Warren Buffett’s Favorite Valuation Metric and Real Returns

by Glenn Busch on August 29, 2011

According to the website Pragmatic Capitalism, Warren Buffett’s favorite valuation metric is the market value of all tradable equities as a percentage of U.S. GNP, a similar valuation metric to Tobin’s Q.

To recreate this metric I used the Market Value of Equities from the Federal Reserve Flow of Funds Report and the most recent GNP measurement from the St. Louis Federal Reserve Bank’s FRED program. The chart below shows where this metric stands as of Q1 2011, the most recent Flow of Funds report.

Warren Buffett’s favorite metric also has similar drawbacks to Tobin’s Q: it is not a timing mechanism, it is not an alpha generator, the measurement itself has a time lag.

The strength of this metric is as a tool to measure potential real long-term returns. When equity as a percentage of GNP is above-average then total real returns for U.S. equities have a high probability of being below average. When equity as a percentage of GNP is below-average then total real returns for U.S. equities have a high probability of being above-average.

The first chart combines the 10 year annualized total real returns for the S&P 500 from Professor Shiller’s website with the chart above.

The second chart below highlights the 5 year annualized total real returns and Equity as a percentage of GNP.

Based on the equity value as a percentage of GNP, the probability that U.S. equity investors experience below-average annualized real returns over the next 5-10 years is high.

Related posts:

  1. Robert Shiller’s PE Ratio & Real Returns
  2. S&P 500 Real Returns and Tobin’s Q
  3. Stock Market Returns and Tobin’s Q
  • http://www.manhattancalumet.com/ Dennis the Menace

     I would like to comment about a seldom talked about metric concerning value stocks. I know that warren buffett could never have abtained the great returns in value stocks unless he was a heavy user of this metric. And that metric Is the price to sales ratio of a stock.  And that is often refered to as the market cap of a company. In other words you must look for a company that has a very low price to sales ratio if you do your chances of making a huge amount of money buying value stocks will be greatly increased. The company I give here as an example  has a market cap of just 8 billion dollars but does 55 billion dollars in annual sales in other words what we have here is a really great business that is worth only 8 billion dollars on the market but this business does 55 billion dollars in annual sales get the idea. I will give an example of a company of really decent quality that I consider really undervalued. The company is Bunge Limited symbol {BG} engages in the agriculture and food businesses worldwide. The stock currently trades around 59 dollars a share. I think the stock could easily get to 450 dollars a share over the next five years. Yes you heard it right four hundred and fifty dollars a share. Assuming their are not stock splits. And what do I base this on If the companies profit margain expands from around 1.75% to 4% over the next five years and if the sales of the company expand from 54 billion to 85 billion thats growth of about 7 or 8 percent a year and if the companies stock than trades at a price earnings ratio of about 20. That would put the price of the stock at 450 dollars a share. It could even be more than 450 dollars a share if you reinvest your dividends the company pays a dividend also if the company does a share buyback this could increase the value of the stock even more. Keep in mind that their are stocks that are popular that trade at much higher price earnings ratios than 20 times earnings one example is whole foods market it currently trades at 35 times earnings. Also keep in mind that bunge is a company of really decent quality not at all a high risk stock. It has the potential to leave a company like proter and gamble in the dust. I understand your skepticsm if you are reading this but go to any stock broker or financial planner CPA that knows how to value stocks and they will confirm everything that Im saying here.

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