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time. If you purchased a stock for $25 a share and it had earnings in the most recent year of $5 a share (which equates to a return of 20%), and the next year the company earns nothing, the annual rate of return on your investment goes to zero. What Warren wants is companies with business economics and management that create reasonably predictable earnings. Only then is it possible for Warren to predict the future rate of return on his investment and the investment merit of a company. Don't worry. We will go over all of this in greater detail later in the book. But for now it is imperative that you grasp two fundamentals of Warren's way of thinking: • The price you pay will determine the rate of return you are going to get on your investment. • In order to determine the rate of return, you must be able to reasonably predict the company's future earnings. The three variables you will constantly address when using Warren's system of analysis are: 1 the yearly per share earnings figure 2 its predictability 3 the market price of the security The higher the market price, the lower the rate of return, and the lower the market price, the greater the rate of return. The higher the per share earnings, the greater the return, given the market price for the security. All this may make perfect sense to you. Then again, it may not. Let's look at a real example of how this works. WARREN'S METHODS AT WORK In 1979 Warren started buying up the stock of a company called General Foods, paying an average price of $37 a share for approximately 4 million shares. What Warren saw in this company was strong earnings (in the prior year, 1978, of $4.65 per share) and that earnings had been growing at an average annual rate of 8.7%. Since General Foods' earnings were growing at an average annual rate of 8.7%, we, like Warren, could project that the company's earnings would grow from $4.65 a share in 1978, to $5.05 a share in 1979 ($4.65 × 1.087 = $5.05). Thus, we are projecting that 1979's earnings will be $5.05 a share. So, if we paid $37 for a share of General Foods in 1979, we would be getting an initial rate of return of 13.6% for our first year ($5.05 ÷ $37 = 13.6%). (Note: actual per share earnings for General Foods in 1979 turned out to be $5.12, versus our projection of $5.05.) If interest rates— the rates of return on, for example, long-term U.S. Treasury bonds (hereinafter referred to as "government bonds")— are around 10%, which they were back then, then a 13.6% rate of return on the General Foods investment looks pretty good. And because we are projecting that General Foods' annual per share earnings are going to continue to grow at an annual rate of 8.7%, we can argue that we are getting an initial rate of return equal to 13.6% and that that rate of return is going to increase each year by 8.7%. Thus, your share of General Foods stock, with its initial rate of return of 13.6%, which is going to grow at a rate of 8.7% a year, appears to be a better investment than the government bond paying a static rate of return of 10% a year. If you are making a strict business decision, based on projected performance, an investment in General Foods appears to be a much better investment than the government bond. Now, if we paid more for our General Foods stock— say, $67 a share— then we could calculate that our initial rate of return would be less. On 1979 earnings of $5.05 a share, with a cost of $67 a share, our General Foods investment would produce an initial rate of return of 7.5% ($5.05 ÷ $67 = 7.5%). This is much lower than the initial rate of return of 13.6% we were projecting to earn at a purchase price of $37 a share. Likewise, a 7.5% rate of return is not nearly as competitive as the government bond that is paying a 10% rate of return. Choosing between the General Foods stock and government bonds becomes a tougher question. If we paid less— say, $15 a share— then we could calculate that our initial rate of return would be 33.6% ($5.05 ÷ $15 = 33.6%). Pay less, get more. The price you pay determines your rate of return. The lower the price, the higher your rate of return. Price determines everything. Once a price is quoted, it is possible to figure your expected rate of return and then compare it to other rates of return. They are simple comparisons to make. That is why Warren is famous for making extremely fast business decisions. He simply calculates the annual compounding rate of return he expects an investment to produce and then determines whether it's what he is looking for. EPILOGUE Warren believed that since General Foods was earning him an initial rate of return of 13.6%, which would increase at a rate of 8.7% a year, over a period of time the stock market would acknowledge this increase in value and adjust the stock's price upward. And from 1978 to 1984, General Foods' per share earnings rose at an average annual rate of approximately 7%, from $4.65 a share to $6.96 a share. During this period the stock market reappraised the stock's price upward, to approximately $54 a share in 1984. Then, in 1985, the Philip Morris Company saw the value of General Foods' many brand-name products, which created a strong and expanding earnings base, and bought all of Warren's General Foods stock for $120 a share in a tender offer for the whole company. This gave Warren a pretax annual compounding rate of return on his investment of approximately 21%. That's right, a pretax annual compounding rate of return of 21%. A nice number in anybody's book. Now, I know that some of you with advanced degrees in Buffettology are probably thinking that I have oversimplified things, which I have; but if I stormed off the deep end of financial esoterica, some of us would be forever lost when we get to the really heady stuff. Yes, it gets much more convoluted, and there are many subtleties to Buffettology, but for the moment we must concentrate on laying the foundation so that we can start building the house.

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The Corporation, Stocks, Bonds— A Few Useful Explanations

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23-Oct-10