Well, after lauding Greenwald’s IRR valuation method for franchises, I might have just found another of Bruce’s approaches that I like even better. It really makes franchise investing dirt simple!
It all goes back to margin of safety, and is so easy we can describe it in just a few sentences.
(1) For a non-franchise, come up with the current earnings power value (EPV) for the firm and don’t pay more than 50% of that price. The remaining 50% is your margin of safety.
(2) For a franchise, do the same but be willing to pay 100% of EPV. Why? Because the growth you’re not paying for is the margin of safety!
How cool is that? What’s the future growth rate? Don’t care. What return do we expect to make? Don’t know, but it should be good.
Source:pages 10-11 from this pdf at csinvesting.org
Let’s do a quick example with Coke. Assume for sake of argument that the franchise is as strong as ever and 2014 earnings are “normal”. How much should we pay?
First we need a cost of equity. We’ll skip the beta and go instead to Morningstar’s bond page for KO and sort by maturity. Those maturing about 10 years from today are trading at about a 3% YTM. That’s like a live, realtime cost of debt for KO and a lower bound to cost of equity. So… I’ll add a 4% equity risk premium to that to get 7% as their cost of equity.
Next we need an estimate of KO’s current earnings power. We’ll go to Value Line’s free KO report and see that $2.10 is the 2014E estimate. Note the little “A” superscript to the right. Value Line has a note (not shown) that says these earnings exclude non-recurring gains & losses. That’s good because we want “normal” earnings. The only other thing that could affect them is cyclicality, but KO isn’t in a cyclical industry.
So what’s a good price for KO today? The full EPV = $2.10 / 7% = $30
Is there some way we could check this? Value Line shows KO’s tax rate at 23%. So, if we could buy KO at $30 today, we’d be starting with a $2.10/ 77% / $30 = 9% pretax yield that would grow over time.
We don’t know what the growth rate (g) will be, but as long as it’s positive the return should be nice.
Bonus: use the VL pdf to divide the earnings of 2008, 2009, and 2010 by 7%, and then look above at the stock’s price range for the year. Could you have gotten your price?