Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price".
Today, I'm considering whether FTSE 100 consumer-goods giant Unilever (LSE: ULVR) (NYSE: UL.US) is a wonderful company, and whether its shares are trading at a fair price.
A wonderful company?
Buffett loves big, powerful businesses with great international brands. Which is why you'll find Coca-Cola, Wal-Mart and Procter & Gamble (NYSE: PG.US) among the top six holdings of his Berkshire Hathaway investment company.
Procter & Gamble (P&G) is the world's biggest consumer-goods group -- and Unilever's arch-rival. How does Unilever measure up against P&G for brand strength? Supremely well, according to brand-researchers Kantar.
P&G has eight brands in Kantar's global top 50, led by Pantene at number seven. Unilever easily surpasses that with 15 top-50 brands, including three -- Lifebuoy, Knorr, and Dove -- in the top 10.
A high return on equity (ROE) is another Buffett hallmark of a wonderful company. P&G delivered a decent ROE of 16.6% for its latest financial year; but Unilever posted 29.6%.
Now, before we get too excited, Buffett doesn't like to see too much debt at a company; and debt can inflate ROE. P&G and Unilever both have debt, but if we leave out the 'equity multiplier' component (the effect of debt) from their ROEs we can see how much each company would have earned if it were debt free.
In P&G's case, 8.1% of its ROE was due to profit margin and asset efficiency, while 8.5% was due to returns earned on the debt at work in the business. In Unilever's case, 9.7% was due to margin and asset efficiency, and 19.9% to debt.
Clearly, Unilever is doing a good job for shareholders of increasing the return on their equity by the use of debt. But also, on a debt-free basis, still comes out ahead of P&G. That leaves the question of whether Unilever's debt is too high for it to be considered a wonderful company.
I don't believe Buffett would view Unilever's level of debt as an issue. Net gearing of 51% is higher than P&G's 38%, but still perfectly reasonable. In fact, Unilever's gearing is exactly the same as a UK share Buffett already happens to own!
A fair price?
Buffett values businesses as if he was buying the whole company.
EV/EBIT (enterprise value divided by earnings before interest and tax) is a simple whole-company metric that Buffett uses for a quick take on valuation. EV -- a company's market capitalisation, plus net debt (or minus net cash) -- is the price he would have to pay to buy the whole company debt-free.
At a share price of 2,366p, Unilever is on an EV/EBIT of 12.6. This rating compares favourably with P&G's EV/EBIT of 15.1. Therefore, I'd say Unilever not only measures up on Buffett's key wonderful-company qualities, but also currently trades at a fair price.
Buffet's big UK bet
Buffett rarely invests outside his home US market, but has backed one well-known UK business big-time. The multi-billionaire owns over 5% of this company's shares.
If you'd like to learn all about Buffett's big UK bet, you may wish to read this exclusive in-depth report. The report is 100% free and can be in your inbox in seconds -- simply click here.
G A Chester does not own any shares mentioned in this article. The Motley Fool has recommended shares in Unilever.