In my first article about Buffettology, I looked at how a stock was viewed as an equity/bond by Warren Buffett, chairman of Berkshire Hathaway (NYSE: BRK-A, BRK-B), in that it earned a certain percentage based on price and earnings like a bond yield, but had a growing, compounding increase in earnings.
Basing a company's future earning prospects on its past earnings history isn't a 100% predictor, yet despite the occasional ups and downs a company may have over a one- or two-year period, the past 10-year compounded annual growth rate (CAGR) can indicate a staying power in growth and earnings that can go into the future.
So how can we use this past growth to determine future value? Previously, we saw that ARB Corporation (ASX: ARP) had a 10-year CAGR of 13.61%. It had per share earnings of 58.44 cents in 2013. If the earnings were to continue growing at that rate into the future, where would it be in 10 more years?
Compounding the earnings would be like receiving 13.61% interest on the earnings, and an extra 13.61% each year for 10 years, giving you interest on interest. In 10 years that 58.44 cents, at that hypothetical rate, would total to $2.09 earnings per share. If the stock were to be priced with the past PE ratios it actually had, its future price might be based on a PE of between 19.5 and 10.4, with an average of 14.9.
Lower potential price: $2.09 X 10.4 = $21.73
Average potential price: $2.09 X 14.9 = $31.14
Higher potential price: $2.09 X 19.5 = $40.75
If earnings could get to $2.09 a share, then the share price could be in the range of these values. Again, this is based on a compound annual growth rate that was achieved in the past. Currently, ARB's share price is $12.20, so those potential values would show attractive increases if they turned out to be true.
We can't say where the share price will be next week, month or year, yet if the company's management can maintain its previous performance, then these results may be possible. That is why it is crucial to have a history of long-term, stable earnings growth.
Foolish takeaway
This method shows possible earning potential, but you have to follow and study a company to assess whether its previous earnings story is truly a thing of the past due to changes in the company or industry it's in, or whether it has the staying power to grow in the future.
