It's more important to be right on the business than right on the exact price to pay.
How do you decide how much to pay for a business?
This is an interesting question because Buffett—despite producing incredible returns in his partnership and the early Berkshire years—says he was never trying to go for home-run type returns. He was more focused on finding the sure bets—investments where he was fairly certain to make money without taking much risk:
“I don’t want to buy into any business that I’m not terribly sure of. So if I’m terribly sure of it, it probably isn’t going to offer incredible returns. Why should something that is essentially a cinch to do well offer you 40% a year or something like that? So we don’t have huge returns in mind. But we do have in mind never losing anything.”
He uses Sees Candy as a case study for how he thinks about what to pay for a business. They bought Sees in 1972 for $25 million. It was selling 16 million pounds of candy at $1.95 per pound, and making $4 million pretax. He said that he and Munger basically had to decide if there was some untapped pricing power. If they could sell candy at $2.25 a pound, then $0.30 per pound on 16 million pounds was another $4.8 million of pretax profit on the same volume, which would have doubled the then-current earning power of the business. Even raising prices by a nickel per pound would have produced a 20% gain in pretax earnings.
What I find interesting is that the purchase price itself was quite cheap—just 6 times pretax earnings, the equivalent of an after-tax P/E of about 10. But Buffett never even mentions the valuation in answering the question—almost as if it was an afterthought. Notice how this was very similar even in his early two writeups of GEICO and Western Insurance–much more focused on the business, with barely a mention of valuation.
With Sees, he talked about the pricing power, references the return on capital (in this case Sees basically needed no capital), and talked about the attractiveness of the product. In the end, the decision to buy the business was made not based on whether the “multiple” was cheap enough, but because he and Munger decided the product had plenty of untapped pricing power—in other words, the product itself was very undervalued from the customer’s point of view. They surmised they could raise prices and still maintain or grow volumes.
Buffett and Munger were correct in their view that the product was undervalued, and through pricing power and unit growth, Sees has produced over $1.9 billion in pretax profits to Berkshire from an incremental investment of just $40 million and a purchase price of $25 million.
Sees is an extreme example to be sure, but one that exemplifies why it’s more important to be right on the business than right on the exact price to pay.
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