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How To Determine A Stock’s Initial Rate Of Return?

To answer this question, you now enter the mind of the most successful investor in the world, Warren Buffett.

These past few days, I see a lot of first-time investors like me asking these type of questions on Facebook forums that somewhat goes like this;

In my opinion, as first-time investors, we should learn to know how to evaluate a company and not just base our investing decisions on some financial guru’s stock picks.

Whether the tip came from a respected analyst, or a friend who happens to overhear the exact date when the biggest market crash will occur or a person that came from the future, we should still be responsible enough to research and study those tips.

If someone says that stock ABC is good and we invest in it and after a few months the price went down dramatically, who is it to blame? Is it that someone who told us to invest in the company? Or you who blindly decided to invest by relying on someone else’s speculation that went wrong?

It is by these reason that for the past week, I started to study the investing techniques that made the greatest investor of all time super rich. I’m talking about Warren Buffett’s Equity Bond Theory explained in the book “Warren Buffett and the Interpretation of Financial Statements” by Mary Buffett and David Clark.

How To Determine A Stock’s Initial Rate Of Return?

Warren Buffett’s secret to amassing enormous wealth thru the stock market is finding companies with durable competitive advantage, or DCA. His techniques got him his title “The Oracle of Omaha” and that is why he is now $68.6 billion dollars worth as of today.

I will not discuss about how he finds companies with DCA. There’s a lot of things that you need to know about it so we’ll just skip that part for now. So let’s just assume that the company you’re interested to invest in has all the qualifications of a company that has a DCA. So now, we use the technique he called the Equity Bond Theory.

The Equity Bond Theory is the “Theory of Everything” when it comes to stock market investing. It states that companies with DCA’s have yields that equals or surpasses gov’t yields.

While gov’t bonds have fixed yields, a company with a DCA grows every year and therefore, the price of the stock goes up. If the company’s rate of return is higher than the bond’s rate of return, you buy the stock. What happens is that you bought a stock purchased at a value price.

The equation is simple;

To compute for the % Rate of Return;

If the % Rate of Return is higher than the Gov’t Bond Yields, buy the stock. Companies with a % Rate of Return that is 10% or higher are the ones that we are looking for to invest in to maximize gains in the long-term.

Here’s an example;

Jollibee Foods Corporation’s last traded price on June 26, 2015 is PHP 200.00 per share. The Market Capitalization of JFC is PHP 211,429,998,252.00. Its Net Income for the fiscal year of 2014 is PHP 5,488,941,506.00. The 10-yr Gov’t Bond Yield rate as of June 25, 2015 closing is 4.38%

Applying the equation;

The Gov’t Bond Yield is higher than the computed % Rate of Return. This suggests that investing in gov’t bonds today is the better choice rather than investing in JFC.

Even if we get the average Gov’t Bond Yield for 1-month to 25-yr which is 3.29%, the Gov’t Bond Yield is still higher.

This tells us is that if we buy shares of JFC worth PHP 100,000.00 today, our money will grow to only PHP 102,590.00 after a year. Or, if I buy one stock of JFC at PHP 200.00 today, that would become PHP 205.18 exactly next year.

We now therefore conclude that JFC’s stock price is expensive today. Take note that buying expensive companies will not make us rich.

I studied JFC’s financial statements from 2006 to 2014 and found out that the Earnings Per Share or EPS, Net Income, Gross Profit and Retained Earnings are growing year after year. From my opinion, JFC is a company with a DCA but according to the theory, the stock price today is valued at a high price that buying it today will only give us little capital gains on the coming years.

Here’s another example;

Megaworld Corporation’s last traded price on June 26, 2015 is PHP 4.92 per share. MEG’s Market Capitalization is PHP 161,481,564,732.00. Its reported Net Income for the fiscal year of 2014 is PHP 21,554,715,514.00.

Applying the equation;

This company has a DCA and is also what we are looking for based on the theory. Assuming the same Gov’t Bond Yield rates above and comparing it to the company’s computed % Rate of Return, it surpasses the 10% threshold.

This tells us is that if we buy shares of MEG worth PHP 100,000.00 today, it will be PHP 113,490.00 exactly next year. Or a single stock of MEG bought today for PHP 4.92 will be PHP 5.58 next year.

We now conclude that MEG’s stock price today is on a bargain and is now the great time to buy this great company.

Final Thoughts

Please note that the first thing to consider in order for us to know what companies to buy is to know if the company has a durable competitive advantage or DCA. In order to know this, we need to study the 10-yr earnings history of the company by looking through its financial statements, balance sheets and cash flows for the past ten years.

Now, after identifying that a company has a DCA, we now use this formula to know if the company’s stock is selling for a bargain or not. We buy what we find that’s a bargain and hold on to it for ten to twenty years.

This is one of the investing principles of Warren Buffett that made him super rich.

Happy investing!