THE RULE OF 72

Here's a question I get asked every day, and an answer I think will help everyone doing a 4M company analysis.

How do you calculate the equity (or book value per share) growth rate? (And I'll expand that to include sales, EPS and cash growth rates.)

I'm going to teach you how to do this in your head. Once you learn it you will understand why Warren Buffett doesn't need a computer to figure out whether he likes a business or not. Here's how:

MSN Money reports book value per share numbers for 10 years in a column under Financial Results - Key Ratios - 10 year summary. Investools puts up ten years of balance sheet info under Fundamentals - Balance Sheet. Others do it similarly.

• Start with the oldest number (and of course don't even bother unless the growth is consistent -- but at this point that goes without saying, right?), round it off to something that is easy, and double it in your head. Keep doubling until you get to a number that is as high as the most recent equity number.

• How many times did you double it? Let's say you doubled the oldest number two times. Now divide two into the number of years from the oldest to the most recent equity number. On the sites I use, it's usually 9 years. Two goes into nine 4.5 times. 4.5 is the number of years it took for the equity to double once.
  
  
• This next bit is called The Rule of 72. When you divide the number of years it takes to double your money into 72, you get the growth rate. For some unknown-to-me reason this actually works. 4.5 into 72 is about 16. Ballpark. So the equity in this example is growing at 16% a year for the last 10 years.

I use the Rule of 72 all the time. It isn't perfect but it's quick and doesn't require a calculator. Here's a real world example from EXBD using data from MSN Money: Book value per share in 1999 (the oldest number) is .40. In 2004 it was 8.41.

Start doubling .40. double once to .80. Double twice to 1.60. Double three times to 3.20. Double 4 times to 6.40 and then part of a double to get to 8.41. I look to see the number of years. 1999-2000 is one, and so on. I get 5 years with 4 doubles. That's a double almost every year.

Divide 1 into 72 and you get 72. So EXBD has a book value per share compounded growth rate of 72% for the last 5 years. That's crazy but it happens to new, fast growing businesses.

Let's do it again more recently and see how they're doing: In 2001 their BVPS (Book Value Per Share) was $4. Now it's $8. So in three years (2001-2002, 2002-2003, 2003-2004) they doubled their book value per share. 3 years to double once. 3 into 72 is 24. So more recently their BVPS is growing at 24% a year. Still phenomenal.

And how about 2003-2004? it went from 6 to 8 bucks. Thats up $2 in one year starting from $6. If they keep up that growth ($2 a year or so) then in three years they will have doubled the $6 again - probably a bit faster than 3 years. So recently they're still growing equity at 24%.

You gotta love the rule of 72 for quick and dirty calculations. After a while, you get to where you can just glance at the numbers and see consistency -- and then quickly do the doubles on the oldest number and see if the equity growth rate is high enough to make this a business worth considering. No computer required.

Comments

[Alexander Barbara]

Phil, I see that you mention Investools a lot but I'm having trouble figuring them out. Do I have to take a course to get access to the tools you are talking about? When I go to investools.com it looks like my only real option is to sign up for a course.

[Phil]

Hi Alex,

The class is required because it's a powerful database with a lot of tools you might miss out on without guidance & instruction. If you have more questions shoot me an email.

[Rodney]

How do you calculate Equity in technical service industry. For example for an engineering firm, since the value can be greater than property due to intelectual value. Is it similar to a computer software firm? please tell me how to do it!

[JSoccermom]

Dear Phil, I heard you speak in Halifax a few months ago and have read your book twice - I am ready to change my life. I could not attend the weekend sessions because my sons had a soccer tournament so I am trying it alone. I am a math person - how do I calculate the EXACT rate of growth, not using the Rule of 72 method. I know, I am a geek.... I ran through the Gramin example in your book a number of times using the math I know and got growth of 39% for equity which is overstated accoridng to your calculations. It is driving me MAD!!! I calculated the growth % for each year and averaged them over the 6 year period....MY EPS number was 25.% (over yours) and Sales 23% (below yours). Can't figure out the formula to do this in excel either. I don't want to be making these mistakes when I invest my money.

[SH]

JSoccermom,

I follow grmn extremely close, and i recently pulled the trigger on the stock. I pulled the data on grmn for the years that phil covers in his book FY2000-2005.

I am not sure if you are using the right formula in excel. I think you might be using the average function instead of the rate function.

Heres an example
Garmin Revenues
2000 = $345.7MM
2005 = $1027.77MM

In excel, you would click on the function button which is marked FX on the type prompt, go to financial, then scroll down until you hit the rate function. you then have to input the following fields

nper = number of years which is 5
pmt = ignore this
PV = will equal -345.74
FV = 1027.77

if you input everything correctly, you should get a 5 year average growth rate of 24.35%

Here are the others.
5 year equity gr = 33.6%
5 year net income = 24.12%

Again, i am not sure what years phil used, but it should be pretty close. Also, PHil mentioned in his book that the rates might be slightly off depending on what website you use.

Also, if you want to be exact, you might want to invest in a TI financial calculator. They run about 29$ at walmart, and they are nice to have so you dont have to run the math in your head. If you are interested, i ran a sticker value on garmin of 88-90$, and it trades for $44.

[JSVSoccermom]

Thanks so much. I am now trying to figure out how to run ROIC because I see that there are no numbers on MSN for the CDN compnaies I am looking at....wish me luck...I have to unravel the mysteries of the financial statements....

[JSVSoccermom]

I ran those Garmin numbers and got $92. I used a PE of 20 - that is the historical average. Do you think it was high since the current PE is only 11.40. Do I need to look at that number also because if I do that sticker falls to $53 and it's a no touch for me..sorry to pick your brain - I am learning.....
J

[SH]

JVS,

You dont need to calculate ROIC b/C MSN will do it for free. If you go to MSN, pull up the stock by the ticker symbol, go to financial highlights, key ratios, and investment returns, it will give ROIC for 1 year and 5 years. Another good tool i use is the Value Line Investment report. They have it for free at the library. I have pulled it, and since 2000(when the company became public) garmin has posted ROIC in excess of 20% every year. All ROIC is is net operating profits after taxes/ equity+total bank debt. It is a measure that looks at investment returns with debt to make sure a company is not employing high degrees of leverage to achieve results. Garmin has no debt, so it is a solid a company. Another rule of thumb that Phil's book didnt really point out is that you want to make sure that the ROE parrells the ROIC. If it does you have a solid company

As far as you P/E, i used 19. According the value line and MSN, the median P/E is 19. I got that from looking at MSN, key ratios, 10 year summary. The median P/E(Historical) = 18.95 since 2000. The default P/E would be 34 since analysts expect revenues to grow at 17% over the next five years.

The current p/e is 11 because the market has punished this stock over the last several months. i have been building a posistion for several months because the fundamentals havent changed. Most analysts are focused on the new Nuviphone that garmin is coming out with, and that it wont compete well with Apple.

What every analyst misses is that Garmin's primary business is coming from autos not phones. Garmin is imply capatilzing on its strong brand name and product, so it makes sense to explore this market. But, autos is where the company's revenues come from. In a few years GPS will be standard in every car. Margins may slip a bet, but voume will continue to increase as well as revenues and Cash flow. Plus with no debt and insiders holding alot of stock makes me feel good.

Hope this helps

SH

[Erin]

SH,

this is really helpful info, thanks for sharing with everyone!