How can you know the value of a company to judge whether the price you are paying now is worth it? There are many ways to add up the sum of the parts of companies and see what the final total is. Alternatively, you can try to project what the company will earn 20 or even 50 years from now, yet predictions that far out are wrought with potential mistakes and bloated estimates.
Berkshire Hathaway Chairman Warren Buffett, probably the world's most famous investor and one of the top five richest people in the world, looks for value by changing his mind set on how to view a company.
The equity/bond concept
First, he sees the company as a whole, not a share, to be bought. He can afford to buy whole companies, but you can think the same way, and scale it down.
When you invest in a company, you buy a piece of the shareholders equity, so every year when the earnings are reported, you see how much extra money you earned against your equity. That's the return on equity (ROE), so a 15% ROE means you had a rate of return of 15%.
If the company could continue its 15% ROE over many years, then your investment has returns like a bond with compounding interest. That's why he considers it an equity/bond.
Which equity is best?
The ideal company is one that has a high profit margin and return on equity, and has a past history of stable earnings growth. The stable earnings growth is important because you need that for compounding. What good is a bond-like equity that pays interest that goes up then down, positive and negative? You can't tell what it will be in several years much less than 10 or 20 years.
BHP Billiton vs. Rio Tinto
Take the two big miners, BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO). BHP's average ROE over the past 10 years is 30%, and Rio Tinto's is 27%. BHP is about four times larger by market capitalisation, but is it possibly the better buy?
When you buy one share of BHP, currently you are buying $14.55 in equity/share. For Rio Tinto, it's $24.39.
Using their ROE as a compound interest rate over 10 years, BHP's $14.55 would become $200.58. Rio Tinto's $24.39 would be $266.23 projected 10 years ahead.
Now, for me, I want a 15% return on my investment, at least, so now I want to see what I should pay in the present to get that future value. Discounting back by 15% over 10 years means that $200.58 would be worth $49.58 now, which is 30% more than the current price.
By the same token, Rio Tinto's $266.23 discounted back to the present would be worth $65.81. The current price of Rio Tinto is $65.60 — only a 21 cents difference.
| 10-year avg ROE | Share price | Equity per share | Projected equity/share value in 10 years* | Required rate of return | Present value of returns per share over 10 years | |
| BHP | 30% | $38.09 | $14.55 | $200.58 | 15% | $49.58 |
| Rio Tinto | 27% | $65.60 | $24.39 | $266.23 | 15% | $65.81 |
Foolish takeaway
Based on this simple valuation, BHP is a better buy than Rio Tinto. Because the two are strong, consistent earners, this approximation is easier to do. That's why Buffett looks for strong earners with stable growth.
Whether you buy one share or whole companies, the value is the same, so don't think of a stock share as a lottery ticket. It's an equity/bond, and truly good companies pay handsome rates of return.
