Before everything else, you need to refer to the video as you read this in order to fully understand this lesson. Let’s start.
We have a person named Andrew, and we’ve been tracking Andrew’s equity, earnings, and debts for the last 10 years from 2002 to 2012. We’ll assess Andrew on each of the areas – equity, earnings, and debts – that he’s managed over the last 10 years for himself. This is not a company. This is just Andrew.
Andrew’s equity over the last 10 years had ups and downs, but generally it moved in the upward direction. The numbers on the left and the graph on the right are his earnings. However, in the last 5 years, it’s been steady. His debt is all over the place – both high and low – and is at the same level which is high compared to how much equity he has.
The point here is if we were going to predict how much equity Andrew would have in the year 2022, it might be a little hard for us to determine that based off of his past performance. Now that doesn’t mean in the future he could just start having very sustained equity growth. He could have very sustained earnings every year. That can happen, but most likely that won’t happen. This type of person will continue to live this style and he’s going to have his ups and downs most likely in the future which makes predicting how much he’ll be worth, because that’s really what this is. His equity is his net worth. If he would liquidate or he would die, Andrews’ assets would be added and subtracting at his liabilities that would be his equity. Predicting how much equity he would have 10 years from now would be difficult based off of his previous lifestyle.
Let’s look at a different person named Linda. Linda lives a completely different way than Andrew. Her equity grows very steadily every single year, almost by the same margin and it’s a very linear graph. When we estimate how much equity she’d be worth 10 years from now, everyone would agree that would be a lot easier compared to Andrew.
As we look at this two people, the take away here is that businesses are managed just like individual people. The business that we want to find and invest in is that business that is very steady and predictable, because when we try to figure out the intrinsic value of a business, we’re adding up all the cash that we can take out of the business over a 10-year period. When walking that assessment, it’s very difficult to do when you have a business that moves like Andrew opposed to a business that moves like Linda.
Just because business has volatile numbers doesn’t mean it won’t a make a lot of money in the future. That‘s not my point. Andrew could be worth as much as Linda in the future, but again, Andrew is unpredictable. Linda has a much better idea where she’s going to be. That predicts the value where some things are going to be in the future. That’s risk. We’re trying to minimize the risk while still having some decent returns.
Now we look at Disney’s and Sirius Radio’s equity, debt to equity, and earnings, and see how it’s progressed over the last 10 years. We will compare.
Go to MSN money again and first study Sirius Radio. Enter S-I-R-I. It takes us to the top level page where it gives us all the imfortaion. At the top is a 10-year summary; click that. Look at the book value per share and see how it’s changed for Sirius Radio over the last 10 years.
We’re looking at the equity of the business and how it’s hanging over the 10-year period. When we look at Sirius, back in 2002, it was worth $7.33 a share, and then the next year it went down to $1.16. You see that progression and how that number really dipped enormous amount? In the last 3 years they have been slowly making some growth in their equity.
The next number is from Warren Buffett’s first rule about debt to equity ratio. This gives you the debt to equity ratio for the average of the debt to equity ratio for each year. Remember, we want to find a business that has a debt toequrity below .5. Sirius Radio has got very high numbers. That’s something you really want to avoid if you were going to invest in this company.
As far as the earnings per share which you remember from course 1 unit 1 lesson 2, that’s essentially your profit per share. To find that, go to the left of the screen where it says 10-year summary. Click that and it will show the EPS. This is the trend for the last 10 years. The earning on Sirius Radio is -$6 a share, -$.38 a share, -$.57 a share, and it goes only recently in the last 2 years where they have had a positive earnings per share with $.1 and $.7. That’s the trend of this company. Now I will show you how that would look on a graph if we plotted all the numbers.
I’ve plotted out 2 of the numbers – equity and debt to equity ratio. The equity is not a good trend. We want it going in a positive direction and not into negative direction. Not only do you want to be going in a positive direction, but you want that to be really linear. The more linear, the more predictable it is to assess how much it will grow in 10 years. The debt to equity sirus is unfortunately so high in 2008 that that we can’t even see how those values were fluctuating that much for all the other years. To go from a 15.5 in 2010 down to a 4.28 in 2011, those are enormous changes. That’s something to avoid.
Predicting the intrinsic value of the company is exceptionally hard to do, because in the past the company has been all over the place. We can’t come up with an intelligent estimate of what we think this company would do over the next 10 years. If I were to calculate the intrinsic value of Sirius, I would stop right here right now.
Let’s take a look at Walt Disney Company. Type D-I-S. Just like we did before, scroll down and go to the key ratios tab and go to the 10-year summary. It takes us to this page. The book value, which is the equity per share, in 2002 was $11 and even goes up to $13. This nice steady trend is exactly what we’re looking for when finding a business.
Their debt to equity is really good. Disney has generally managed their debt below .5, which is exactly the number that we want to see.
Click again on the 10-year summary and now look at the earnings per share. This is generally trending. It’s starts off at $.60 10 years ago, and now it’s up to $2.50. It keeps increasing. At a minimum, if the earnings is consistent, for example it’s $2.50 for 10 years, that’s wonderful. When you see it growing, even better.
Now put all this numbers on a chart to graphically see what those numbers are doing. On the left is the equity and on the right is a nice linear graph over the last 10 years. They’re growing that equity. When you have a company that’s growing their equity nice and consistent, that will reflect in the market price. The market price will trend exactly with the equity.
Now the debt. Back in the early 2000s, Disney had a little bit above of .5, but in the last 5 years, they maintained it below .5 and has been trading in a downward direction since. That’s obviously really good as well. If we’re looking at a stable company, it’s not necessarily the company you should buy, because there’s still a lot to figure out, likewise worth.
However, if we’re trying to predict where the company will be in 10 years, Disney is going to be so much easier to predict than a company like Sirius. In 10 years form, Sirius might be the best company after 10 years and Disney is vice versa, but we are trying to predict which company is going to be where 10 years from now based off of this chart and numbers. We can see that Disney is much more stable and calculable than Sirius radio.
In this rule, we not only want to have stable business, but we want a business that we understand. I’ve never really understood the Sirius Radio thing. My friends swear by this company and they love the service, but for me, it’s not something that I really care for.
For Disney, I’ve been there a few times and their products are impressive. It’s a viable product and I’ll be there for years to come.
In this lesson, students learned the importance of stability. The most important reason why we must pick a stable stock is because we’re unable to accurately predict the growth of the earnings without stability. If a company has an unstable past, it is possible that their future will become stable – it’s just less likely than a company that’s already demonstrated those attributes. I like to think that companies perform and act like individual people you might know. Some people are very conservative and grow their assets at a nice and controlled pace. Others do not. As you look at that example, it becomes obvious that the person that manages their finances conservatively will be easier to predict future performance. This is very important as we move to the next lesson and learn to calculate the intrinsic value of a stock.