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:
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.
It's important enough that you can't put a decent valuation together without it. The reason you can't is that you cannot use the current negative growth rates to derive value, obviously, so you have to figure out what the long term growth is going to be. Not a one year growth rate, but how much this business will be earning five years out.
The current situation is anomalous. Figure how the industry is going to grow over the long haul. Then figure if this business is going to grow faster than the industry. That will put your growth expectations in the ballpark.
2. Moat. Your business has to have a big moat or it won't be able to sustain long term growth through all sorts of economic ups and downs. Know what it is. Make sure the big five are improving over ten years.
Yes, the big five may go through a dip through a recession. This is the value of looking back long term and forward long term.
Using the 4 growth rates, determine a long term growth rate. Look at EPS and determine what earnings should be in 5 years. Work back to today to give yourself a starting point for long term growth. Then run out the earnings ten years. Look at what you get.
Ask this question: Are your expectations for earnings in ten years reasonable or seriously deranged? You want reasonable.
3. Management. If they are honest and passionate with a BAG [Big Audacious Goal], then you should be hearing some long term plans and estimates in their discussions with analysts. Use their estimates with your own. If theirs are lower than yours, you might want to rethink yours.
4. MOS. NOW you can do the valuation. Not before.You can't just take a shot in the dark based purely on recent growth (or losses) or analysts' valuations. You have to know the business you're thinking of buying.
When you come up with a growth rate you can double it to get the PE, or you can look at historical averages to come up with it. Either way, make sure that the PE makes long term sense out of the valuation.
Here's the thing, guys: This is a great market right now for people who know what they are doing. That means you. You can do this. Just do your Rule #1 homework. Do it now.
Things can still go down like a brick and if they do, you want to be wolfing down your favorite business as it drops. But to do that without freaking out, you have to know that you have a good handle on the long term value of this business as a business.
Now go play. Yee haw!