Sheet: FCFF Valuation Sheet: EVA Valuation INPUTS FOR VALUATION Current Inputs Enter the current revenues of the firm = 12406.0 Enter current capital invested in the firm = 20000.0 { As a naïve estimate, you can use BV of debt + BV of Equity) Enter the current depreciation = 233.0 Enter the current capital expenditures for the firm = 298.0 Enter the change in Working Capital in last year = 115.0 Enter the value of current debt outstanding = 0.0 Enter the number of shares outstanding = 1500.0 High Growth Period Your Inputs Enter the growth rate in revenues for the next 5 years = 0.25 What will all operating expenses be as a % of revenues in the fifth year? 0.7 (Operating expenses include depreciation: This is equal to (1-Pre-tax Operating Margin)) How much debt do you plan to use in financing investments? 0.0 Enter the growth rate in capital expenditures & depreciation 0.25 Enter working capital as a percent of revenues 0.075 Enter the tax rate that you have on corporate income 0.36 What beta do you want to use to calculate cost of equity = 1.25 Enter the current long term bond rate = 0.065 Enter the market risk premium you want to use = 0.055 Enter your cost of borrowing money = 0.085 Stable Period Enter the growth rate in revenues = 0.06 Enter operating expenses as a % of revenues in stable period = 0.75 Enter capital expenditures as a percent of depreciation in this period 2.0 See capital expenditure worksheet (capex.xls) for details. How much debt do you plan to use in financing investments? 0.05 Enter interest rate of debt in stable period = 0.075 What beta do you want to use in the stable period = 1.1 ESTIMATED CASHFLOWS Base Growth in Revenue 0.25 0.25 0.25 0.25 0.25 0.212 0.174 0.136 0.098 0.06 Growth in Deprec'n 0.25 0.25 0.25 0.25 0.25 0.212 0.174 0.136 0.098 0.06 Revenues 12406.0 15507.5 19384.375 24230.46875 30288.0859375 37860.107421875 45886.4501953125 53870.69252929687 61197.10671328125 67194.42317118282 71226.08856145378 Operating Expenses % of Revenues 0.7 0.7 0.7 0.7 0.7 0.7 0.71 0.72 0.73 0.74 0.75 - $ Operating Expenses 8684.199999999999 10855.25 13569.0625 16961.328125 21201.66015625 26502.0751953125 32579.379638671875 38786.89862109375 44673.887900695314 49723.87314667529 53419.566421090334 EBIT 3721.800000000001 4652.25 5815.3125 7269.140625 9086.42578125 11358.0322265625 13307.070556640625 15083.793908203123 16523.21881258594 17470.55002450753 17806.52214036345 Tax Rate 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.36 EBIT (1-t) 2381.9520000000007 2977.44 3721.8 4652.25 5815.3125 7269.140625 8516.52515625 9653.628101249999 10574.860040055002 11181.15201568482 11396.174169832608 + Depreciation 233.0 291.25 364.0625 455.078125 568.84765625 711.0595703125 861.80419921875 1011.7581298828125 1149.357235546875 1261.9942446304688 1337.713899308297 - Capital Expenditures 298.0 372.5 465.625 582.03125 727.5390625 909.423828125 1262.6246222233187 1615.8254163216375 1969.0262104199564 2322.227004518275 2675.42779861659.

1. Sheet: FCFF Valuation
Sheet: EVA Valuation
INPUTS FOR VALUATION
Current Inputs
Enter the current revenues of the firm =
12406.0
Enter current capital invested in the firm =
20000.0
{ As a naïve estimate, you can use BV of debt + BV of Equity)
Enter the current depreciation =
233.0
Enter the current capital expenditures for the firm =
298.0
Enter the change in Working Capital in last year =
115.0
Enter the value of current debt outstanding =
0.0
Enter the number of shares outstanding =
1500.0
High Growth Period
Your Inputs
Enter the growth rate in revenues for the next 5 years =
0.25
What will all operating expenses be as a % of revenues in the
fifth year?
0.7
(Operating expenses include depreciation: This is equal to (1-
Pre-tax Operating Margin))
How much debt do you plan to use in financing investments?
0.0
Enter the growth rate in capital expenditures & depreciation
0.25
Enter working capital as a percent of revenues
0.075

2. Enter the tax rate that you have on corporate income
0.36
What beta do you want to use to calculate cost of equity =
1.25
Enter the current long term bond rate =
0.065
Enter the market risk premium you want to use =
0.055
Enter your cost of borrowing money =
0.085
Stable Period
Enter the growth rate in revenues =
0.06
Enter operating expenses as a % of revenues in stable period =
0.75
Enter capital expenditures as a percent of depreciation in this
period
2.0
See capital expenditure worksheet (capex.xls) for details.
How much debt do you plan to use in financing investments?
0.05
Enter interest rate of debt in stable period =
0.075
What beta do you want to use in the stable period =
1.1
ESTIMATED CASHFLOWS
Base
Growth in Revenue
0.25
0.25
0.25
0.25
0.25
0.212
0.174

3. 0.136
0.098
0.06
Growth in Deprec'n
0.25
0.25
0.25
0.25
0.25
0.212
0.174
0.136
0.098
0.06
Revenues
12406.0
15507.5
19384.375
24230.46875
30288.0859375
37860.107421875
45886.4501953125
53870.69252929687
61197.10671328125
67194.42317118282
71226.08856145378
Operating Expenses
% of Revenues
0.7
0.7
0.7
0.7
0.7
0.7
0.71
0.72

4. 0.73
0.74
0.75
- $ Operating Expenses
8684.199999999999
10855.25
13569.0625
16961.328125
21201.66015625
26502.0751953125
32579.379638671875
38786.89862109375
44673.887900695314
49723.87314667529
53419.566421090334
EBIT
3721.800000000001
4652.25
5815.3125
7269.140625
9086.42578125
11358.0322265625
13307.070556640625
15083.793908203123
16523.21881258594
17470.55002450753
17806.52214036345
Tax Rate
0.36
0.36
0.36
0.36
0.36
0.36
0.36
0.36

5. 0.36
0.36
0.36
EBIT (1-t)
2381.9520000000007
2977.44
3721.8
4652.25
5815.3125
7269.140625
8516.52515625
9653.628101249999
10574.860040055002
11181.15201568482
11396.174169832608
+ Depreciation
233.0
291.25
364.0625
455.078125
568.84765625
711.0595703125
861.80419921875
1011.7581298828125
1149.357235546875
1261.9942446304688
1337.713899308297
- Capital Expenditures
298.0
372.5
465.625
582.03125
727.5390625
909.423828125
1262.6246222233187
1615.8254163216375

6. 1969.0262104199564
2322.227004518275
2675.427798616594
- Change in WC
115.0
232.61249999999998
290.765625
363.45703125
454.3212890625
567.901611328125
601.9757080078125
598.818175048828
549.4810637988285
449.79873434261737
302.3749042703224
= FCFF
2201.9520000000007
2663.5775
3329.471875
4161.83984375
5202.2998046875
6502.874755859375
7513.729025237619
8450.742639762346
9205.710001383091
9671.120521454395
9756.085366253988
Terminal Value (in '05)
167812.58398749254
COSTS OF EQUITY AND CAPITAL
1.0
2.0
3.0
4.0
5.0
6.0

7. 7.0
8.0
9.0
10.0
Cost of Equity
0.13375
0.13375
0.13375
0.13375
0.13375
0.1321
0.13045
0.1288
0.12715
0.1255
Proportion of Equity
1.0
1.0
1.0
1.0
1.0
0.99
0.98
0.97
0.96
0.95
After-tax Cost of Debt
0.054400000000000004
0.054400000000000004
0.054400000000000004
0.054400000000000004
0.054400000000000004
0.05312
0.051840000000000004
0.05056
0.04928

8. 0.048
Proportion of Debt
0.0
0.0
0.0
0.0
0.0
0.010000000000000009
0.020000000000000018
0.030000000000000027
0.040000000000000036
0.050000000000000044
Cost of Capital
0.13375
0.13375
0.13375
0.13375
0.13375
0.13131020000000002
0.12887780000000001
0.1264528
0.12403520000000001
0.121625
Cumulative WACC
1.13375
1.2853890625000002
1.4573098496093753
1.6522250419946292
1.8732101413614108
2.119181739665606
2.392297220073882
2.6948099019844407
3.029061187139061
3.39747075402485
Present Value
2349.35170893054

9. 2590.2444420402867
2855.8373120620577
3148.6629680948818
3471.5137465213693
3545.5802985652567
3532.480232327219
3416.0888286049662
3192.778198907477
52264.958909031935
FIRM VALUATION
Value of Firm
80367.496645086
- Value of Debt
0.0
Value of Equity
80367.496645086
Value of Equity per Share
53.57833109672399
Value of Firm by year
80367.496645086
88453.07182136623
96954.19830247399
105759.98248167988
114703.08033391708
123541.7425727191
132250.30447305375
140843.69012310874
149448.0591001251
158313.7584787665
$ Value of Debt
0.0
0.0
0.0
0.0
0.0
1235.417425727192

10. 2645.0060894610774
4225.310703693266
5977.9223640050095
7915.6879239383325
Base
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
Terminal Year
EBIT (1-t)
2381.9520000000007
2977.44
3721.8
4652.25
5815.3125
7269.140625
8516.52515625
9653.628101249999
10574.860040055002
11181.15201568482
11396.174169832608
12079.944620022565
- WACC (CI)
2675.0
2716.979109375
2769.4529960937502
2835.0453544921875
2917.0358024902343
2964.443232060147

11. 3038.767822353046
3133.697769006417
3243.6086661588956
3364.2378030482064
3524.0724796560758
EVA
302.44000000000005
1004.8208906250002
1882.7970039062498
2980.2671455078125
4352.104822509766
5552.081924189853
6614.860278896953
7441.162271048585
7937.543349525924
8031.936366784401
8555.87214036649
Terminal EVA
138837.68179093694
PV
266.76074972436606
781.725097824224
1291.9675279837875
1803.7900829235225
2323.3404124893027
2619.9177825427746
2765.066239843168
2761.293947142231
2620.463192763336
43229.10446947356
PV of EVA
60463.42950271027
+ Capital Invested
20000.0
+ PV of Chg Capital in Yr 10
-95.93285762427642

12. This reconciles the assumptions on stable growth, ROC and
Capital Invested
= Firm Value
80367.496645086
WACC
0.13375
0.13375
0.13375
0.13375
0.13375
0.13131020000000002
0.12887780000000001
0.1264528
0.12403520000000001
0.121625
0.121625
ROC
0.148872
0.18321478743887334
0.22467918335413278
0.27435118300402606
0.3332998373772976
0.37724001913001687
0.4094219843172778
0.42672291977188725
0.427565890104183
0.4119981299033129
0.41691062624047676
Capital Invested
20000.0
20313.8625
20706.190625
21196.60078125
21809.6134765625
22575.879345703124
23578.675476715507

13. 24781.56093820316
26150.710976875074
27660.7424711055
28974.90219655561
(Adjusted to reflect terminal ROC)
Calculation of Capital Invested
Initial
20000.0
20000.0
20313.8625
20706.190625
21196.60078125
21809.6134765625
22575.879345703124
23578.675476715507
24781.56093820316
26150.710976875074
27660.7424711055
+ Net Cap Ex
81.25
101.5625
126.953125
158.69140625
198.3642578125
400.82042300456874
604.067286438825
819.6689748730814
1060.2327598878062
1337.713899308297
+ Chg in WC
232.61249999999998
290.765625
363.45703125
454.3212890625
567.901611328125
601.9757080078125

14. 598.818175048828
549.4810637988285
449.79873434261737
302.3749042703224
Ending
20000.0
20313.8625
20706.190625
21196.60078125
21809.6134765625
22575.879345703124
23578.675476715507
24781.56093820316
26150.710976875074
27660.7424711055
29300.83127468412
Cumulated WACC
1.13375
1.2853890625000002
1.4573098496093753
1.6522250419946292
1.8732101413614108
2.119181739665606
2.392297220073882
2.6948099019844407
3.029061187139061
3.39747075402485
Finding StocksFinding Stocks the Warren Buffett Wayby John
BajkowskiLike most successful stockpickers, Warren Buffett
thinks that the efficient market theory isabsolute rubbish.
Buffett has backed up his beliefs with a successful track record
throughBerkshire Hathaway, his publicly traded holding
company.Maria Crawford Scott examined Warren Buffett's
approach in the January 1998 issue of the AAIIJournal. Table 1
below provides a summary of Buffett's investment style. In this

15. article, wedevelop a screen to identify promising businesses and
then use valuation models to measurethe attractiveness of stocks
passing the preliminary screen.Buffett has never expounded
extensively on his investment approach, although it can
begleaned from his writings in the Berkshire Hathaway annual
reports. Many books by outsidershave attempted to explain
Buffett's investment approach. One recently published book
thatdiscusses his approach in an interesting and methodical
fashion is "Buffettology: The PreviouslyUnexplained
Techniques That Have Made Warren Buffett the World's Most
Famous Investor," byMary Buffett, a former daughter-in-law of
Buffett's, and David Clark, a family friend andportfolio
manager [published by Simon & Schuster, 800-223-2336;
$27.00]. This book was usedas the basis for this
article.Monopolies vs. CommoditiesWarren Buffett seeks first
to identify an excellent business and then to acquire the firm if
theprice is right. Buffett is a buy-and-hold investor who prefers
to hold the stock of a goodcompany earning 15% year after year
over jumping from investment to investment with thehope of a
quick 25% gain. Once a good company is identified and
purchased at an attractiveprice, it is held for the long-term until
the business loses its attractiveness or until a moreattractive
alternative investment becomes available.Buffett seeks
businesses whose product or service will be in constant and
growing demand. Inhis view, businesses can be divided into two
basic types:Commodity-based firms, selling products where
price is the single most important factordetermining purchase.
Buffett avoids commodity-based firms. They are characterized
with highlevels of competition in which the low-cost producer
wins because of the freedom to establishprices. Management is
key for the long-term success of these types of firms.Consumer
monopolies, selling products where there is no effective
competitor, either due to apatent or brand name or similar
intangible that makes the product or service unique.While
Buffett is considered a value investor, he passes up the stocks
of commodity-based firmseven if they can be purchased at a

16. price below the intrinsic value of the firm. An enterprisewith
poor inherent economics often remains that way. The stock of a
mediocre business treadswater.How do you spot a commodity-
based company? Buffett looks for these characteristics:The firm
has low profit margins (net income divided by sales);The firm
has low return on equity (earnings per share divided by book
value per share);Absence of any brand-name loyalty for its
products;The presence of multiple producers;The existence of
substantial excess capacity;Profits tend to be erratic; andThe
firm's profitability depends upon management's ability to
optimize the use of tangible assets.Buffett seeks out consumer
monopolies. These are companies that have managed to create
aproduct or service that is somehow unique and difficult to
reproduce by competitors, eitherdue to brand-name loyalty, a
particular niche that only a limited number companies can
enter,or an unregulated but legal monopoly such as a
patent.Consumer monopolies can be businesses that sell
products or services. Buffett reveals threetypes of
monopolies:Businesses that make products that wear out fast or
are used up quickly and have brand-nameappeal that merchants
must carry to attract customers. Nike is a good example of a
firm with astrong brand name demanded by customers. Any
store selling athletic shoes must carry Nikeproducts to remain
competitive. Other examples include leading newspapers, drug
companieswith patents, and popular brand-name restaurants
such as McDonald's.Communications firms that provide a
repetitive service that manufacturers must use topersuade the
public to buy the manufacturer's products. All businesses must
advertise theiritems, and many of the available media face little
competition. These include worldwideadvertising agencies,
magazine publishers, newspapers, and telecommunications
networks.Businesses that provide repetitive consumer services
that people and businesses are in constantneed of. Examples
include tax preparers, insurance companies, and investment
firms.Mary Buffett suggests going to your local 7-Eleven or
White Hen Pantry to identify many ofthese "must-have"

17. products. These stores typically carry a very limited line of
must-haveproducts such as Marlboro cigarettes and Wrigley's
gum. However, with the guidance of thefactors used to identify
attractive companies, we can establish a basic screen to
identifypotential investments worthy of further analysis.The
rules used for our Buffett screen are identified and discussed in
Table 2. AAII's StockInvestor Professional was used to perform
the screen. Consumer monopolies typically have highprofit
margins because of their unique niche; however, a simple screen
for high margins mayhighlight weak firms in industries with
traditionally high margins, but low turnover levels.Our first
screening filters looked for firms with both gross operating and
net profit marginsabove the median for their industry. The
operating margin concerns itself with the costsdirectly
associated with production of the goods and services, while the
net margin takes all ofthe company activities and actions into
account.Understand How It WorksAs is common with successful
investors, Buffett only invests in companies he can
understand.Individuals should try to invest in areas where they
possess some specialized knowledge andcan more effectively
judge a company, its industry, and its competitive environment.
While itis difficult to construct a quantitative filter, an investor
should be able to identify areas ofinterest. An investor should
only consider analyzing those firms operating in areas that they
canclearly grasp.Conservative FinancingConsumer monopolies
tend to have strong cash flows, with little need for long-term
debt.Buffett does not object to the use of debt for a good
purpose--for example, if a company usesdebt to finance the
purchase of another consumer monopoly. However, he does
object if theadded debt is used in a way that will produce
mediocre results--such as expanding into acommodity line of
business.Appropriate levels of debt vary from industry to
industry, so it is best to construct a relativefilter against
industry norms. We screened out firms that had higher levels of
total liabilities tototal assets than their industry median. The
ratio of total liabilities to total assets is moreencompassing than

18. just looking at ratios based upon long-term debt such as the
debt-equityratio.Strong & Improving EarningsBuffett invests
only in a business whose future earnings are predictable to a
high degree ofcertainty. Companies with predictable earnings
have good business economics and producecash that can be
reinvested or paid out to shareholders. Earnings levels are
critical invaluation. As earnings increase, the stock price will
eventually reflect this growth.Buffett looks for strong long-term
growth as well as an indication of an upward trend. In thebook,
Mary Buffett looks at both the 10- and five-year growth rates.
Stock Investor Professionalcontains only seven years of data, so
we examined the seven-year growth rate as the long-termgrowth
rate and the three-year growth rate for the intermediate-term
growth rate.For our screen, we first required that a company's
seven-year earnings growth rate be higherthan that of 75% of
the stocks in the overall database. Stock Investor Professional
includespercentile ranks for growth rates, so we specified a
percentile rank greater than 75.It is best if the earnings also
show an upward trend. Buffett compares the intermediate-
termgrowth rate to the long-term growth rate and looks for an
expanding level. For our next filter,we required that the three-
year growth rate in earnings be greater than the seven-year
growthrate. This further reduced the number of passing
companies to 213. Not surprisingly, thecompanies passing the
Buffett screen have very high growth rates--as a group, nearly
threetimes the median for the whole database.Consumer
monopolies should show both strong and consistent earnings.
Wild swings in earningsare characteristic of commodity
businesses. A examination of year-by-year earnings should
beperformed as part of the valuation. The earnings per share for
Nike are displayed in the Buffettvaluation spreadsheet. Note
that earnings per share growth has been strong and consistent
withonly one year in which earnings did not increase from the
previous period.A screen requiring an increase in earnings for
each of the last seven years would be toostringent and not be in
keeping with the Buffett philosophy. However, a filter requiring

19. positiveearnings for each of the last seven years should help to
eliminate some of the commodity-based businesses with wild
earnings swings.A Consistent FocusCompanies that stray too far
from their base of operation often end up in trouble. Peter
Lynchalso avoided profitable companies diversifying into other
areas. Lynch termed thesediworseifications. Quaker Oats'
purchase and subsequent sale of Snapple is a good example
ofthis common mistake.Companies should expand into related
areas that offer high return potential. Nike's pastdevelopment of
a line of athletic clothing to complement its athletic shoe
business is anexample of a extension that makes sense. This
factor is clearly a qualitative screen that cannotbe done with the
computer.Buyback of SharesBuffett views share repurchases
favorably since they cause per share earnings increases forthose
who don't sell, resulting in an increase in the stock's market
price. This is a difficultvariable to screen as most data services
do not indicate this variable. You can screen for adecreasing
number of outstanding shares, but this factor is best analyzed
during the valuationprocess.Investing Retained EarningsA
company should retain its earnings if its rate of return on its
investment is higher than theinvestor could earn on his own.
Dividends should only be paid if they would be better
employedin other companies. If the earnings are properly
reinvested in the company, earnings shouldrise over time and
stock price valuation will also rise to reflect the increasing
value of thebusiness.An important factor in the desire to
reinvest earnings is that the earnings are not subject topersonal
income taxes unless they are paid out in the form of dividends.
The use of retainedearnings delays personal income taxes until
the stock is sold.Buffett examines management's use of retained
earnings, looking for management that haveproven it is able to
employ retained earnings in the new moneymaking ventures, or
for stockbuybacks when they offer a greater return.Good Return
on EquityBuffett seeks companies with above average return on
equity. Mary Buffett indicates that theaverage return on equity
over the last 30 years has been around 12%.We created a custom

20. field that averaged the return on equity for the last seven years
toprovide a better indication of the normal profitability for the
company. During the valuationprocess, this average should be
checked against more current figures to assure that the past
isstill indicative of the future direction of the company. Our
screen looks for average return onequity of 12% or
greater.Inflation AdjustmentsConsumer monopolies can
typically adjust their prices quickly to inflation without
significantreductions in unit sales since there is little price
competition to keep prices in check. Thisfactor is best applied
through a qualitative examination of a company during the
valuationstage.Reinvesting CapitalIn Buffett's view, the real
value of consumer monopolies is in their intangibles--for
instance,brand-name loyalty, regulatory licenses, and patents.
They do not have to rely heavily oninvestments in land, plant,
and equipment, and often produce products that are low
tech.Therefore they tend to have large free cash flows
(operating cash flow less dividends andcapital expenditures)
and low debt. Retained earnings must first go toward
maintaining currentoperations at competitive levels. This is a
factor that is also best examined at the time of thecompany
valuation although a screen for relative levels of free cash flow
might help to confirma company's status.The above basic
questions help to indicate whether the company is potentially a
consumermonopoly and worthy of further analysis. However,
stocks passing the screensare not automatic buys. The next test
revolves around the issue of value.The Price is Right(Using the
Spreadsheet)The price that you pay for a stock determines the
rate of return--the higher the initial price,the lower the overall
return. The lower the initial price paid, the higher the return.
Buffettfirst picks the business, and then lets the price of the
company determine when to purchasethe firm. The goal is to
buy an excellent business at a price that makes business
sense.Valuation equates a company's stock price to a relative
benchmark. A $500 dollar per sharestock may be cheap, while a
$2 per share stock may be expensive.Buffett uses a number of

21. different methods to evaluate share price. Three techniques
arehighlighted in the book with specific examples and are used
in the buffet spreadsheettemplate.Buffett prefers to concentrate
his investments in a few strong companies that are priced
well.He feels that diversification is performed by investors to
protect themselves from theirstupidity.Earnings YieldBuffett
treats earnings per share as the return on his investment, much
like how a businessowner views these types of profits. Buffett
likes to compute the earnings yield (earnings pershare divided
by share price) because it presents a rate of return that can be
compared quicklyto other investments.Buffett goes as far as to
view stocks as bonds with variable yields, and their yields
equate tothe firm's underlying earnings. The analysis is
completely dependent upon the predictabilityand stability of the
earnings, which explains the emphasis on earnings strength
within thepreliminary screens.Nike has an earnings yield of
5.7% (cell C13, computed by dividing earnings per share of
$2.77(cell C9) by the price $48.25 (cell C8)). Buffett likes to
compare the company earnings yield tothe long-term
government bond yield. An earnings yield near the government
bond yield isconsidered attractive. With government bonds
yielding around 6% currently (cell C17), Nikecompares very
favorably. By paying $48 dollars per share for Nike, an investor
gets an earningsyield return equal to the interest yield on bonds.
The bond interest is cash in hand but it isstatic, while the
earnings of Nike should grow over time and push the stock price
up.Historical Earnings GrowthAnother approach Buffett uses is
to project the annual compound rate of return based onhistorical
earnings per share increases. For example, earnings per share at
Nike have increasedat a compound annual growth rate of 18.9%
over the last seven years (cell B32). If earnings pershare
increase for the next 10 years at this same growth rate of 18.9%,
earnings per share inyear 10 will be $15.58. [$2.77 x ((1 +
0.189)^10)]. (Note this value is found in cells B49 andE39) This
estimated earnings per share figure can then be multiplied by
the average price-earnings ratio of 14.0 (cell H10) to provide an

22. estimate of price [$15.58 x 14.0=$217.43]. (Notethis value is
found in cell E42) If dividends are paid, an estimate of the
amount of dividendspaid over the 10-year period should also be
added to the year 10 price [$217.43 + $13.29 =$230.72]. (Note
this value is found in cell E43)Once this future price is
estimated, projected rates of return can be determined over the
10-year period based on the current selling price of the stock.
Buffett requires areturn of at least 15%. For Nike, comparing
the projected total gain of $230.72 to the currentprice of $48.25
leads projected rate of return of 16.9% [($230.72/$48.25)
^(1/10) - 1]. (Note this value is found in cell E45)Sustainable
GrowthThe third approach detailed in "Buffettology" is based
upon the sustainable growth rate model.Buffett uses the average
rate of return on equity and average retention ratio (1 average
payoutratio) to calculate the sustainable growth rate [ ROE x ( 1
- payout ratio)]. The sustainablegrowth rate is used to calculate
the book value per share in year 10 [BVPS ((1 +
sustainablegrowth rate )^10)]. Earnings per share can be
estimated in year 10 by multiplying the averagereturn on equity
by the projected book value per share [ROE x BVPS]. To
estimate the futureprice, you multiply the earnings by the
average price-earnings ratio [EPS x P/E]. If dividendsare paid,
they can be added to the projected price to compute the total
gain.For example, Nike's sustainable growth rate is 19.2%
[22.8% x (1 - 0.159)].(Sustainable growthrate is found in cell
H11) Thus, book value per share should grow at this rate to
roughly $65.94in 10 years [$11.38 x ((1 + 0.192)^10)]. (Note
this value is found in cell B64) If return on equityremains
22.8% (cell H6) in the tenth year, earnings per share that year
would be $15.06 [ 0.228x $65.94]. (Note this value is found in
cell E54) The estimated earnings per share can then
bemultiplied by the average price-earnings ratio to project the
price of $210.23 [$15.06 x 14.0].(Note this value is located in
cell E56) Since dividends are paid, use an estimate of the
amountof dividends paid over the 10-year period to project the
rate of return of 16.5% [(($210.23 +$12.72)/ $48.25) ^ (1/10) -

23. 1]. (Note this return estimate is found in cell
E60)ConclusionThe Warren Buffett approach to investing makes
use of "folly and discipline": the discipline ofthe investor to
identify excellent businesses and wait for the folly of the
market to buy thesebusinesses at attractive prices. Most
investors have little trouble understanding Buffett'sphilosophy.
The approach encompasses many widely held investment
principles. Its successfulimplementation is dependent upon the
dedication of the investor to learn and follow theprinciples.John
Bajkowski is editor of Computerized Investing and senior
financial analyst of AAII.(c) Computerized Investing -
January/February 1998, Volume XVII, No.1
Table 1Table 1. The Warren Buffett ApproachPhilosophy and
styleInvestment in stocks based on their intrinsic value, where
value is measured by the ability togenerate earnings and
dividends over the years. Buffett targets successful businesses--
thosewith expanding intrinsic values, which he seeks to buy at a
price that makes economic sense,defined as earning an annual
rate of return of at least 15% for at least five or 10
years.Universe of stocksNo limitation on stock size, but
analysis requires that the company has been in existence for
aconsiderable period of time.Criteria for initial
considerationConsumer monopolies, selling products in which
there is no effective competitor, either due toa patent or brand
name or similar intangible that makes the product unique. In
addition, heprefers companies that are in businesses that are
relatively easy to understand and analyze,and that have the
ability to adjust their prices for inflation.Other factorsA strong
upward trend in earningsConservative financingA consistently
high return on shareholder's equityA high level of retained
earningsLow level of spending needed to maintain current
operationsProfitable use of retained earningsValuing a
StockBuffett uses several approaches, including:Determining
firm's initial rate of return and its value relative to government
bonds: Earningsper share for the year divided by the long-term
government bond interest rate. The resultingfigure is the

24. relative value-the price that would result in an initial return
equal to the returnpaid on government bonds.Projecting an
annual compounding rate of return based on historical earnings
per shareincreases: Current earnings per share figure and the
average growth in earnings per share overthe past 10 years are
used to determine the earnings per share in year 10; this figure
is thenmultiplied by the average high and low price-earnings
ratios for the stock over the past 10years to provide an
estimated price range in year 10. If dividends are paid, an
estimate of theamount of dividends paid over the 10-year period
should also be added to the year 10 pricesStock monitoring and
when to sellDoes not favor diversification; prefers investment
in a small number of companies that aninvestor can know and
understand extensively. Favors holding for the long term as
long as thecompany remains "excellent"--it is consistently
growing and has quality management thatoperates for the
benefit of shareholders. Sell if those circumstances change, or if
analternative investment offers a better return.
Table 2Table 2. Translating the Buffett Style Into
ScreeningQuestions to determine the attractiveness of the
business:Consumer monopoly or commodity?Buffett seeks out
consumer monopolies selling products in which there is no
effectivecompetitor, either due to a patent or brand name or
similar intangible that makes the productunique. Investors can
seek these companies by identifying the manufacturers of
products thatseem indispensable. Consumer monopolies
typically have high profit margins because of theirunique niche;
however, simple screens for high margins may simply highlight
firms withinindustries with traditionally high margins. For our
screen, we looked for companies withoperating margins and net
profit margins above their industry norms. Additional screens
forstrong earnings and high return on equity will also help to
identify consumer monopolies.Follow-up examinations should
include a detailed study of the firm's position in the industryand
how it might change over time.Do you understand how it
works?Buffett only invests in industries that he can grasp.

25. While you cannot screen for this factor, youshould only further
analyze the companies passing all screening criteria that operate
in areasyou understand.Is the company conservatively
financed?Buffett seeks out companies with conservative
financing. Consumer monopolies tend to havestrong cash flows,
with little need for long-term debt. We screened for companies
with totalliabilities below the median for their respective
industry. Alternative screens might look forlow debt to
capitalization or to equity.Are earnings strong and do they show
an upward trend?Buffett looks for companies with strong,
consistent, and expanding earnings. We screened forcompanies
with seven-year earnings per share growth greater than 75% of
all firms. To helpindicate that earnings growth is still strong,
we also required that the three-year earningsgrowth rate be
higher than the seven-year growth rate. Buffett seeks out firms
with consistentearnings. Follow-up examinations should include
careful examination of the year-by-yearearnings per share
figures. As a simple screen to exclude companies with more
volatileearnings, we screened for companies with positive
earnings for each of the last seven years andlatest 12
months.Does the company stick with what it knows?A company
should invest capital only in those businesses within its area of
expertise. This is adifficult factor to screen for on a quantitative
level. Before investing in a company, look at thecompany's past
pattern of acquisitions and new directions. They should fit
within the primaryrange of operation for the firm.Has the
company been buying back its shares?Buffett prefers that firms
reinvest their earnings within the company, provided that
profitableopportunities exist. When companies have excess cash
flow, Buffett favors shareholder-enhancing maneuvers such as
share buybacks. While we did not screen for this factor, a
follow-up examination of a company would reveal if it has a
share buyback plan in place.Have retained earnings been
invested well?Earnings should rise as the level of retained
earnings increase from profitable operations. Otherscreens for
strong and consistent earnings and strong return on equity help

26. to the capture thisfactor.Is the company's return on equity above
average?Buffett considers it a positive sign when a company is
able to earn above-average returns onequity. Marry Buffett
indicates that the average return on equity for over the last 30
years isapproximately 12%. We created a custom field that
calculated the average return on equityover the last seven years.
We then filtered for companies with average return on equity
above12%.Is the company free to adjust prices to inflation?True
consumer monopolies are able to adjust prices to inflation
without the risk of losingsignificant unit sales. This factor is
best applied through a qualitative examination of thecompanies
and industries passing all the screens.Does company need to
constantly reinvest in capital?Retained earnings must first go
toward maintaining current operations at competitive levels,
sothe lower the amount needed to maintain current operations,
the better. This factor is bestapplied through a qualitative
examination of the company and its industry. However, a
screenfor high relative levels of free cash flow may also help to
capture this factor.
buffett valuationBuffett Valuation Worksheet (January/February
1998, Computerized Investing, www.aaii.com)Enter values into
shaded cellsDate of Analysis:12/31/97Current Stock DataSeven
Year AveragesCompany:Nike, Inc.Return on
Equity:22.8%Ticker:NKEPayout Ratio:15.9%Price:$48.25P/E
Ratio-High:18.4EPS:$2.77P/E Ratio-Low:9.5DPS:$0.48P/E
Ratio:14.0BVPS:$11.38Sustainable Growth19.2%P/E:17.4(ROE
* (1 - Payout Ratio))Earnings Yield:5.7%Dividend
Yield:1.0%P/BV:4.2Gv't Bond Yield:6.0%Historical Company
DataPriceP/E
RatioPayoutYearEPSDPSBVPSHighLowHighLowROERatioYea
r 80.800.092.628.703.2010.94.030.5%11.3%Year
70.940.133.3911.986.0012.76.427.7%13.8%Year
61.070.154.3518.948.7817.78.224.6%14.0%Year
51.180.195.3322.5613.7519.111.722.1%16.1%Year
40.990.205.7722.3110.7822.510.917.2%20.2%Year
31.360.246.6819.1311.5614.18.520.4%17.6%Year

27. 21.880.298.2835.1917.1918.79.122.7%15.4%Year
12.680.3810.6364.0031.7523.911.825.2%14.2%EPSDPSBVPSHi
gh PriceLow PriceAnnually Compounded Rates of Growth (7
year)[(Year 1 / Year 8) ^ (1/7)] -
118.9%22.8%22.1%33.0%38.8%Annually Compounded Rates of
Growth (3 year)[(Year 1 / Year 4) ^ (1/3)] -
139.4%23.9%22.6%42.1%43.3%Projected Company Data Using
Historical Earnings Growth
RateYearEPSDPSCurrent$2.770.4415.58Earnings after 10
yearsYear 13.290.5213.29Sum of dividends paid over 10
yearsYear 23.910.62Year 34.650.74$217.43Projected price
(Average P/E * EPS)Year 45.530.88$230.72Total gain
(Projected Price + Dividends)Year 56.571.05Year
67.811.2416.9%Projected return using historical EPS growth
rateYear 79.281.48[(Total Gain / Current Price) ^ (1/10)] -
1Year 811.031.76Year 913.112.09Year 1015.582.48Projected
Company Data Using Sustainable Growth
RateYearBVPSEPSDPSCurrent$11.382.600.4115.06Earnings
after 10 years (BVPS * ROE)Year 113.573.100.4912.72Sum of
dividends paid over 10 yearsYear 216.173.690.59Year
319.284.400.70$210.23Projected price (Average P/E *
EPS)Year 422.985.250.84$222.96Total gain (Projected Price +
Dividends)Year 527.396.261.00Year
632.667.461.1916.5%Projected return using sustainable growth
rateYear 738.938.891.42[(Total Gain / Current Price) ^ (1/10)] -
1Year 846.4110.601.69Year 955.3212.642.01Year
1065.9415.062.40
Using Average ROE
Using Average Dividend Payout Ratio