Warren Buffett and Sherlock Holmes

As we said in the introduction to these templates, the most important activity of an investor is to estimate with confidence the percentage return over a specified holding period when buying stock in a company. And you want to be able to do this based on numbers that you can see and adjust such as the growth rate of earnings.

Because I am interested in medium to long term investments (remember, Buffett's favorite investment period is forever), I need to have dependable forecasts of earnings for the next five years or more. However, for most companies it is extremely difficult to be able to forecast earnings with any confidence.

Most people rely on forecasts provided by the various stock analysis firms. Unfortunately, many studies show that their results are extremely unreliable.

Valuesoft has two functions that allow you to remove much of the guesswork from forecasting earnings. These functions are STAEGR® and HGROWTH.

STAEGR: The name STAEGR stands for STAbility of Earnings Growth. This function measures the stability of earnings growth from year to year and expresses it as a percentage. The maximum figure of 100% represents earnings that go up, or down, by the same percentage each year. The calculations are based on fitting an exponential curve to the historical data with more emphasis on recent data. Special adjustments are made for negative earnings, for extreme outliers, and for earnings near zero.

The important thing for us is that large-scale studies in the USA and Australia show that stocks with a high level of STAEGR are likely to have earnings that continue to grow in the future at the same rate as they grew in the past. For details see the article Earnings Forecasts Made Easy.

We particularly look for stocks that have STAEGRs of 80 percent or more for both their earnings and their sales. If a company does not satisfy this criterion, I usually just pass it by. After all, if there was little stability in sales and earnings in the past, then it becomes virtually impossible to make confident forecasts for the future.

HGROWTH: Once it is seen that the threshold for STAEGR has been passed, the next step is to calculate the growth rate for the earnings. This is done with the function HGROWTH (which stands for Historical GROWTH). Just as for STAEGR, the function works by fitting an exponential curve to the historical data with more emphasis on recent data. Special adjustments are made for negative earnings, for extreme outliers, and for earnings near zero.

Now we can use growth rate as it is, or modify it, to do calculations as you did in the Level 1 template with Valuesoft. (I will assume that you are familiar with the steps for the Level 1 analysis.)

Once again we will use Johnson & Johnson (JNJ). After having done an analysis of the company (its products, competitors, and so on), you are ready to crunch some numbers. (For an example of an Australian company, click here.)

Suppose you are interested in estimating the percentage return on buying Johnson & Johnson now and holding it for 5 years. You can get all the data you need from Money Central. The data is contained on the following pages:

Now all you do is type the numbers into a template supplied with Valuesoft. All the rest is done for you. The final result will look like this:-

Data is typed in the white cells

, forecasts go in the cells

, and the Valuesoft results are displayed automatically in the cells

Column E contains Return on Equity or Return on Capital. These are important measures of how well management is doing with the money they have. Consistently above 15% is a desirable level.

Notice the high levels of STAEGR in the cells C13 to D14. The chart also shows the smooth growth of sales and earnings. These are the types of companies I love. When they are purchased at the right price you can get outstanding profits with as much safety as bonds.

Amazing new functions that allow you to automatically incorporate a margin of safety!

Benjamin Graham and Warren Buffett said that the three most important words in investing are margin of safety.

In this example I have added a margin of safety by using the new ground-breaking functions PESAFETY and ESAFETY in Valuesoft. Applying the function PESAFETY lowers the PE ratio from the current level of 18.07 (in cell I3) to 16.01 (in cell I10). PESAFETY uses the current PE ratio and last year's PE ratio to estimate a more conservative level. Instead of last year's PE ratio, you can use other values such as the average PE ratio over the past 5 years.

The function ESAFETY lowers the growth estimate from the historical level of 15.6% per year (as seen in cell D15) to 10.2% (in cell I11). This lower level is based on the historical growth rate of earnings (in cell D15), the historical growth rate of sales (in cell C15), and the stability of earnings over the past 5 years as measured by STAEGR (in cell D12).

In cell I7 the estimated annualized percentage profit assuming that dividends are reinvested is 7.6%. This is under quite a strong margin of safety. It is equivalent to saying that there is a very strong probability that I will make at least this return over the next 5 years.

With Valuesoft you can find those stocks that you can lock ensure a satisfactory return while at the same time leaving open the possibility of a much higher return.

Target Prices Another Valuesoft feature included in this template is the use of the function TARGD. This calculates the target price, or buying price, necessary to achieve your desired percentage profit. In this case, a percentage profit of 12% (cell I6) is asked for. The target price in cell I8 is $49.68.

Admittedly it has been a while since Johnson & Johnson was this low. But the market does funny things. When you know exactly how much you are willing to pay for a stock, often you get that temporary dip that you are looking for. Setting target prices is a vital part of the investment strategies used by Warren Buffett. He said that he is willing to wait indefinitely to buy the stock he wants at the price he is willing to pay.

These Level 1 and Level 2 templates are just a taste of what is possible with Valuesoft. See the Contents of the Manual for a complete list of the functions that come with Valuesoft.