### See’s Candies

My question was in regards toward proving mathematically why it would be appropriate to apply a 3X tangible book value for See’s Candy.

Remember, however, that See’s had net tangible assets of only \$8 million. So it would only have had to commit an additional \$8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for \$18 million of additional capital.
After the dust had settled, the mundane business, now earning \$4 million annually, might still be worth the value of its tangible assets, or \$36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning \$4 million, might be worth \$50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained \$25 million in nominal value while the owners were putting up only \$8 million in additional capital – over \$3 of nominal value gained for each \$1 invested

How mathematically can you justify paying 3x tangible book value for See’s Candy, I realize they have some pricing power however growth in the candy industry is roughly flat.

Editor: Any smart readers want to have a go at this question?

I will chime in in a few days.

One clue might be this case study on how Buffett analyzed a start-up: Buffett_Case Study on Investment Filters Tabulating Company

### Second Question from another reader

Got a question – apologies if you’ve covered this in a post I haven’t gotten to yet.

In examining WM, I see a 16B market cap, 9B in net debt, and 2B in trailing operating income. The TTM earnings yield is therefore 2 / (16 + 9) = 8%.

Check his work here:WM_VL

Now I say to myself, 8% isn’t bad, but I’d ideally like at least 10% – so maybe I’ll wait for a pullback to make the stock a little cheaper. BUT, if you do the math, the stock would actually have to drop a whopping 30% just to move the earnings yield needle from 8% to 10%, due to debt being 1/3 of the enterprise value.

So, do you still continue to use EBIT/EV for companies with a lot of debt, or do you convert to something like EBT/MarketCap? Even if WM’s stock goes to 0, the earnings yield maxes out at 22%!

My reply: No you don’t prostitute your standards. Stick with EV because debt gets paid before equity. You wouldn’t ignore a mortgage debt when buying a house.  WM is basically a slow growth bond.  Too rich for me, but my hurdle rate may be different than yours. But would I rather own WM vs. a US Bond–yes.

Other companies like this might be Paychex, PAYX. High Dividend and slow growth. PAYX_VL. I have owned both WM and PAYX but no longer because I view them as fair value not UNfair value. But you are looking in the right place if you want a sleep at night portfolio.

### 14 responses to “Readers’ Questions”

1. Comatozz

To answer the 1st Q …the math is relatively simple. In fact, it’s been discussed here re: Greenwald. EV = IC x (ROIC-g)/(R-g), where

EV = enterprise value
IC = Invested Capital
ROIC = return on IC
g = growth rate
R = required rate of return

So for See’s with \$2 in earnings and \$8 in assets (I’m simplifying here but its ok) the ROIC = 25%. For the other company it’s 11%. If you assume R = 10% and g = 5% then you can pay upto 4x the IC (or tangible book if simplified again) for See’s.

By the way this “Nominal” growth and See’s should have some operating leverage. So a 1-2% real GDP growth + 2-3% inflation + operating leverage will get you to 5% in earnings if there’s moat. The bigger question is whether they can maintain 25% ROIC.

You can similarly calculate what you’ll pay for the other company. It’ll be much lower. Bottomline: See’s requires very little investment to sustain the normal level of growth so paying that price is ok.

These sort of companies are better analyzed in terms of earnings ratios. For See’s its 12x (if 3x tangible book). Doesn’t seem that bad does it?

2. Thanks for answering my question on WM. I also concluded it looked like a bond and decided to pass.

Side note: I’ve only recently begun paying attention to mgmt compensation in proxy statements, but I really liked their setup. Base salary isn’t (too) outrageous, annual cash awards are tied to specific improvements in prices, EBITDA, and operating margins. Stock awards are based on 3-yr ROIC to incentivize good long-term capital allocation.

Unfortunately, they chose to ramp DOWN on stock buybacks when the financial crisis hit, and ramped back UP once the market recovered. They of course should have done the opposite – but they’re not alone there.

3. Hi lumilog,

Thinking about poor capital allocation such as you mentioned, how would you measure, discount, quantify, etc., the effect this has on the value of the company and thereby recalculate your measures of intrinsic value, MoS, etc?

How does one appropriately handicap poor capital allocation?

• hey valueprax – this is something i’ve only started to begin paying attention to, so i’m not sure yet. i used to just COMPUTE marginal returns on capital to see whether they were good or bad. now i’m trying to graduate to understanding the WHYs behind good / bad returns. not sure how this will find its way back into valuation at this point.

4. Arthur Clarke

The question about See’s is really a question about compounding. See’s throws off a lot of excess cash. As a free-standing entity this cash presents a problem, which brought down similar companies that reinvested the cash poorly in store expansion. Putting it simply, a cash generating business that reinvests its cash at zero return asymtotically approaches zero return. In the hands of Buffett that free cash flow was compounded at 20+%, hence it’s value was considerably higher. The late Chuck Huggins told me twice that his arrangement with Warren, originally oral, eventually in writing (“only a couple of paragraphs”) was that he would receive a percentage of the cash he turned over to Warren. In all his years running See’s this agreement was honored. See’s under the umbrella of Berkshire, where cash is easily upstreamed to Warren, has produced billions of wealth for Berkshire shareholders. As a standalone company, who knows what it is worth. It all depends on the marginal return on capital. Dividend lovers will love their dividend, but will they be richer? Warren has demonstrated that the answer is probably no.

• If only we could find early Wal-Marts (WMT) which both earn high returns while having high marginal returns on capital with its new locations as the company grew on the periphery of its regional economies of scale. WMT now has not earned high returns on capital in its foreign markets net/net so far.

5. John, I’m reading your notes on the “Case Study on Investment Filters”.

On page 5, it says: “He wanted 15% on \$2 million of sales (a doubling from \$1 million current sales). ”

I’m puzzled. 15% as what divided by what? It seems like a roundabout way of “I’m only going to buy on a max PER of 6.7”, which is 100/15.

It says: “It had a 36% profit margin—he said I would take half that or 18%
“. “He got 16% of the company’s stock”. Huh? So he’s assuming that the profit margins would reduce from 36% to 18%?? It’s not clear what Alice means.

• Dear Mcturra:

I am sorry. I will go back and correct that. He means 15% required return on his investment. He knew sales were growing fast–70% a year and at 36% profit margins he would have his 15% return and then some.

I may be wrong so listen to the talk here: http://youtu.be/KwAkiVUnKx0

Let me know if seeing the 9 minute video helps.

• ‘ve listened to the video, but I’m still none the wiser. Alice refers to 15% ROI (Return On Investment), which is defined as the profit from the investment divided by its cost. Seeings as Buffett didn’t sell for years, it doesn’t make sense within that context. Perhaps she meant a 15% discount to intrinsic value. In that sense the return would be “immediate”.

Like all things Buffett, you get the best soundbites in the world, but the devilish details are left out, so it’s usually never particularly clear how the results can be replicated by the listener.

• OK, mcturra2000, once more into the breach. I will post the definitive case study today.

6. One Simple version of thinking:
Here’s a business earning \$2mn every year with small or negligible incremental capital requirements. Moat of this business is such that it can pass on inflation to its customers. Now I need RoI of 15% and I also know ‘Time is friend of a great business’ (for that matter See’s is an excellent business). So effectively this is an annuity of \$2mn.
A simple value of annuity will be \$2/(15%-6%) =22.2 which is ~2.8x of Net tangible assets. BTW my investment yield comes out to be around 9% (2/22.2). Over the time this earnings will catch up (as I know time is a friend of a great business) and during the time it will give me 2mn which I can invest in other great franchises.

So \$2mn annuity was worth more in Buffett’s hand and that why he might have paid full value for See’s

• Thanks. Simple, clear thinking is good. Buffett has never–like Graham–explicitedly said what is the intrinsic value of a particular investment. Back then in the 1970s his hurdle rate was estimated to be 15%. I don’t believe he paid full value for See’s or else he would have been violating the margin of safety principle. Buffett has tremendous knowledge of businesses so he was able to place See’s in context to know it had a moat (pleasurable experiences in the customer’s mind–a box of Sees’ to your Sweet means a big kiss). Try telling her that you bought on the cheap–a second hand box of chocolates. You will get a slap on the face. Yes, I learned that there are problems with being cheap. See’s had untapped pricing power which is another sign of a franchise.

Let’s see what Buffett says in the CS I will post today.

7. John, is’nt the MoS inbuilt in the potential growth in ‘unit volume’ of See’s.