Warren Buffett can be thought of the way Winston Churchill once described the Soviet Union, In 1939, Churchill said, “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.” This sums up Buffett.
No one can forecast what the great investor will do but there is value in trying to understand his actions. Buffett has attained a remarkable record of success with returns averaging more than 20% a year over a 50 year career. If we could understand his decision making process, we might be able to duplicate his success. This is why Buffett is widely studied.
Each word Buffett utters in an interview and his annual letters to shareholders are closely scrutinized for clues into his thinking. But, Buffett seems to know this and chooses his words carefully. After decades of study, he remains a riddle, wrapped in a mystery, inside an enigma. But, as with the Soviets, perhaps there is a key and that is the fact that Buffett does act only when it is in his best interest to do so.
Buffett is capable of sitting for months or even years without taking action. Then, he seems to spot a bargain and quickly makes a deal. From his writings, we know he doesn’t negotiate. He decides on the fair value, makes an offer and that is the end of it.
The company either accepts or rejects the offer. We rarely hear about deals he doesn’t make which makes the recent attempt by Kraft Heinz to buy Unilever so unusual. This proposed deal offers us insight into what Buffett looks for in an acquisition and allows us to apply some tools he may have used to value the company.
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From news reports, we know that a Buffett-backed investment group was interested in acquiring 100% of Unilever, the multi-national consumer goods company whose products include food, beverages, cleaning agents and personal care products. Unilever is the world’s largest consumer goods company measured by revenue. Its products are available in around 190 countries. Although the company owns over 400 brands, it focuses on 13 brands with annual sales of over $1 billion including Axe/Lynx, Dove, Hellmann’s, Lipton and Surf.
Under the proposal, according to press reports, Kraft Heinz offered $30.23 in cash and 0.222 shares in a new holding group for each existing Unilever share. The total value came to $50 a share, with about $86 billion of the transaction being paid in cash and an additional $57 billion worth of consideration coming from newly issued shares.
The cash portion of the deal, $30.23 is probably the value Buffett believed Unilever is worth right now. Shareholders would be rewarded for the long term potential of the company with the new shares they received.
Buffett is widely believed to be a traditional value investor, but a review of this transaction indicates Buffett wasn’t trying to buy the company for an amount value investors would find attractive. The proposed value of deal priced Unilever at more than 23 times next year’s expected earnings. This is not a level value investors usually consider paying. Value investors tend to prefer low price-to-earnings (P/E) ratios, generally under 15 and often significantly lower than that. The price of Unilever with a P/E ratio of 23 is well above average and out of the widely accepted zone of value.
Other commonly used valuation tools bring us to a similar conclusion. At the proposed price, Unliver’s price-to-sales (P/S) ratio of 2.5 is nearly double the industry average P/S ratio and a significant premium to Unilever’ own long-term average ratio. Ratios calculated with the company’s book value, cash flow, free cash flow and other financial statement ratios are also all overvalued when compared to the broad market average ratio, industry average and historic comparisons for the company.
This leads us to the first conclusion we can draw from the Unilever proposal. Buffett isn’t using widely followed, simple ratios in his analysis. We know that Buffett thinks about investments as if he were the sole owner of the company, often because he buys 100% of the company. An owner’s value of a company is different than the stock price because it also includes any outstanding debt.
In financial statements, owner’s value is equivalent to enterprise value (EV), a measure which includes debt and accounts for other interests. EV represents the total cost of ownership for someone buying an entire company.
Just like we use the stock price to find the P/E ratio and other valuation metrics of a company, we can use the EV to value the company. Doing so, we learn that under the terms of the proposed deal, Unilever was being valued at a premium to its industry using EV metrics.
This leads to the conclusion that there is no simple metric that Buffett uses. He is valuing something about the company that isn’t measured by traditional valuation tools.
Most investment techniques are based on value or growth. If Unilever isn’t a value stock, we need to check if it is a growth stock.
An analysis of Unilever’s performance over the past seven years shows it is not. We used seven years in this analysis because that was the time frame used by Ben Graham, a Columbia business school professor who taught Buffett.
Unilever has reported average growth in sales of about 4% over the past seven years and revenue has been on a downward trend in recent years. Earnings per share and various measures of earnings from the income statement show average growth of about 6%.
Financial statements can also be used to evaluate management. Return on equity (ROE) is one way to evaluate management effectiveness. A good management team should generate more profit for each dollar of the company’s equity. Unilever’s ROE of about 33% is more than twice its industry average. We now have our first clue of what Buffett might look at – a higher than average ROE.
Next, we need to consider what a dollar of equity costs. While management delivers higher than average ROE, it’s important to ensure the equity is obtained at a low cost. Otherwise, the company will not maintain profitability over the long run. In the case of Unilever, the cost of equity is about 8%. This is less than average for multinational companies like Unilever.
Buffett may have noticed that the company is generating returns 4 times larger than the cost of equity and the equity carries a lower than average cost. This indicates, in effect, Unilever, is a money printing press.
Buffett has said he likes to own money printing presses and in the case of Unilever, the printing press could generate billions of dollars a year. We can measure the output of the printing press with cash flow from operations (CFO).
Unilever’s CFO has averaged about $7 billion a year. About a third of that amount is reinvested in the business to maintain and grow operations. This leaves Buffett with an average of about $4.5 billion a year to allocate for other investments and this could be what Buffett was trying to buy, a measure we could call the owner’s cash flow.
At $30.23 a share, Buffett was offering 19 times the owner’s cash flow. This provides a cash yield of about 5% on his investment, an adequate rate of return in the current low interest rate environment. It’s likely Buffett could increase that yield with some simple financial engineering like issuing debt at near-zero rates in Unilever’s euro-denominated bonds.
After this review, it’s possible to reach several conclusions on how we can value companies like Buffett:
- Find strong management teams by focusing on companies with higher than average ROE
- Find companies with access to lower cost capital by measuring the cost of capital
- Limit investments to companies with CFO that significantly exceeds the company’s required capital expenditures
- Measure the yield on owner’s cash flow and set a minimum hurdle for this metric, possibly two times the yield on long-term Treasuries
Finding potential winners with this technique won’t be as simple as scanning the market for stocks with below average P/E ratios. We should expect to do more work to attain better than average results like Buffett has. His results demonstrate the importance of digging into the data.