Buffettology:

The book, Buffettology, is a fantastic resource, primarily written by Warren Buffett’s former daughter-in-law, Mary Buffett. The co-author, David Clark, is a long-time friend of the Buffett family. Since these authors probably have some special insight into how Warren Buffet privately analyzes stocks.

Buffettology outlines a few different methods to determine the value of a stock and whether or not it is a good buy. Two of the most popular methods revolve around “Earnings Yield” and “Future Price Based on Past Growth.”

1. Earnings Yield

The concept behind this is elementary and rooted firmly in the price-to-earnings ratio, or more correctly, the opposite, which is called the earnings yield. When you divide the annual earnings by the current share price, you find your rate of return. Therefore, the lower the stock price is in relation to its earnings, the higher the earnings yield. Here are three examples for comparison:

Aeropostale Inc. (NYSE: ARO) has a share price of around $25 and an annual earnings of $2.59. If you divide $2.59 by $25 you get the earnings yield of 10.36%.

Hansen Natural Corporation (NASDAQ:HANS) has a share price of $56 and an annual earnings per share of $2.39 and only 4.2% of the share price is annual earnings.

McDonald’s is trading at a $75 with annual earnings of $4.62 per share, which gives us an earnings yield 6.2%.

Warren would use this formula to compare similar stocks with steady earnings to see which would provide a higher earnings yield based on share price. Based on these examples, Aeropostale has the most attractive earnings yield.

Keep in mind, this is only to be used as a very quick and crude method of comparing similar stocks, or to compare yields to bond rates. As you will see in the next two valuation methods, the earnings yield is far from accurate in giving us a long-term growth rate.

2. Future Price Based on Past Growth

For this, Buffett would analyze the long-term growth trend to determine how it might perform over the next 10 years. Depending on the company and the industry, it may make sense to use any of a variety of metrics, including both the PE ratio and the Enterprise Value/Revenue multiple.

Let’s use the PE ratio to illustrate how this strategy works. To guess what growth might be like over the next 10 years, you first need to determine what the average earnings growth rate has been on the stock over the past 5 to 10 years.

I will use McDonald’s as an example. They are a big name brand, they aggressively opened up in new markets, and McDonald’s provides a consumable product that has a loyal following. Let’s say the EPS growth over the past 5 years averages 17.6%. Using an EPS of$4.62 EPS in year 0, and a growth rate of 17.6% per year, will yield the following 10-year forecast:

Year 0, EPS: 4.62

Year 1, EPS: 5.43

Year 2, EPS: 6.39

Year 3, EPS: 7.51

Year 4, EPS: 8.84

Year 5, EPS: 10.39

Year 6, EPS: 12.22

Year 7, EPS: 14.37

Year 8, EPS: 16.90

Year 9, EPS: 19.88

Year 10, EPS: 23.37

Now you have an estimated total earnings per share by the end of year 10. Today, the EPS is $4.62 and in a decade that should appreciate to $23.37.

Now, you must determine what this means for the share price. To do this, you simply look to a long-term average of P/E, or the price-to-earnings ratio. The 5 year P/E average in this example is 17.7. Multiply this by the future expected earnings rate of $23.37, and you get an estimated price of $413.65.

If the price right now is $75, what is the rate of return over the next 10 years?

You can simply use an online rate-of-return calculator to calculate annual profits of 18.62%. Remember, this is a basic estimate that doesn’t include dividends, which can boost your yield by 3% every year, or almost 22% when using capital gains and dividend yield together. Moreover, it is based on the assumption that the PE ratio will remain constant, which is unlikely, but still serves as a good example

For those of you who find all of this a little overwhelming, that doesn’t mean that Buffett-style investing isn’t for you. There is a simpler option.