Image source: The Motley Fool
Todd Combs, CEO of GEICO – a Berkshire Hathaway an insurance subsidiary – once explained what Warren Buffett looks for in investment opportunities. There are three conditions.
One is a forward price ratio (P/E) of less than 15, another is a 90% chance of making more money five years from now, and the third is a 50% chance of 7% annual growth. That’s all.
Low price
A forward P/E ratio of less than 15 is easy to spot. A good illustration of why this is important comes from looking at the same stock Microsoft (NASDAQ:MSFT).
Over the past five years, Microsoft has grown its earnings per share by 18% annually. That is very impressive and the company seems to have more potential to do more in 2029 than today.
The problem is, the stock trades at a forward P/E ratio of 26, which means an earnings yield of 3.85%. That means the business needs to grow to make a good return for shareholders.
If Microsoft continues to grow at 18% per year, the dividend yield will be 27.18% over the next five years. But a stock trading at a P/E ratio of 15 without growth would have a yield of 33%.
This is why a low P/E is so important. It guarantees a decent profit from the start, which means that the return on investment does not depend on waiting for future growth.
Better in the future
Sometimes, stocks trade at low P/E multiples because of unusual short-term opportunities. Croda International‘s (LSE:CRDA) is a good example of this.
Back in 2021, the stock was trading at about 15 times earnings. But those earnings were boosted by high demand for Covid-19 vaccines, for which the company supplied chemicals.
When this decreases, the company’s income decreases significantly. While the stock trades at a forward P/E of less than 15 in 2021, it would not be a good investment.
This is what Buffett’s second scenario is designed to sort out. The goal is to find businesses that have a lasting competitive advantage, rather than enjoying short-term demand increases.
Croda has this to an extent – its patents give it strong protection. But it is important to know that this means that the company will make more money in the future even if it does not.
7% growth
Buffett’s 7% growth scenario requires only a 50% probability. That’s because a solid business at a P/E multiple of 15 would be a decent investment.
Apart from this, the difference between a business that can grow and one that won’t is significant over time. And this is important for investors with a long-term perspective.
An AP/E multiple of 15 implies an initial dividend yield of 6.6%. If this grows at 3% per year, the implied return in year 10 is 9.2% of the original investment.
That’s not bad, but if the company’s earnings grow 7%, the earnings in year 10 represent a 13.25% return. And the gap widens over time.
This is why Buffett prefers to buy shares of a great business at a decent price rather than shares of a decent business at a great price. Over time, growth potential is important.
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