In his 2008 shareholder letter Warren Buffett stated that *“Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”*

In my earlier post Valuation of AMEX in 1964 (Part 2) I concluded with the following questions that I also left unanswered. *“Does an intrinsic value of $60 per share seem reasonable? Or is it too high?”*

I calculated an intrinsic value per share of approximately $60. But at the moment of my calculation, I did not know the historical share price of American Express during 1963-64. What I did know, was that the share price of American Express took a dive due to the Salad Oil Scandal and that Buffett put a great amount of his capital into the stock.

As Benjamin Graham liked to say *“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” *So the question was if Mr. Market did in fact overreact or not in the wake of the Salad Oil Scandal?

*Source: Business Insider*

My earlier valuation of AMEX updated with the share price low of $38 in January 1964 resulted in a margin of safety of approximately one third of the calculated intrinsic value per share. So, looking back we can probably understand why Buffett felt that the decline in the AMEX share price presented a great opportunity to buy into this business.

But, for this to be a real investment opportunity an investor would also have needed a conservative estimate of any potential liability arising from the Salad Oil Scandal. So, without a proper idea about any potential impact from this event, it would be hard to make an investment due to the fact that a thorough analysis was clearly missing.

In the next post I will take a look at what a reasonably and conservative estimate of any liability arising from the Salad Oil Scandal could look like.

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Hi!

Before I ask my questions I’d like to comment that this is a really interesting post. Especially in relation to the use of your valuation method for AMEX in 1964. Anyway, this brings me to my questions:

In the valuation spreadsheet what is the name of the ratio used for your calculation of IV per share? I understand through [3] that is calculated by the EPS divided by the average AAA Corporate Bond Yield of a particular period (in this case 1964). But I am quite unsure on what it is for I have not come across it before.

In addition I would also like to know your reasoning in using this metric in establishing the IV instead of the most commonly used valuation techniques such as the DCF, RE (Residual Earnings) and ReOI (Residual Operating Income) models?

Thanks in advance of you have taken the time to look upon my questions above. 🙂

Hi Warren!

Thanks for taking the time writing and posting your question.

To answer your first question it’s basically a multiple valuation which in a way is a discounted cash flow valuation. The yield of 4.40% inverted (1 divided by 0,044 to get a multiple of 22.7) gives the multiple. Taking the assumed earning power of $2.80 per share multiplied with 22.7 gives a value of $63 per share. I treated the earning power as a bond coupon. I also expect this coupon to grow so the total annual return comes in around at least 10%, i.e., a growth rate of 6%, but preferable in the higher end of the range 10-15%. Including the assumed growth in earning power of 5-10 percent would give an assumed annual return of approximately 10-15%, i.e., 4.40% plus 5-10% equals 9.40-14.40%. So in this case the margin of safety is in the expected future growth.

To answer your second question. The above calculation is kind of a cash flow valuation by using the following formula: Earning power/(Discount Rate-Growth). For example $2.80/(10%-5.5%)=$62.

As you see it’s all in the assumptions being made. You can also see that at a price per share of $38, the earnings yield is 7.4% ($2.80/$38), compared to the bond yield of 4.40%. Plus, expected growth in earnings will add to this. Earnings yield plus assumed annual growth rate gives the total expected annual return.

All the best,

/HC

Thanks HC!

I appreciate the clarification. 😀

You’re welcome. Have a great weekend! /HC

This is great stuff! Where is Part 4??

I’m afraid it’s still a draft version. Guess I have to write and publish it. Thanks for commenting.