You figured the earnings were lower because of some amounts
I’ll never have to spend, like depreciation on my station wagon,” the
old man went on. “It seems to me these earnings are an idea worked
up by the accountants.”
Intrigued, she asked, “What is important, then?”
“Cash,” he answered. “I’m talking about dollars you can spend,
save, or give to your children. This tree will go on for years yielding
revenues after costs. And it is the future, not the past, we need to
reckon with.”
“Don’t forget the risks,” she reminded him. “And the uncertainties.”
“Quite right,” he observed. “If we can agree on the possible range
of future revenues and costs and that earnings averaged around $45
the last few years, we can make some fair estimates of cash flow
over the coming five years: How about that there is a 25% chance
that cash flow will be $40, a 50% chance it will be $50, and a 25%
chance it will be $60? “That makes $50 our best guess if you average it out,” the old
man figured. “Then let’s just say that for ten years after that the
average will be $40. And that’s it. The tree doctor tells me it can’t
produce any longer than that.
“Now all we have to do,” he finished up, “is figure out what you
pay today to get $50 a year from now, two years from now, and so
on for the first five years until we figure what you would pay to get
$40 a year for each of the ten years after that. Then, throw in the
20 bucks we can get for firewood.
“Simple,” she confessed. “You want to discount to the present
value of future receipts including salvage value. Of course you need
to determine the rate at which you discount.”
“Precisely,” he concurred. “That’s what my charts and the calculator
are for.” She nodded as he showed her discount tables that
revealed what a dollar received at a later time is worth today under
different assumptions about the discount rate. It showed, for example,
that at an 8% discount rate, a dollar delivered a year from
now is worth $.93 today, simply because $.93 today, invested at 8%,
will produce $1 a year from now.
“You could put your money in a savings account that is insured
and receive 5% interest. But you could also buy U.S. Treasury obligations
with it and earn, say, 8% interest, depending on prevailing
interest rates. That looks like the risk-free rate of interest to me.
Anywhere else you put your money deprives you of the opportunity
to earn 8% risk-free. Discounting by 8% will only compensate you
for the time value of the money you invest in the tree rather than
in Treasuries. But the cash flow from the apple tree is not risk less,
sad to say, so we need to use a higher discount rate to compensate
you for the risk in your investment.
“Let’s agree to discount the receipt of $50 a year from now by
15%, and so on with the other deferred receipts. That is about the
rate that is applied to investments with this magnitude of risk. You
can check that out with my neighbor, who just sold his strawberry
patch yesterday. According to my figures, the present value of the
expected yearly profit is $268.05, and tod ay’s value of the firewood
is $2.44, for a grand total of $270.49. I’ll take $270 even. You can
see how much I’m allowing for risk because if I discounted the
stream at 8%, it would come to $388.60.”
After a few minutes of reflection, the young woman said to the
old man, “It was a bit foxy of you yesterday to let me appear to be
teaching you something. Where did you learn so much about finance
as an apple grower?” The old man smiled. “Wisdom comes from experience in many
fields.”
Computation
First Five years
50 50 50 50 50
At 3% Inflation Adjusted 50(.97) 50(.97)(.97) 50(.97)(.97)(.97) etc.
48 47 46 44 43
Inflation adjusted price when Discounted at 15% 48(1/1.15) 47(1/1.15)(1/1.15) etc
42 36 30 25 21
Next Ten Years (Don't take inflation just take discounted value of 15%)
40 40 ......40 for the tenth year it is actually worth $10
So roughly $100 for all these years
Roughly the total Value of cash-flows is 42+36+30+25+21+100 = $254
“Nice try, you crafty old devil,” she rejoined. “You know there is
plenty of room for mistakes in your calculations too. It’s easy to
discount cash flows when they are nice and steady, but that doesn’t
help you when you’ve got some lumpy expenses that do not recur.
For example, several years from now that tree will need serious pruning
and spraying that don’t show up in your flow. The labor and
chemicals for that once-only occasion throw off the evenness of your
calculations.”
“But I’ll tell you what,” she bellied up. “I’ll offer you $250. My
cold analysis tells me I’m overpaying, but I really like that tree. I
think the delight of sitting in its glorious shade must be worth something.”
“It’s a deal,” agreed the old man. “I never said I was looking for
the highest offer but only the best offer.”
