After a quick re-read from Buffettology, I decided to go on the hunt for stocks using a few Warren Buffett tricks. (If you like the Benjamin Graham style, check out these six defensive picks)
My goal was to pick stocks that had:
A high, sustained return on equity [ROE] of at least 25%
Low debt to equity ratio
Equity growth of at least 15% annually over the past 5 years
Price/book ratio within 10% of its 3 year average
Some sort of forecast EPS growth when looking forward one and two years.
Here are the 4 stocks that made my list...
4 High ROE Stocks
American Public Education (NASDAQ:APEI) – Not everyone is a believer in American Public Education, Inc. Alex Pape of Motley Fool says that the stock would have to double in five years to justify his valuation. He didn’t give his valuation technique so I thought I could offer a simple one right now, supposedly based on Warren Buffett, to see if this stock might be a deal or not.
Over the past four years, the return on equity has ranged from annual averages of 26 - 31 (Numbers varied by source so I used the lowest available). To give this stock the benefit of the doubt, we will use the lowest figure of 26. Next we use the book value of $5.43 and forecast five years in the future. In five 5 years time, if equity jumps at 26% per year, the book value will be $17.24. If the ROE stays constant, we can forecast annual earnings of $4.48.
The PE has been cooling over the past 4 years and recently jumped up a little. The PE is currently at 26.55 and had a 2010 average of around 23. Even using a lower PE of 20 times the $4.48 estimated earnings, we get a sticker price of $89.60. As prices are only $42.16 today, we should be justified in the price doubling in five years. Our compound annual growth rate is 16.27% which is above the 15% Warren uses as a benchmark. If the PE was to stay constant at 26.55, this would translate into a 23% average annual compounded gain.
Sorry Motley Fool, I do think that this stock can possibly double in 5 years.
Hansen Natural Corporation (HANS) – Hansen Natural Corporation is next on the list. Although the four year average on ROE is around 35, the current ratio is closer to 30. So to be fair we will use the lower number of 30. Book value per share is $9.31.
With a ROE of 30% and no dividend being paid, the book value should theoretically grow to 128.34 in 10 years. Multiply this by the ROE to get an annual EPS of $38.50. We will use a seven year average PE ratio of 24. So PE of 24 x $38.50 = $924. If we work backwards from a $56.40 price-tag, we get a compound annual growth rate of 32.26%.
Questcor Pharmaceuticals (NASDAQ:QCOR) – Questcor Pharmaceuticals, Inc. is another company with a high four year average ROE that is now dropping from 60.8% in 2007 to 29.2% average in 2010. We will even give it a lower valuation of 25% over the next five years.
Book value is at $1.92, which should jump to $5.86, for annual earnings of $1.46. That's a price tag of $21.97 in five years if the PE ratio was a lowly 15. This is an 11% compounded annual growth rate. Of course, some of the numbers were low-balled on purpose, so the upside could be higher.
MasterCard Incorporated (MA) – MasterCard pays a tiny 0.20% yield, which we will consider as negligible for our rough calculations. We will use a 30% ROE, which is 12% below current amounts. I use this number since the past decade has been a bit rocky and I will low-ball my estimate.
With a current book value of 39.76 and an average PE of 16, the price of this stock in five years should be around $708 per share. This is a 24% compound annual growth rate. Should MA continue at current ROE levels, the growth rate could jump to 44% as unlikely as this might seem.
A Few Other Quick Picks
Some other large-cap(also check out these large and mega cap momentum stocks), high ROE earning stocks with little long-term debt are:
Research In Motion Limited
Texas Instruments Inc.
Compania de Minas Buenaventura SA
Keep in mind that the above table did not necesarily pass all my criteria, just big stocks with a high recent ROE and low debt.
Risk and Warnings
That being said, this is not a definite valuation tool as high historical returns on equity is no assurance of future high ratios. The assumption is that the stock will consistently earn similar returns and trade at an average historical PE ratio. There may be caveats in the future of these stocks that are not reflected in simple ROE ratios. Also, the ratios can cool as growth stocks turn into value picks. High growth is hard to maintain the bigger a company gets.
(You might like to look at stocks that have low price to earnings to growth ratios - PEG - both forecasted and historically here)
Still, this is one simple valuation tool outlined in Buffettology, and perhaps more than one of these stocks will make a choice pick for your portfolio. At least contemplate the possibility over a Coca-Cola (NYSE:KO).