One of the most important aspects of investing is paying the right price. It protects you from permanent losses, gives you every chance to profit, and allows a big cushion for things to go wrong.
As investors, we need to think like owners, and when we buy stocks we need to think and act like we’re buying the whole business. Of course when buying stocks we don’t buy the whole company, we buy shares. But viewing companies as a whole makes it much easier to know what to pay for the individual shares.
There are a few different ways we need to look at a company to figure out what to pay. Using more than one method helps us to see things that may not show up in the other methods, and basically covers our basis as much as possible. The Cap rate method uses something called “owners earnings”, which is essentially the cold hard cash the business is generating, and it’s very hard for companies to fudge these numbers, so it’s a great place to start.
Cap rate is a commonly used real estate term that helps real-estate investors know what is a good price to pay for a commercial property or an apartment, or even a farm. Say you pay $100,000 for a rental property, and get $10,000 put into your pocket each year as pure profit after all your costs, like replacing roof shingles or fixing a broken window, this is a 10% return, or a ‘Cap rate of 10’ to start.
In his 2013 Letter to shareholders, Warren Buffett went into detail about how he used the Cap rate method of valuation to figure out what to pay for two non-stock investments he made, one a farm and the other a commercial building in New York. But he says the cap rate method of valuation isn’t just for real estate, it’s a super helpful and simple way to get an idea of what a business is worth.
But Warren Buffett says the cap rate method of valuation isn’t just for real estate, it’s a super helpful and simple way to get an idea of what a business is worth.
In that same 2013 letter, he went on to show how it’s a lot easier to find 10 Cap investments in the stock market, than in real estate, where cap rates are usually around 4 or 5. Because stock prices are quoted by the second, he says we have a huge advantage because stock prices can fluctuate wildly for all sorts of reasons. He says to think of it like owning a farm bordering on another farm owned by this moody person called “Mr. Market” and every morning he wakes up, and like a rooster yells a price for his farm at which he would either buy your farm, or sell you his. If the price he shouts is super low, you can go ahead and buy his farm, if it’s crazy high, you can sell your farm to him. The stock market is much more liquid than real estate, and it’s in its nature to offer up some wonderful opportunities regularly, instead of once in a lifetime like in real estate.
Warren Buffett’s minimum threshold for cap rates is 10, meaning a minimum 10% return each year to start. If we can make a rough estimate of future production, and it looks like it’ll be higher in ten years from now, then buy the whole things, whether it’s a farm, commercial property, a business, whatever. Say the business your buying has shown to compound owner earnings at 7%, think of it like being able to raise the rents for a rental property each year by 7%, well in ten years that 10% return, or 10 Cap rate, is now closer to a 20 Cap rate because a 10% return, compounded at 7% doubles to become a 20% return after ten years, and the compounding starts to just get crazy.
By basing our valuation on owners earnings, which is the cold hard cash the business is generating right now, and not some wild projection of what they might do, we avoid the problem of having to precisely figuring out how the business will be doing in ten years. So as long as the business will be doing better in the future than it is now, and we can buy it valued at a 10 cap rate, we’re good to go.
To quote John Maynard Keynes – “I would rather be vaguely right, than precisely wrong…”
Because we’re investors, all we care about is the cold hard cash that the business, or real estate, or whatever asset we’re buying will put in our pockets over time. So the cap rate method is a great way to figure this out.
How can we find out what the ‘rent’ is on a business? What are the owner’s earnings? Again Warren Buffett shows us the way. Owners earnings are the owner’s money, pre-tax, that they can spend on the company to either grow it, or to acquire other companies, or distribute to themselves as a dividend, or buy out other shareholders, or leave in the company as a retirement fund.
So we find owners earnings like this*
*These numbers are not precisely what Warren Buffett would use, he’s a genius and I don’t think many of us are on his level, so we’re going to keep our ‘training wheels’ on when we look at these numbers. We’re going to keep it super simple and just value it like we would with a rental property.
Net Income (Rental income)
(plus +) Depreciation & Amortization (phantom money we can deduct from our property for tax purposes, but it’s actually real money.)
(+/- ) Accounts Receivable (What we’re going to be paid within 30 days)
(+/-) Accounts Payable (What we need to pay within 30 days)
(Minus – ) Maintenance capital expenditures. (Roof tiles need replacing, hot water tank, etc.)
Also a note about maintenance capital, we can try to find that number by diving into the company’s annual report, but a quick shortcut is to look at net investment in property, plant, and equipment, also known as PP&E. While combing through companies, simply adding the whole amount can be a way to save time, and if the numbers look good by adding the whole amount, you may have a winner on your hands!)
(plus +) Income Taxes (Remember, as the owner, this money is our to distribute before the government gets their share.)
Let’s use Morningstar’s website to look at Apple Inc.,
When we add up our numbers we get close to $70 billion in “owners earnings” so multiplied by 10 gives us a price of 700 billion for the whole company. With AAPL’s market cap being at 762 Billion, it’s very close to meeting one of our three price criteria.
Ideally we’d like to meet two out of three valuation criteria. The three methods we use for deciding what to pay for a business are the Cap Rate method, the Free Cash Flow method and the Discounted Cashflow (DCF) method.
NOTE: The limitations to the Cap Rate method is that it doesn’t take growth into account and maintenance capital is most often a guess. This is why we need more than one way to value a business, which I’ll get into in other posts.