Monday, March 12, 2007
Mr. Bernhard was echoing Williams in pointing out the need for generally accepted criteria to value stocks. He also joined Williams in warning that the effect of not having such criteria resulted in excess stock market and economic volatility, which damaged investor confidence not only in the stock market but also in the free markets. Bernhard then boldly states, “In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock. Whenever, over a period of years, the dividend, or the ability to pay dividends, went up, so too did the price of the stock. When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.” In applauding Williams’s theory, however, Bernhard inserted a subtle twist to Williams’s basic premise by adding the words, “the dividend, or the ability to pay dividends.” By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value. Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist. He is famous for saying that investing is easy: “just buy wonderful companies at good to great prices.” When asked to explain what good to great prices means, he credits John Burr Williams’s formula for intrinsic value, but defines it with a different twist: “The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.” Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings. Neither Buffett nor Bernhard nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said. Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his thesis a section titled “A Chapter for Skeptics.” There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company..” Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following: “Earnings are a means to an end, and the means should not be mistaken for the ends. In short, a stock is worth only what you can get out of it.” [Italics are the author’s.] He then added the following poem: “ Even so, the old farmer said to his son: A cow for her milk, A hen for her eggs, And a stock, by heck, For its dividends. An orchard for fruit Bees for their honey, And stocks, besides, For their dividends. The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.” In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets. Williams answered this issue with the following statement, “The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading, and dividends for years to come, not income for the moment only.” John Burr Williams struck a bright line between being in the chicken business and being in the egg business. He believed, as we will see later, that buying and selling chickens had no predictor and thus was pure speculation. On the other hand, investing in egg-laying chickens was completely different. It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.