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Use Buffettology to spot good growth stocks

Recently, I was re-reading Buffettology, by Mary Buffett and David Clark, which explains how Warren Buffett, Chairman and CEO of Berkshire Hathaway (NYSE: BRK-A, BRK-B) analyses and assesses the future growth and earnings prospects of companies to find strong, long-term investments.

Mary Buffett had uncommon access to his methods and thinking as his daughter-in-law, and had the opportunity to be up close with the world-famous investor.

There are seven initial steps to go through, but let’s get the basics out of the way. As an example, I’ll use two companies to compare, and see how they fare.

Earnings quality and growth

Since we can’t predict what earnings a company will have in the near future, we have to rely on a history of steady growth over the past 5 and 10 years. You should be able to see the general trend just by looking at earnings per share. If it is steady and increasing, then it deserves more attention.

These are the per share earnings (cents) of ARB Corporation (ASX: ARP) and Cabcharge (ASX: CAB) since 2003.

ARB Corporation

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

16.32

19.15

21.77

20.17

23.67

29.52

33.86

46.28

52.23

53.12

58.44

Cabcharge

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

17.96

20.57

24.28

33.88

44.89

50.28

50.97

47.83

50.76

54.86

55.01

Overall a good stable progression of earnings, but what was the growth? The average annual EPS growth over the whole 10 years for ARB Corporation was a compounded 13.61%.  This steady trend won’t tell you exactly how much the company will earn next year, but Buffett looks for those predictable earnings over 10-year periods.

He is looking for an equity that pays like a bond or bank interest. He calls it an equity/bond. Cabcharge’s earnings per share rose through steadily at a compounding annual growth rate (CAGR) of 11.84% over 10 years.

Your initial rate of return

Buffett’s logic is if ARB Corporation costs around $12 a share, and the company made $0.58 a share in earnings, then he would consider the initial rate of return to be 4.83% ( $0.58/$12). This is actually the inverse of what many investors know as the price-earnings (PE) ratio.

Yet different from a bond paying a yield of 4.83%, this equity’s earnings have been growing by 13.61% annually on average. Would you like a bond that grew like that?

Looking at Cabcharge, now at $3.92 a share, it had EPS in 2013 of $0.55, so the theoretical initial rate of return would be 14%. With its 10-year compounded annual growth rate of 11.84%, that would be an attractive bond if it paid a 14% yield and grew at 11.84%.

Foolish takeaway

Would we make our decision to buy one, both or neither of these stocks at this point? No, these two steps would only show us that these two are at least worthy of further investigation. According to the book, there are at least five more initial steps before a full decision can be made.

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned. 

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