Young and Invested

As most of you young and invested people should have heard, Warren Buffett recently purchase a significant stake in General Electric (GE). As you should also know, Mr. Buffett is arguably the most renowned value investor in the world, using the magic of compounding returns to grow his investments at rates often averaging 20-25% annually. We thought an interesting analysis would be to see what has attracted Buffett, as a value investor, to General Electric. Be aware that we will only be showing a snippet of Buffett’s usual analysis, using the methods from the book Buffettology. It’s also key to keep in mind that the future analysis trends that Buffett uses are only valid due to a consistent track record by the company for periods of 5-10 years.

Qualitatively:
Besides practically inventing electricity, GE is one of today’s largest and most diversified industrial giants in the world. It is certainly a brand with what Buffett likes to call a consumer monopoly. Imagine, if you had all the capital you needed and the best management team in the country, would you be able to start a company that could directly compete with GE? Likely not; their brand name is just too strong.
1. Consumer monopoly – check.
2. Do we understand how it works? The company’s fundamental business is simple: produce most profitable products and sell them – check.
3. Is it conservatively financed? A check of debt-to-equity indicates in 2007 GE had total debt of $577.7K and about $111.5K in equity. In fact, GE is quite aggressively financed with a debt-equity ratio of 5.18, so let us see what else attracted Buffett to GE besides this.

[singlepic=4,320,240,,left]Quantitatively:
1. Are the earnings strong and do they show an upward trend?

A check of GE’s per share earnings indicates that they grew at an annual compounding rate of 10.09% for the period of 1997 to 2007. They can be considered very stable, increase every year with the exception of 2002 and 2005, in which the entire economy was experiencing a recession, which could have been a great buying opportunity then too.

Further investigation indicates GE has been buying back its shares. With 11.142B (adjusted for stock-splits) shares outstanding in 1997, the company has bought back about 1.1 billion shares to end at 9.988B shares outstanding in 2007. This is a sign that management uses its excess retained earnings, when available, to increase shareholder value.

2. Is the return on equity above average?[singlepic=3,320,240,,right]

General Electric has maintained a return on equity that is above average over the past 10 years. Buffett considers it a really good sign that the business is in good hands when it can earn-above average returns on equity. The average of American corporations, if you are wondering, is about 12% for the last 30 years.

This gives GE an annual average rate of return of 23.2%. Despite the fact that the figures have fallen from 2001 to 2004, the latter period of the decade shows another upswing, meaning that management is doing a better job in profitably allocating retained earnings to profitable projects.
3. Projecting annual compounding rate of return using historical EPS figure

General Electric’s average dividend payout rate over the past 10 years is 53% of earnings. We can figure out that if per share earnings continue to grow at a rate of 10.09% annually and if GE continues to pay out dividends at a rate of 53% of per share earnings, then the following EPS and dividend disbursements will develop over the next ten years:[singlepic=2,320,240,,left]

This means that in the year 2018, Buffett can project that General Electric will have per share earnings of about 6.25. With this, we can project GE’s rough price per share in 2018. Conservatively, if we assume that GE will be trading at the extremely low price-to-earnings ratio that it has been lately of about 12, then we can calculate that market price will be $75 (6.25 * 12 = 75). We should also add the dividend pool that we acquired over this time, and our pre-tax return jumps to $98.58 per share (75 + 23.58 = 98.58).

On the other hand, if we decide to be optimistic and use a P/E ratio of about 19, which GE traded at during some times of this year, then we can calculate market price for the stock will be $118.75 in 2018. Add in the dividend we calculated, and our pretax return becomes $142.33 per share.

Putting all this together, we can project that in 10 years, using this method, GE’s stock will be worth with dividends anywhere from $98.58 to $142.33. Let’s finally assume we paid a price of about $24, which the stock has been going for lately. This equates to a pretax annual compounding rate of return of somewhere between 15.18% to 19.48%.

If we put in $1,000,000 into GE today at $24, this means that in ten years’ time we would have anywhere from $4,109,327 to $5,928,560. Think you can find that type of long-term rate of return with any bonds or speculation? Think again.

Last 3 posts by Daniel Eskin

• Google Boasts its Backbone - March 22nd, 2010
• Short-term Versus Long-term Investments - March 16th, 2010
• Expert Interview - Puru Saxena - March 9th, 2010