On August 1, 1994, when Berkshire bought its first common stock in American Express, the company’s market capitalisation was $12bn. Was Mr Market too optimistic, too pessimistic or about right? To try to answer I’ll estimate annual owner earnings and, from those derive possible intrinsic values.
In the following calculations I make a simplifying assumption, but one that is not too far from the truth: The amount American Express needed to spend annually on capital items and increases in working capital to maintain its economic franchise, volume and invest in value-adding projects amounted to roughly the same as the non-cash charges in the accounts (e.g. depreciation and amortisation). (see older Newsletters for owner earnings and intrinsic value calculations without this assumption)
With this assumption in place owner earnings equals net income (This assumption works with some companies, but for many others capital expenditure and working capital investment can absorb far more than the allowance made for depreciation, amortisation, etc., leaving little cash for shareholders to take away from the business without damaging its franchise.) This allows us to estimate intrinsic value by using published net income figures rather than making the adjustments to published earnings which might otherwise be necessary to obtain owner earnings estimates.
To calculate intrinsic value the investor needs to look at the financial record of the company, and its qualities in terms of strategic position and management to gauge likely earnings power in the future. This is a process Buffett went through in the 1994 as he grasped for estimates of future owner earnings.
His starting point might have been observing 1993’s owner earnings/net income of approximately $1.5bn and the expectation for 1994 of $1.4bn. It is likely he would also examine a number of years before that. And he separated income from the core economic franchise businesses from that of non-core activity which often produced write-offs and losses.
If he then took a conservative approach and assumed no change in future years, i.e. a perpetuity of say $1.4bn, and used a discount rate of 10% (The US ten-year Treasury yielded between 5.6% – 8.0% in 1994, so using a 10% pa required return allows for additional equity risk) he would calculate an intrinsic value of $1.4bn/0.10 = $14bn, slightly higher than the $12bn market capitalisation.
But that estimate does not allow for the elimination of drag from the investment bank and brokerage businesses. If he could allow himself some optimism, imagining that the new managers would effectively re-focus the business on the core and would raise capital by selling under-performing units, then perhaps owner earnings would rise from one year to the next. Let us estimate that average annual growth at 5%
Then estimated intrinsic value would be $1.4bn/(0.1 – 0.05) = $28bn, providing a very large margin of safety on the market price.
We have the benefit of hindsight – we know the net earnings after 1994 – see Table. Our perfectly foresighted selves can use actual future owner earnings/net income to calculate intrinsic value in 1994.
The final column of shows the present value of net income if discounted to 1994.
Table 3.1 American Express, net income, discounted net income
Year Net income, $bn Discount factor (10% per year) Discounted net income, $bn – to present value in 1994
1995 1.56 0.9091 1.42
1996 1.90 0.8264 1.57
1997 2.00 0.7513 1.50
1998 2.14 0.6830 1.46
1999 2.48 0.6209 1.54
2000 2.81 0.5645 1.59
2001 1.31 0.5132 0.67
2002 2.67 0.4665 1.25
2003 2.99 0.4241 1.27
2004 3.45 0.3855 1.33
2005 3.73 0.3505 1.31
2006 3.71 0.3186 1.18
2007 4.01 0.2897 1.16
2008 2.70 0.2633 0.71
2009 2.13 0.2394 0.51
2010 4.06 0.2176 0.88
2011 4.94 0.1978 0.98
2012 4.48 0.1799 0.81
2013 5.36 0.1635 0.88
2014 5.89 0.1486 0.88
2015 5.16 0.1351 0.70
2016 5.41 0.1228 0.66
2017 2.75 0.1117 0.31
2018 6.92 0.1015 0.70
2019 6.76 0.0923 0.62
Assume perpetuity thereafter 6.76
(6.76/0.1) = 67.6
Intrinsic value estimate in 1994 (total of discounted earnings) £32bnClearly, the conservative………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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