Price

Is our company cheap or expensive? Relative value to Treasury Bonds

Most investments must compete with the rate of return offered by Treasury Bonds. If the rate of return is better, we can venture into such investments.

Lets imagine that we are to choose between a Treasury Bond yielding, say 3% and company earning us a 12,1% Rate of return on our initial investment (see chapter 1) and additionally with earnings per share growing also at a rate of 12% (see chapter 2). The stock is a far better investment than Bonds. Buffett used to pick stocks that are the so-called bond proxies or equity/bonds which are known for the stability of their business, thus bearing some traits of bonds. He also used to say that is is just as important not to loose money as earn money.

But how to calculate if a stock is better or worse than bonds? That is pretty simple, you just have to use the following formula:

Relative value (price) = Earnings per share / Bonds rate of return.

The relative value (price) tells you that paying that price you will get a return equal to treasury bills. So what you want is for the actual stock price to be lower than the result of the equation (the relative price) so you can get a better return then the treasuries. Yup, its that simple!

In other words, if the treasuries are 4% and you put a good stock's earnings per share into the equation and end up with a price that is higher than the actual price, that means you can buy that stock and get a better return than treasuries. You go buy that stock (if its a strong company).