How We Set Buy-Up-To Prices – And Why You Should Care

How We Set Buy-Up-To Prices – And Why You Should Care

In the spring of 1972, Morgan Stanley portfolio manager John Bristol sat in a wood-paneled conference room on Sixth Avenue in Manhattan and made a decision that, three years later, would cost his clients nearly half of everything they had given him to protect.

He bought shares of Polaroid at 91x earnings.

It wasn’t recklessness. It wasn’t even ignorance. It was, by the standards of Wall Street in 1972, considered sophisticated thinking.

The logic went like this: certain American companies – Coca-Cola (KO), Xerox (XRX), Avon Products (then AVP), Johnson & Johnson (JNJ) – were so dominant, so reliably profitable, so structurally irreplaceable, that the normal rules of valuation simply did not apply to them. You didn’t ask whether the price was right. You asked whether you owned them. These were the Nifty Fifty, and on Wall Street, they were considered as close to a sure thing as the market had ever produced.

Fund managers bought them at 50x earnings. Then 80x. Then 90x.

The analysts who raised their hands and asked uncomfortable questions about price were quietly dismissed. One well-circulated piece of institutional research from the era put it plainly: these companies were so superior that they represented a “one-decision” investment. Buy them. Then do nothing. Forever.

It was the most expensive piece of research Wall Street ever produced.

When President Richard Nixon’s inflation crisis hit in 1973, the Nifty Fifty didn’t just decline. They were dismantled. Polaroid fell 91%. Avon dropped 86%. The great “one-decision” stocks that institutional America had decided could never be overpriced turned out to be among the most overpriced assets in the history of the New York Stock Exchange.

The investors who lost fortunes weren’t fools. They had correctly identified great businesses. Coca-Cola really was irreplaceable. Johnson & Johnson really did have durable competitive advantages. Their analysis of business quality was almost perfectly right.

Their crime was simpler than that: they had no number.

They had no price above which they would not buy. No ceiling. No framework for translating the undeniable quality of these businesses into a rational entry point. They treated “great company” as a synonym for “buy at any price” – and the market taught them, painfully, that those two things have never been the same.

That lesson – that even the finest business in the world can destroy your wealth if you overpay for it – is the foundation of everything we do when we calculate a “buy up to” price for our recommendations.

We are not in the business of finding mediocre companies at cheap prices. We are in the business of finding exceptional businesses – companies with high returns on equity and durable growth – and then doing the one thing the Nifty Fifty investors neglected to do.

We give ourselves a number.

This week we are revising “buy up to” prices for the entire Complete Investor recommended list – using a rigorous new equity-pricing model and using the latest data from each company’s quarterly earnings report.

The intrinsic value of any business is created by its earnings quality and its earnings growth rate. Seems simple enough, but there are many ways of objectively measuring business quality and earnings growth.

Quality

We’re using the five-year average Return on Equity (“ROE”) as our proxy for earnings quality.

That’s calculated by comparing the profits (net income) to the total amount of equity in the business. Again, that sounds pretty simple and straightforward, but it can be surprisingly complicated. Trying to figure out exactly how much equity is in a business can be hard. For example, goodwill is a very important line item to companies that own valuable brands or intangible assets. Accountants must evaluate their market value each year and they require companies to take a charge against earnings if the value of those intangible assets has declined. But… they’re not allowed to revalue goodwill higher if a brand becomes more valuable. The impact of these accounting rules tends to inflate the returns on equity of “asset lite” businesses. But despite its imperfections, ROE is correlated to investment performance. Charlie Munger famously articulated why:

Over the long term, it’s hard for a stock to earn a much better return than the business that underlies it earns. If the business earns 6% on capital over 40 years… you’re not going to make much different than a 6% return. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.

We also know this empirically by looking at indexes that model for “quality,” like the MSCI World Quality Index. It selects the top 300 companies in the world, based on three factors: high ROE, consistent earnings growth, and low debt. It has annual returns (over rolling 10-year periods) of between 12% and 14%. The MSCI World Index, which is a market-cap weighted index of 1,500 companies, and doesn’t filter for quality, compounds at around 10% annually. Over long periods of time, the difference of investing only in high-quality businesses will make a huge difference in your results. By the way, the top 10 holdings of the MSCI World Quality Index: Alphabet (GOOG), Meta (META), Apple (AAPL), Nvidia (NVDA), Microsoft (MSFT), Eli Lilly (LLY), ASML (ASML), Visa (V), TJX (TJX), and Mastercard (MA). These 10 stocks make up 31% of the index.

To determine our buy-up-to price, we measure the five-year average ROE of all of our recommended companies against the average ROE in the S&P 500, which is 17% annually. Companies with higher ROE than the average stock in the index are obviously worth more. Companies with lower ROE are worth less than the average.

Growth

Next, we look at the forward earnings per share (“EPS”) growth rate based on consensus estimates.

These are made by the Wall Street firms that provide banking services to these companies. While Wall Street analysts catch a lot of flack for “pumping” weak stocks to naïve investors, the analysts that cover major, high-quality companies actually do a pretty good job of estimating their quarterly earnings.

Today the S&P 500 average EPS growth rate is 8%. Companies that are consistently growing faster than this are worth more than average. Companies that consistently grow at a slower pace are worth less than average.

Valuation

Our analysis compares the quality (return on equity) and the earnings per share growth rate of each of our recommended stocks to the S&P 500 and then adjusts the resulting valuation accordingly.

If one of our stocks has an ROE that’s the same as the S&P 500’s (17%) and a growth rate that’s the same (8%) then we would apply the S&P 500 earnings multiple (20x) to the estimated earnings for the coming 12 months to determine the stock’s intrinsic value.

And there’s one caveat. We want a margin of safety to make sure that we’re not going to pay too much. So we discount our estimated intrinsic value by 20%. That – plus a few proprietary factors that compress the extreme ends of the valuations – is how we calculate our current buy-up-to price.

A company that’s less profitable and growing slower than the S&P 500 is obviously worth less than the average S&P 500 stock. And a company that’s more profitable and growing faster is obviously worth more.

Using Judgement On The “Edge” Cases

Deere & Co. (DE) is one of the best industrial businesses in the world, but its earnings are expected to dip slightly this year because of the farm equipment cycle. Without an adjustment, the model would penalize Deere for a temporary earnings dip. So when forward growth is negative, we set a floor in our model. As we know, over time, Deere will grow at around double-digit rates.

One other important note for the accountants among you.

Some of our best holdings – Domino’s Pizza (DPZ), Philip Morris International (PM), and Winmark (WINA) – have negative shareholder equity because they’ve bought back so much stock. Their accounting gets screwy because the impact of the buybacks leads to a negative number for net asset value. Thus, ROE literally doesn’t work – you can’t divide anything by a negative number. For these companies, instead of ROE we use Return on Tangible Assets (“ROTA”) averaged over five years, which measures profitability against the physical asset base.

In the past we’ve set our buy-up-to prices by making these same basic judgements, but we haven’t done as much rigorous computation and we haven’t re-set them quarterly (which we will do from now on).

We think this new approach will deliver more useful information to you, on every stock we follow.

Our intrinsic value estimates and the resulting buy-up-to prices are now based on real-time quarterly earnings results and one-year earnings estimates, not “gut” or five-year outlooks. We’re not building discounted-cash-flow models with terminal growth assumptions out to 2040. We’re anchoring to what the market actually pays for these results, right now.

It makes comparison easy. Every stock goes through the same framework, so you can quickly see where the biggest gaps are between price and estimated value. When you have limited capital and need to choose between positions, that’s valuable.

What It Doesn’t Do (And We’re Honest About It)

The model uses one benchmark for all sectors. A 12% ROE is outstanding for a utility but average for a software company. That means our buy-up-to prices will favor asset-light, high-quality businesses. And we think that’s appropriate, as these companies will compound your capital faster, given an identical growth rate.

It also penalizes companies that are strong on one dimension but weak on the other. A business with a 50% ROE and 3% growth might be an absolute gem – a cash machine compounding quietly – but the multiplicative formula drags it down because the growth score is below the S&P benchmark.

Finally, looking at a one-year’s future earnings outlook can greatly overestimate long-term growth.

Thus we cap expected growth rates to a maximum of 25%. Even so, for cyclical companies at peak or trough earnings, the model can overstate or understate fair value. The five-year ROE average smooths the profitability side, but there’s no equivalent smoothing on the earnings input itself – something to be aware of when our buy/sell/hold advice seems counter to the model.

Putting It All Together

There’s one thing an objective and rigorous intrinsic value formula doesn’t offer: judgment.

There may be situations where we urge you to ignore the current buy-up-to price. For example, with the Persian Gulf closed for who knows how long, the earnings estimates for many of the companies we’ve recommended as hedges against an enormous energy price spike could end up being woefully low. In situations like this, paying more than the buy-up to price could be good advice.

The point is, the buy-up-to price is only a good starting point – an objective point of reference. You should always overlay your own judgment: competitive positioning, management quality, capital allocation, regulatory risk, and the macroeconomic picture.

The goal isn’t a perfect number. It’s a disciplined, repeatable process that gives you a clear and objective measuring stick. This stock looks cheap, this one looks fair, this one looks expensive. Combined with our research and your own judgment, that’s a powerful tool for making smart decisions about when to buy.