PHIL TOWN

The 4M Valuation Process Still Applies, Even in this Market

A few days ago, Nathan asked the following question -- which is echoed in a lot of emails I've received from RULE #1 investors:

Mr. Phil Town, I'm struggling with putting a value on a company right now b/c of how much the P/E and the growth rate we use affects the results. Should we stick to your standard way: using either the historical P/E or double the lowest growth rate (b/w historical and analyst projections), whichever is lower? That method is providing pretty high P/E ratios and, therefore, nice and high sticker prices for some companies. Should we slash the P/E ratio used in the calculation given the current market environment? If so, any rule as to how much?

I also wonder about the growth number that we use in the calculation. What should we do when analysts are predicting negative growth in 2009 for Rule #1 companies? Should we still consider it? If so, what number should we use for growth?

Thanks for all your help.

Here is my answer:

Nathan,

Let's go over the process of valuation:

1. Meaning:  You've got to know the business.

In a sketchy economic environment like the one we're in, it's even more important. 

DOING 4M COMPANY SEARCHES ON INVESTOOLS AND ON MSN MONEY

Richard posted a comment that requested Phil Town give detailed information about how to find a business that is on sale for 50% off. A stock's value is what I call the Sticker Price (and what Investools calls the "estimated target price" and what Warren Buffett calls "Intrinsic Value").  Rule # 1 investors buy at a Margin of Safety, or 50% off Sticker.

Good question, Richard, because this whole thing is academic if you can't find a wonderful business that you can buy cheap.

Finding wonderful businesses is easy.  There are tons of them. But finding wonderful businesses that are on sale takes some digging.

Pay Attention Now

Phil Town doesn't do a lot of predicting about the market direction.  The market doesn't matter.  What matters is whether you are buying wonderful businesses and what price you are paying for what you are getting.  But the question keeps coming up about how far down this market can go before the bottom.

In the last 100 years, the market has gotten into single digit PE ratios at least once per decade in 7 of the last 11 decades.  We were there in the 70s repeatedly, and the last time was at the beginning of the 80s when I started investing.  Then double digit PEs for almost 30 years. 

So of the 4 decades when the market sustained moderate to high prices in the last 100 years, 3 of them just happened.  But now we're right at the bleeding edge of sliding into single digits on the DJIA.  So this is a kind of historic moment.  For the first time in over twenty years, we're starting to see very good businesses go on sale big time.  This is when great investors in the Rule #1 tradition load up the truck.

I've been telling you to wait.  To stay in cash.  To protect yourself by being very careful about valuations.  You've been doing good.  You're ready.  Now is the time to begin consuming great businesses.