Today… a new lesson from the old master, Warren Buffett.

Two weeks ago saw the famed value investor provide financing for a gigantic acquisition. The target was Heinz (HNZ), the food-products maker. The buyer was a Brazilian private-equity firm.

Deals this big, involving such great investors, don’t happen often. When they do, you ought to try to learn from them.

[ad#Google Adsense 336×280-IA]While today’s letter is a bit more “detailed” than normal (yes, we actually have to talk about the numbers)…

I hope you will focus on the ideas below relating to valuation.

As I’ve often explained, one of the great weaknesses of most individual investors (even otherwise smart and talented people) is that they do not have the faintest idea of how to value a stock or a bond.

The deal for Heinz gives us the perfect “recipe” to understand how world-class investors value a great business.

That, in turn, will help us better understand how to value other, similar high-quality companies. While there are no definitive right or wrong answers to the process of valuing a company, the tools we have in deals like this are a great help to getting closer and closer when we estimate the intrinsic value of great businesses.

Let’s start with the simple terms of the deal. Brazilian billionaire Jorge Paulo Lemann is buying Heinz. He is doing the deal through an investment firm he controls with two other partners, called 3G Capital. Nominally, this firm is called a “private equity” fund because it buys operating companies and uses leverage. But… this isn’t your typical private-equity firm. It’s not investing other people’s money. It’s investing the partners’ money. Specifically, 3G Capital is putting up $4.4 billion in cash to acquire Heinz in a deal that has a total value of $28 billion.

How, you might wonder, can you buy a $28 billion, iconic American business with “only” $4 billion in cash? It helps to be good friends with the world’s richest investor. Warren Buffett is putting up $12.4 billion to help fund the deal. Like Lemann’s group, he’s putting $4.4 billion into the company’s common stock (at a $23 billion valuation).

He’s also putting up $8 billion in preferred stock that will pay a 9% annual dividend. That’s similar to the kind of coupons Buffett was getting at the height of the 2008/2009 financial crisis. This is an extremely good deal for Buffett and his Berkshire Hathaway shareholders. The rest of the capital will come from new debt financing (JPMorgan) and rolling over existing Heinz debt.

In short… with just $8.8 billion in new equity… Lemann and Buffett are buying a business with an enterprise value (equity and debt) of $28 billion. That’s more than three times leverage… which seems like a lot, at first. But it’s probably not that risky given the consistency of Heinz cash flows. The more important question is harder to answer. Putting aside the preferred stock for a moment… did Buffett get a good price with his common-stock investment?

The equity value of this deal was $23 billion. That represents roughly 24 years of free cash flow from Heinz, based on its current sales and earnings. That is, based on current cash flows, these investors will make back the total equity value of the deal after 24 years. That seems like a very high price to pay…

We prefer to buy capital-efficient, high-quality stocks when we can buy them for less than 10 times cash flows, which usually translates into about 15-20 times free cash flow.

Why would great investors like Buffett and Lemann be willing to spend so much for “fully” developed, large, slow-growing businesses like Heinz? Why would Procter & Gamble pay 30 times free cash flow for Gillette (where Buffett was a seller)? Why would Mars (the privately owned candy company) pay 28 times for gum maker Wrigley? There’s a simple and good reason. It’s one of the only true secrets to successful, long-term investing…

Careful readers of our newsletters might remember that Heinz was one of the four companies we profiled in the December issue of my Investment Advisory newsletter. Much of that letter was dedicated to understanding the idea of capital efficiency, which is the primary investment approach Buffett has used to build his fortune.

In my December letter, I explained the core concept of capital efficiency and why it ought to be the primary consideration of all long-term investors…

We judge companies primarily by how efficiently they produce cash. We’re interested in how much cash a company generates per unit of sales. And we’re interested in how much of this profit is reinvested into the business (through capital expenditures or acquisitions) versus how much is simply returned to the company’s real owners – its shareholders…

Branded, consumer-product companies – like Coke (KO), Hershey (HSY), and Heinz (HNZ) – tend to be capital-efficient because they don’t have to spend much (if anything at all) on technology… or creating whole new products… or building expensive new factories. Instead, the value they create comes mostly from the loyalty and devotion of their customers… which can be relied upon in good times and bad. As I wrote specifically about Heinz…

If you’re a Heinz ketchup man, you’re not going to switch brands. As long as Heinz delivers the same high-quality product at the same reasonable price, you’ll stick with it. Heinz doesn’t have to build lots of new plants or constantly create new products. It doesn’t even have to spend a fortune on advertising. It has an installed, loyal, and ready base of buyers… and a large moat around its business, thanks to brand loyalty.

Buffett calls this quality of a business economic goodwill. Because there’s no real good place to put the value of a brand on the balance sheet, it ends up in the catch-all entry of “goodwill.” I call this unique and valuable quality capital efficiency because these companies have the ability to return more of their gross margin to their shareholders than other firms, which have to spend the capital on advertising, capital investments, or research and development.

I’ve long known that companies that are highly capital-efficient will earn investors extremely high returns if they reinvest their dividends. We found that over the last 30 years, the average total return from these four companies was around 6,000% – or 15% annualized.

It’s difficult for equity investors to earn more than 15% annualized returns over long periods. And I believe it’s impossible to make higher returns with less risk than you can make over the long term by investing in high-quality, well-proven, branded consumer-product companies that exhibit lots of capital efficiency.

That’s why in my December newsletter, I published a list of the 20 publicly traded companies that rated the highest on our measure of capital efficiency. And out of all those stocks, McDonald’s (MCD) was the most attractive based on share price (less than 10 times earnings), capital efficiency (42%), and the quality of its business and brand. At the time, it was trading around $89. We recommended subscribers buy the stock up to $90 a share. MCD shares closed earlier this week at $94.14. My subscribers are up 6% in two months.

But what would McDonald’s stock trade at if it were valued on the same basis (24 times free cash flow) as Heinz is today?

According to Bloomberg, McDonald’s generated $3.7 billion in free cash flow over the last 12 months. Applying the Heinz deal multiple (24x) gives McDonald’s a total equity value of $88.8 billion. With 1 billion shares outstanding, that gives us a price target today of $88.80 a share. Currently, the company’s equity value (its market cap) is $94.5 billion.

All these facts lead me to conclude that we got a good deal on McDonald’s (MCD) shares… and I expect folks who bought it on our recommendation will end up making roughly 15% a year… for a long, long time.

Regards,

Porter Stansberry

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Source: The Growth Stock Wire