Here is a rundown of the typical cash flowing assets and the types of income delivered:
Of Assets and Income
· Rental Property = Rental Checks
· Dividend Paying Stocks = Dividend Distributions
· Covered Call Options = Call Premium
· Systemic Business Models = Earnings Distributions
· Intellectual Property = Royalties, Licensing Fees
The question is; where do mutual funds fit into this bucket of cash flowing assets if at all? The first place to look is found in the common ground that lies between Warren Buffett’s “business perspective” investing methodology and the model of a cash flow rental property investor.
Transcending Via the Beachhead of Warren Buffett
“The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” – Benjamin Graham
“The long run is a misleading guide to current affairs. In the long run we are all dead.” - John Maynard Keynes[i]
One can interpret Keynes’ uplifting statement to mean “why be concerned with the capital gains of tomorrow if the cash flows of today do not pay the bills?” An investor who seeks financial independence today will agree that cash flows today take priority over the nest egg of tomorrow and thus they may find solace in the statement that “in the long-run we are all dead.”
Now that everyone is feeling warm and cheery, let us talk about cash flow, financial independence and mutual funds. Financial Independence Defined
By one definition, financial independence is the state of having enough income from asset sources to meet or exceed monthly expenses. In his article for Investopedia, Stephen D. Simpson defines it as “having enough wealth to live as [you] wish for the rest of [your] life without having to work.[ii]
” In specific terms, this means that an individual who has $3,000 in monthly expenses will be financially independent once they have $3,000 in monthly income from assets. This income can come from various asset sources including rental property, dividend paying stocks, intellectual property and yes, in our paradigm to be presented, mutual funds. [i] A Tract on Monetary Reform,
1924, p. 80. [ii]
Read more: http://www.investopedia.com/financial-edge/0611/Declare-Your-Own-Financial-Independence-Day.aspx#ixzz1sRpJytBZ
These are some beautiful records folks. Although it appears that Coke had a dip in 2011, the company is actually coming off of a high of $5.06 in 2010 so, still on a steady, upward trajectory with growth of over 12%
This is what Warren Buffett looks for:
1. I want a consumer monopoly …
2. With strong earnings,
3. A High Rate of Return …
4. With the ability to retain earnings,
5. Possessing low debt levels …
6. With the ability to increase prices with inflation,
7. And healthy margins.
It’s almost like a haiku, a Warren Buffett haiku.
The Consumer Monopoly
If the product disappeared from grocery store shelves tomorrow, would you notice? Do you own a “Tom’s Brand X” product or do you own a Coke, Disney or Kellogg’s? If all of the cereal aisles at your local grocery mart were suddenly wiped clean of Rice Krispies, Frosted Flakes or Corn Flakes, would shopper’s not give a hoot or do you think you might see a few panicked faces uttering “hey, what the hell is going on here?” If your business is similar to the latter, then you may have a consumer monopoly, a brand emblazoned in the hearts and minds of consumers, that would create panic and swearing if it disappeared.
As Opposed To …
The commodity type business. Are you the manufacturer of Ally’s All-Encompasing Aluminum or Phil’s Boisterous, New and Improved Oil? Then you may own a commodity type business.
As a consumer, when’s the last time you shopped around for lumber based on the brand name? Steel? Aluminum? Gas? Okay, you might have some loyalty in the last example to Phil’s Filling Station if Phil makes a great tuna salad sandwich but I bet if Dan’s across the street lowers the gas, you won’t think twice before driving across the street, tuna be damned! These businesses chiefly compete on price alone and summarily knock the stuffing out of each other when it comes to margins.
A business with supreme, consumer monopoly brand name recognition on the other hand cannot be easily knocked off. It has a type of insurance for a sustainable business model that in some instances creates a price premium for a piece of the brand that consumers have fallen in love with.
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The monthly employment report released today from ADP
shows that employment on small payrolls — those private-sector businesses with less than 50 employees — increased by 100,000 in March.
It was the fourth time in the past five months where payrolls of the smallest businesses increased by at least 100,000 employees, according to ADP data. Since October 2011, a total of 548,000 employees were added to small-business payrolls.
Medium-sized businesses, defined by ADP as those having 50 to 499 employees, have also seen a boost in employment numbers, although not as dramatic. From February to March, 87,000 new jobs were added to midsized company payrolls. Since October 2011, a total of 472,000 jobs were added.
Large-company payrolls — those with 500 or more workers, rose 22,000 in March.
First, any yield attributed to the payout of dividends is subtracted from the average, 10 year return on equity in order to reach the true rate of equity growth of shareholder’s equity or in other words, the true return on equity. The reasoning behind this calculation is to exclude dividends from our subsequent compounding calculations. We do not want to include dividends as they are paid out and play no part in the future compounding of our equity.
Next we find the total shares outstanding and total equity in the company off the balance sheet (easy to obtain from Morningstar.com) and divide the total equity by the shares outstanding in order to figure out the per share shareholder’s equity value. This figure is not necessarily the share price but it represents the amount of equity in the company each shareholder can technically claim per share.
Our next step is to determine future value of the company’s per share equity value, using the true rate of growth of our equity, and the current per share equity values, in this case, $14.31, $13.51 and $19.76 for McDonald’s, Coke and Disney respectively. These calculations can easily be computed using a handy-dandy, BAII Plus business calculator and plugging in, in the case of McDonald’s, 10 for N or the number of years, 18.1% for I/Y or the interest rate and $14.31 for the present value. Hit “compute”, “FV” to find the future value and you should get $320.64 for McDonald’s. What this tells us is that if McDonald’s continues to generate an average 18.1% return on equity, in 10 years the equity value per share should grow to $75.82. (See why predictability is so important? We could not count on any reliability going forward 10 years if some degree of consistency was not available in the historics.)
From this result, we can use the full 21% return on equity for McDonald’s, multiplied by the future $75.82 equity share value to determine that the company should have $16.03 in earnings per share. (Remember, the “return” portion of return on equity equates to earnings. By simply multiplying the historic average return on equity by the future per share equity value, we should be able to determine the future earnings per share.We then multiply this result by the average 10 year historic price to earnings ratio (again, Morningstar.com is invaluable) in order to determine the theoretical, future share price. If Price divided by earnings results in the P/E ratio, then using some simple algebra, solving for P should give us the price.
Price / Earnings = P/E Ratio
Price / $16.03 = 20
$16.03 (Price /$16.03) = 20 * $16.03
Price = $320.64
Breaking out our handy BA II Plus calculator again, we plug in the current price of MCD, at the time of this writing $75.78, $320.64 for the future value, 10 for N or the number of years, and compute the I/Y which gives us the company’s projected annual compounding rate of return. In McDonald’s case 15.52%.
Projected Future Trading Price: $320.64
Current Trading Price: $75.78
Projected Annual Compounding Rate of Return: 15.52%
Is This Good or Bad
You tell me. In a mutual fund I would expect to achieve ten to eleven percent a year over the long-haul, cds and t-bill are paying between three and five percent, my four-plex averages about a 10% rate of return. In my opinion, 15.52% is a great return. Coke and Disney have projected returns of 34.88% (whoa!!) and 8.64% respectively.
Is This Reliable?
You’ve seen the reasoning for picking companies that have reliable historic indicators: a consumer monopoly, staple brand, a strong track record of consistent earnings, consistently high return on equity. All roads lead to Rome and this case, they have lead us here and this is how Warren Buffett determines the future value of a stock and his expected rate of return.
It is always nice to have some verification though, especially in the “sounds too good to be true” 34.88% projected Coke return. Let us look at Warren’s second, validating valuation technique.
According to Damodaran, “an accounting balance sheet is useful because it provides us with information about a firm’s history of investing and raising capital, but it is backward looking.”[i]
An alternative on the other hand, a financial balance sheet, would provide a forward-looking picture. [i]
Damodaran, Aswath, The Little Book of Valuation,
John Wiley and Sons, Hoboken New Jersey, 2011, p 27 The Five Components of a Financial Balance Sheet
In the universe of finance, correlation is a “statistical measure of how two securities move in relation to each other.”[i]
A correlation of -1 means that as one variable goes up, one goes down. A +1 correlation means that both variables move in the same direction together and a zero correlation indicates that there is no relationship between the variables. [i] http://www.investopedia.com/terms/c/correlation.asp#axzz1m1ShQ6iy