A few weeks ago, Ven left the following comment:
I just read Michael Brush's article "How Buffet is Playing This Market" on MSN. He says that Buffet is investing in BNSF Railway, but according to Investools, the BNI stock is not a bargain. In fact at the present it is at 77.00, with a valuation of 73.77. Of course I know Buffet knows what he is doing, but is this a good investment for me because Warren says it is?
Ven asks how it is that Buffett could buy BNI in spite of its price being higher than its value.
Well, we have to ask, what is the value of BNI? Buffett has been buying it in the high $70s and low $80s. Is the value really less than the price?
Investools Valuation tool puts the price of BNI at $73.77, based on the median analyst growth rate of 14% (with 5 analysts giving a range of 12%-20%) and a historical PE of 16.
But before we take the result of those numbers at face value, shouldn't we do our homework? We don't want to make a snap decision based on relying a bit too naively on tools.Estimated Future Growth Rate and Historical PE
Remember that the process we go through is to determine for ourselves what these numbers should be by understanding the business and the industry. "Understanding the business" includes being able to see obvious discrepancies in the numbers.
For example (and in this case), I see an estimated growth rate of 14% and a historical PE of 16 and I immediately know that there is a disconnect going on. Something is wrong. The historical PE should approximate 2X the estimated future growth rate, since that is what great businesses historically are valued at. Something is wrong with the business, the analyst, or the history... something. So I start digging in and so should you.
First thing I do in this case is look at the PE history. My first guess is that the business has low PEs years ago that it no longer deserves, and those low PEs are driving down the average historical PE.Checking Historical PE
On Investools, I do this by going to the Financials and scrolling to the bottom, where you will see the high and low PE year by year.
On MSN, you just go to BNI >> Financial Results >> Key Ratios >> Price Ratios and it, theoretically, gives you the highs and lows for the last 5 years. But in BNI's case it has N/A and I don't know why. It should show a 5 year low PE of 11 and a high of 40.
On Investools I can see more: I can see that while the highest PE in the last five years was 40, the average high PE is about 28 and the average low PE is about 18.
That fact tells me that something is off with the Investools "historical average" PE calculation in this case. There is no way the historical can be 16. It would have to be in the ball park (depending on weighting of the data) of around the average of the high average and the low average. That should put the historical average at about 23. (Note that that PE is getting quite close to the expected Rule #1 PE of 28.)Looking at the Big Five Numbers
Now I want to look at the trends of the numbers. I look at these not only for an indication of Moat, but also to get a sense of where this thing is going for future PE. If the business is increasing its earnings growth, then the PE is going to rise in the future if that continues. The big guys like predictability and reward it with higher valuations.
In addition, the managers seem to be using capital better and the ROIC is going up.
(NOTE: Although ROIC is quite a lot below 10%, the nature of this industry is very heavy on capital assets like choo-choos, which makes it much harder to get a high return on invested capital than you would see, say, in a software company with almost no hard assets... so we cut BNI some slack and look more at ROE and the direction that ROIC is going.)
If Buffett gets more involved, the ROIC is going to go way up. I see nothing in the numbers that would make me uncomfortable about a 14% growth rate in the future. And nothing that would preclude a 28 PE as a result.Looking at the Industry
So what about the industry? Do we want to be in the business of shipping stuff across the US in the future?
As gas prices go up, it's going to get more expensive to ship long distance by trucks, right? And that makes trains more competitive.
In addition, BNI is a big shipper of coal. Are we going to be shipping more and more coal as we try to wean ourselves off of Middle Eastern oil and as oil becomes more and more expensive? Yes.
So the long term durability of this business looks quite positive, almost no matter what the economy is doing. I like that and obviously so does Mr. Buffett. And that means that the higher PE is probably going to be supported by the growth of the industry.Conclusion
So for lots of reasons, I'm pretty happy with a 14% growth rate and a 23-28 PE. I'd probably think that the 14% is maybe quite reasonable and that I could think of this at a 15% growth and a 30 PE pretty easily... and that makes me feel good about the 14-28, too.
So let's plug in that set of numbers and we see that we get a $130 value with a $75 price. And we've got Buffett in there as a co-owner.
Looks good to me long term and in terms of value/price MOS. In the ball park of a 50% MOS on a Buffett business. What's not to like!