With Bud Labitan, Physician, Investor, Author of Illustrated Valuations
Steve spoke with Dr. Bud Labitan, a physician and investor who has written several books related to value investing as practiced by Warren Buffett and Charlie Munger. The conversation between Steve and Bud focused on the stock valuation principles discussed in his latest book, Illustrated Valuations.
Pictures Of Value
Bud explained the idea behind his latest book: “I was showing a friend my StocksCalc Software for Windows, and suddenly the thought occurred to me that, if I could show pictures of the actual calculations, that could be helpful to folks who don’t routinely do these types of estimations.”
The chapters of Illustrated Valuations describe Bud’s philosophy of investing in good quality businesses and show exactly how he does stock evaluations of companies such as Apple, Coca-Cola, and Disney to determine whether their stock is overvalued, undervalued or trading around its fair market value.
When Apple Became A Value Investment
Steve pointed out that famed value investor, Warren Buffett, has always—until recently—shied away from buying stock in tech companies that don’t have regular earnings, that are subject to huge ebbs and flows in profits, and that have a lot of competitors. However, Buffett’s Berkshire Hathaway recently made a sizeable investment in shares of Apple.
Steve asked for Bud’s insight into why Buffett was now open to owning stock in Apple. Bud explained that Buffett hasn’t really departed from his core value investing approach. The difference is that Buffett now sees Apple as a consumer brand, a company with a great deal of customer loyalty that gives it a big moat of protection from competitors. That gives Apple some strong fundamental value.
In Bud’s book, the chapter on Apple shows how he uses his proprietary stock valuation software, StocksCalc, to evaluate the free cash flow of a company. Free cash flow, which is, basically, the money a company has left over after paying all its bills, is a key stock valuation metric because it indicates a company’s ability to do things like pay off debt, issue dividends, and grow its business.
Projecting Future Growth
The next stop in stock valuation for Bud, once he’s got the company’s free cash flow figure, is to project future growth in order to then look at how that is likely to impact the stock price. With a solid company such as Apple, he figures on 10% annual growth. That’s a figure that Buffet aims for, a minimum 10% annual return.
In trying to calculate the value of a business, there are a lot of things that you have to take into account, a lot of variables that are really, in the end, unknown—things like the rate of inflation, interest rates, and the changing marketplace. So, evaluating stocks isn’t an exact science. Ultimately, it’s just your best projection of what a company is really worth and what it’s likely to be worth in the future. You have the free cash flow number, you assume an annual growth rate based on the company’s past growth rate, and then you want to divide the number you come up with by the number of outstanding shares so that you end up with a projected price per share figure.
The financial model Bud uses is a generic, two-stage, discounted cash-flow model. It projects the growth rate out 15 years into the future. To be conservative in his estimates, Bud assumes that the company only has negligible growth after 10 years. So, for years 11 through 15, you just use the same free cash flow number as you had projected at the end of year 10. The reason you need to dial back the growth rate is just the plain fact of life that companies don’t just keep growing revenues substantially forever. At some point, things just kind of flatten out.
The Importance Of Dividends
Steve asked Bud to talk a bit about Coca-Cola, another company reviewed in the book, and particularly about the dividend aspect of investing in it. Coca Cola has been in business for more than 100 years and has steadily increased its dividend payments through the years. Steve compared getting dividend payments from Coke to having a bond with rising coupon payments.
Bud’s research showed him that Coke has been able to progressively increase its dividend payments, do share buybacks, and maintain its brand advantage and its moat in worldwide distribution. It’s a very efficient company. Coca Cola makes its brand name product cheaper than Pepsi can make Pepsi. Bud discovered that between 1988 and 2018, Coke had paid out more than $5 billion in dividends on Berkshire Hathaway’s $1.2 billion investment in the company. In other words, just in dividend payments alone, Buffett has made back about four or five times his investment.
There are a lot of factors that go into evaluating a stock, but dividends can certainly be one of the most important ones.
To learn more about Bud Labitan’s stock valuation system, and about all the various factors that his style of value investing takes into account, check out his latest book and his StocksCalc software at his website.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: I’m very happy to welcome back my next guest, he is Dr. Bud Labitan, a physician and investor who has produced books related to value investing as practiced by Warren Buffett and Charlie Munger. He’s written several books, including The Four Filters Invention, and most recently Illustrated Valuations. I reviewed the Four Filters book with him on a previous segment years ago, and both of these books are important books for someone who wants to be a more educated investor. Hey, Bud, welcome back to the show.
Bud Labitan: Hi, Steve, good morning.
Steve Pomeranz: This new book, Illustrated Valuations, takes us under the hood on the thinking behind the great success of Buffett and Munger, and it opens up some of the math used to calculate the rates of return. And we’re going to get into that math a little. Why did you write this book just now?
Bud Labitan: It was an opportunity to show imagery in a book for people … I have a friend in Evansville, Dr. Renee Marillo and he and I talk a lot about stocks, and I was showing him my self-built Stocks Calc Software for Windows, and then the thought occurred to me that, if I could take pictures of the actual calculations and put them into different chapters, it could be helpful to folks who don’t routinely do these type of estimations.
Steve Pomeranz: Okay, yeah, I think you’re right. It’s 12 very succinct chapters, and some of the chapters describe the philosophy of buying good quality businesses, it also takes us through a number of companies like Apple and Coke and Disney and others that show us how do you calculate whether something is overpriced or a fair value, or undervalued. Why did you pick those companies? Why Apple, why Coke, why Disney?
Bud Labitan: First of all, Apple because it is talked about a lot currently. And it is one of the recent major acquisitions of Berkshire half the way in terms of stock. And so I decided just to do a valuation on that and then see what the scenario on that one would be at a current valuation, which occurred on May 6th. And then also do an estimation to see, what would happen to the value of the stock with a stock buyback. So that chapter does include a section on a hypothetical buyback.
Steve Pomeranz: And we’re talking about May 6, 2019, if we do decide to air this show at a later date.
Bud Labitan: Yes.
Steve Pomeranz: Particularly, when it comes to Warren Buffett and Charlie Munger, I think choosing Apple is a good example. The reason? Munger and Buffett have stayed away from companies that don’t have regular earnings and are subject to huge ebbs and flows and a lot of competition. So he’s shied away from technology companies, but he has chosen Apple. Why do think he chose Apple, Bud?
Bud Labitan: He recently stated that Apple, in his mind, has become a consumer brand and has a lot of brand loyalty. I think he got the information through his subsidiary, Nebraska Furniture Mart, and seeing his grandchildren and other people being so loyal to Apple products.
Steve Pomeranz: Okay. So he felt that they have this big moat around them, and that their other businesses that Apple is comprised of are solid enough and steady enough that he doesn’t have to worry too much about competition or the loss of this moat, so to speak.
Okay, so you looked at the Apple numbers, and we can’t really get into too much of the weeds here, but the first thing that you look at is how much Apple makes. And you use a number called the free cash Flow number. Describe what free cash flow is to us.
Bud Labitan: Sure, in simplest terms, the free cash flow is the amount of free cash that’s generated after paying all the current bills.
Steve Pomeranz: Okay, so how would that be for me as a person looking at my own budget. What would that mean to me?
Bud Labitan: To you, that would mean paying the mortgage, the overhead expenses. It’s the money that you take home, and you could deposit in your own account.
Steve Pomeranz: It’s the money left over. And in the case of a business, after all the salaries are paid and other necessities to keep the business running, this is the cash that’s kind of left over, the cash flow that’s left over. So, you take that number, and you have to figure out a rate of growth. How much is that number going to increase over time?
In your example here, you have ten percent annual growth. How do you determine … I mean, it’s just a big guess, isn’t it?
Bud Labitan: Yes, it is a bit of a guess. And with Apple’s numbers from the past, the rate of growth has been tremendously higher.
Steve Pomeranz: Mm-hmm (affirmative).
Bud Labitan: The reason I use 10 is because 10 seems to be the number that Buffett aims for, a 10% return. You see that number recur in a lot of his writings. And I thought, “Well, that is a number that is reasonable. Apple can certainly continue to hit numbers above 10.” But I just went conservatively on this one.
Steve Pomeranz: And let me say that, when you’re making these calculations, even a 1% change in the growth number can have vastly different results.
Bud Labitan: Right.
Steve Pomeranz: So these numbers are, they’re a range. You’re trying to calculate the value of a business, and there’s a lot of things that you have to take into account, a lot of variables that are really unknown. The rate of inflation, the rate of interest rates, and things like this. So it’s just your best shot at getting a sense of what something is worth.
So we have this free cash flow number, we’re growing it at 10%, and now we want to try to find out what that value would be, and then divide it by the number of shares outstanding so we can figure out what the price per-share would be. Take us through that, a bit.
Bud Labitan: Sure. The model I use is a generic, two-stage discounted cash-flow model, which readers can read about. The thing I tell folks is that this is a generic model. What I do is grow it out for 10 years; I take the free cash flow from year 10 and I just use that same number for year 11, 12, 13, 14, and 15. And the reason for doing that is to enforce a little bit of conservativism.
And the other thing I advise folks is that, if you’re going to start doing this on your own, you can either stretch or compress the model. In other words, if you have a company like Coca Cola that’s been around for 100 years, and it can outperform over a long period of time, your second stage could easily be stretched to a 20-year model, which there is an example in the book, of that particular example.
If you have a sub-par or mediocre company, then you have to put a lower front growth rate and maybe even, depending on what you think the life cycle of that business will be, then you’d have to use a shorter time period. But, for me, a 15-year two-stage model has been fairly effective.
Steve Pomeranz: Yeah, so a rate of growth for the first 10 years, and then no earnings growth after that. I like what you said, it imposes a certain conservatism on the model, because, you know, trees don’t grow to the sky.
Bud Labitan: Right.
Steve Pomeranz: You even said before, Apple has been growing at a much faster rate than 10%. But eventually, by the sheer size of a company, the growth rate has got to decrease over time. There’s only so much space that can be taken up.
Bud Labitan: That’s right, just like Berkshire Hathaway.
Steve Pomeranz: Just like him.
Bud Labitan: Traditionally it’s grown, what, 18-and-a-half percent, but eventually that rate of growth is going to slow down.
Steve Pomeranz: Exactly.
Bud Labitan: And you have to account for the slowdown.
Steve Pomeranz: Okay, so we got that. And then we come up with a number, like the current stock price back in May was about 198 dollars a share. And then you come up with a number based on this calculation as to whether, based on these factors, the intrinsic value of the company is higher or lower than the current value of the company, right?
Bud Labitan: Right. And on that day, I come up with an intrinsic value estimate of, I believe it was 266 dollars-per-share, which would have made it about a 25% bargain.
Steve Pomeranz: Yeah, especially when you counted in other factors, like their buying back their own stock and things like that, which we definitely don’t have time to get into. So, the intrinsic value…
Bud Labitan: So we’ll tease the readers into buying the book and reading up on that portion, Steve.
Steve Pomeranz: Okay. Yeah, no, this is a book that I would definitely recommend. If anybody’s interested in learning more about this and kind of … It’s a good start to get into the weeds and figure out how these calculations are made. How are businesses valued? And then, as a buyer of a business, how do I know whether I’m going to pay a good price, or I’m paying too high a price? These are such important things in the business world that have nothing to do with stocks, but they also work quite well in a stock market.
Bud Labitan: Right, and they get pictures and images on top of just reading paragraph after paragraph.
Steve Pomeranz: The other company I want to mention, and by the way, I don’t recommend any of these companies, this is just for example’s sake only.
Bud Labitan: Yes,
Steve Pomeranz: Coca Cola, many people think it’s kind of a sugar water business. I mean really, when you think about it, they make sugar water with a little coloring. But, as you said, they’ve been in business 100 years, they’re doing something right. But one of the aspects that you brought up in your book about Coca Cola was the increase in dividends over time.
This idea that, it’s like having a bond. And normally bonds pay a fixed rate, but this is like having a bond, and that fixed rate, by the way, is called a coupon. It’s like having a bond with a rising coupon. Take us through that.
Bud Labitan: Yes, over the years, Coca Cola has been able to progressively increase its dividend, buy back shares, maintain its brand advantage, its moat in worldwide distribution, its efficiency in terms of free cash flow production per-bottle of coke. You can actually make Coca Cola cheaper than Pepsi can make Pepsi.
So it’s sort of a combination of factors. And towards the end of this chapter, when I add up all the amounts of dividends paid over the … just the period from 1988 to 2018, this company had paid dividends in excess of 5 billion 467 million to Berkshire Hathaway.
Steve Pomeranz: And they only paid about 1.2 billion for it, 1.3 billion. Right?
Bud Labitan: Right, right.
Steve Pomeranz: So in dividends alone, they’ve received five times their investment, four to five times their investment.
Bud Labitan: That’s right.
Steve Pomeranz: Dividends alone.
Bud Labitan: Just in…
Steve Pomeranz: So this idea that, in the future, because of rising dividends, this idea of yield on cost, this is something we talk about a lot in my investment advisory practice, this yield on cost. If you look at the S&P 500 10 years ago, we’ve done some numbers, the dividend yield was about 3%.
10 years later, because of the rising dividend of S&P 500, the yield is just under 9% based upon your original purchase 10 years ago. This is no guarantee that it’s going to continue like in the future, but this is what it was for the last 10 years. That’s powerful, because now you’re earning 10% or 9% a year. I think you calculated that Buffett has earned about 61%.
Bud Labitan: Let me look at the chapter you’re talking about.
Steve Pomeranz: One of your … Yeah, you received an email from an individual who took it a step further, and I think he basically said that, based on the 1.3 billion dollars that Buffett paid so many years ago, by 2013 anyway, the average coupon now is 61.27%. So, in effect, he’s getting half of his investment back every, what, every year. Basically, his original investment, this is how power.
Bud Labitan: Right, right, I mean it’s amazing. Then a lot of people don’t realize. And I think it’s something that people will have to read and go through all the steps.
Steve Pomeranz: Right, definitely. So, the book is Illustrated Valuations, the author is Dr. Bud Labitan. So, you know, Bud, how has your writing style evolved in the last 10 years?
Bud Labitan: Well, when I started out, Steve, that first book that you and I did an interview on, before Filter’s invention of Warren Buffett and Charlie Munger, that book got a little criticism because I used a lot of Buffett and Munger quotes. But I said at the beginning of that book, I was imagining a book that … What it would look life if Warren Buffett and Charlie Munger had written it themselves.
So my style in those days, about 10 or 11 years ago, was more instructional, MBA-type of writing. And about a year ago, I had reread Mark Twain’s Adventures of Huckleberry Fin, and trying to think about, you know, what made him such a good writer. So I’m not claiming anything for myself, but I think it made me a little bit more conversational.
And in this book, we have 12 chapters. I tried to hit some themes in each of the 12 chapters, like the Apple, the Disney. I went back and did a historical chapter on the See’s Candy’s valuation, and tried to tell a story there. And then I had a small chapter on temptation and value traps, and I had one…
Steve Pomeranz: And also inflation and the effects of inflation. I thought that was a good chapter.
Bud Labitan: Right, that’s one of my favorites. I wanted to know how a great company like Pan-American World Airways, which was such a dominant airline when I was a kid, how did such a company with an enormous moat go into bankruptcy?
Steve Pomeranz: Yeah.
Bud Labitan: And came to find out it was several factors, like the inflation of the mid-to-late seventies, the increase in competition of low-cost carriers, and also some political intrigue in there, which the reader will have to read about.
Steve Pomeranz: And Buffett had a lot to say about inflation how it affects companies, and you also put that in the book as well. The book is Illustrated Valuations, the author, Bud Labitan. And to hear this and any interview again, and to ask us questions, we love your questions, visit our website, stevepomeranz.com to join the conversation. Sign up for our weekly update where you’ll hear this interview again, plus we have a transcribe, plus we have a summary if you’re in a hurry. And we do this every single week right into your email inbox.
Bud Labitan: Can I add just one short sentence?
Steve Pomeranz: Absolutely, go ahead.
Bud Labitan: For folks that really want to dig deeper into this and wish to purchase the Stocks Calc Pro Software for Windows, they can go to my website at frips.com. F-R-I-P-S.com.
Steve Pomeranz: Very good. And don’t forget, also, to go stevepomeranz.com. Thanks, Bud.
Bud Labitan: Oh, thank you, Steve.