In one sentence: Phil starts the margin of safety calculation, which needs four inputs (trailing earnings, future growth, a future P/E and a 15% minimum return), and shows why the growth rate should come from all of the "big four" rather than from earnings alone.
Key ideas
- Index funds can be gambling. If you own an index and don't know what you own, you are hoping it goes up. Phil says the Dow has never taken more than about 26–27 years to break even, but that is a long wait for nothing. [06:00–08:00]
- Margin of safety. Graham to Buffett to Phil: the three most important words in investing. Know what a thing is worth and pay much less, so surprises still leave you whole. [08:00–10:00]
- This is a discounted cash flow, done simply. Phil notes MBAs need a spreadsheet and big formulas for it. [31:00]
- Input 1: trailing 12-month earnings. Take it from a site, and make sure it isn't wildly out of line with the previous years. [10:00–11:00, 30:00]
- Input 2: future growth rate. Project 7–10 years. If you can't, the business is too unpredictable. See's Candy, with prices up about 4% a year for decades, is the model of a predictable one. [11:00–13:00, 34:00]
- Input 3: the future P/E. A private business with no growth sells for about 7.5–8× earnings. Public ones fetch about twice that for liquidity and disclosure. The S&P 500 has averaged 15× over about 140 years. It has fallen to single digits in scares and above 40 in manias. [13:00–17:00]
- Input 4: the minimum acceptable rate of return. An annual figure you choose. Rule #1 uses 15%, because you will be wrong sometimes and winners should be big. [17:00–18:00]
- Big four growth rates. Compute growth in sales, earnings, free cash flow and book value, for example 13%, 13%, 15% and 20%. Use the low one, or about the average, as a conservative guess. [19:00–26:00]
- Why not just use the earnings growth rate? Earnings are the easiest number to manipulate. If management inflates them, something else (sales, cash, book value) goes bad, so all four growing together is the check. [27:00–30:00]
- Risk of confusion. Danielle gets "big four" and "four inputs" mixed up. The big-four growth rates feed input 2. [20:00–26:00]
How it maps to RuleOne
- The stock pages' sticker-price and margin-of-safety view uses this structure: earnings, growth, a future P/E and a 15% hurdle.
- The big-four growth rates appear on the stock pages and are the cross-check on any earnings story.
Buffett, Munger and Graham links
- Graham, The Intelligent Investor (1949), chapter 20, "Margin of Safety" as the central concept.
- Buffett's 1992 Berkshire letter describes intrinsic value as the discounted cash a business will produce over its life.
- Berkshire's See's Candy purchase is the standard Buffett example of a business whose past tells you about its future.
Words to know
- TTM (trailing twelve months): the last four quarters combined.
- Minimum acceptable rate of return (MARR): the yearly return you require, 15% in Rule #1.
- Margin of safety: the gap between value and price that absorbs error.
Try this
On a stock page, write down the four growth rates for a company. Pick the lowest and the average. Do they differ by more than a few points? If so, ask which number the business story supports.
Check yourself
- What are the four inputs to the margin of safety calculation?
Answer
Trailing 12-month earnings, future growth rate, future P/E, and minimum acceptable rate of return. - Why check four growth rates instead of one?
Answer
Earnings can be massaged, but not without another line (sales, cash flow, book value) revealing it. - Why does a public company get a higher multiple than a private one?
Answer
Liquidity and mandatory disclosure.
Short quotes
"The three most important words in investing are margin of safety." (Phil, ~09:30, auto-transcribed)