3 May 2004
Let’s say you are given the opportunity to buy a great business. It’s a business you like. You’ve used the products and services of this business for years. You like it. You like it a lot, and now you have this opportunity to buy the business.
Realizing that your love and admiration for the company aren’t sufficient to lay out your hard-earned cash, you decide to do some very basic homework. You want to know what price you should pay for this business.
We’ll keep this (overly) simple. The business sells $1000 worth of goods and services every year. After paying all of its expenses, it earns $100. That’s the profit. As the potential investor, you are being asked to buy all of the 100 shares of stock that this company has issued. What should you pay for 1 share? At what price for a share of stock are you content earning $1.00 of profit per share? At what price for 100 shares of stock are you content earning $100 in profit each year?
Let’s start with a simple comparison. If you went to the bank and put some money in the bank at an interest rate of 2%, how much would you have to deposit in order to get $100 of interest each year? Answer: $5000 ($100 divided by 0.02)
Now, assume you have a really long-term view of life and investing. You’re going to deposit your money in something that is safe and earns a little more than you can earn at the bank. Let’s consider a 30-year Treasury bond. We’ll assume the current yield is 5%. That means, if we want to collect $100 per year of interest, we only need to deposit $2000.
Both of these are about as risk-free as you’re going to find. The business has quite a bit more risk. So, how much ”interest” or what rate of return do you want on your money if you know the business is going to provide $100 of annual profit? At 10%, you should pay $1000 for the whole business. At 20%, the $100 of annual profit says the business is worth $500. Each of the 100 shares should sell for $5.00.
Google’s revenue was $962 million and profit was $106 million in 2003. What is a share of the stock really worth? Bankers and analysts are suggesting that the business is worth $20 billion to $30 billion. The talk is that the whole company may take on a market value of $25 billion or more. In other words, to have the entire $106 million of annual profit, you would have to invest $25 billion. That makes your rate of return (the overly simplified interest rate) just a tiny bit more than 0.4%.
Remember that analysts and prognosticators are tossing around terms like price-to-sales ratios. A company with a market value of $25 billion that sells $1 billion each year has a P/S ratio of 25. IBM has a P/S ratio of 1.68.
Warren Buffett summarized his comments about the Google IPO with something like this:
”It’s a fabulous business, but my guess is that it comes at a fabulous price. We’d never buy a public offering. The chances of buying something undervalued in a public offering – it’s not our game.”
Berkshire Hathaway Annual Meeting
May 1, 2004
Filed under: Investing