In one sentence: Phil lists the four inputs to the margin-of-safety (discounted cash flow) valuation: trailing-twelve-month earnings per share, a future earnings growth rate, a future P/E, and a minimum acceptable rate of return of 15%, and explains how to choose each conservatively.
Key ideas
- Run the four filters on the whole market. Phil tests the US market: understandable and a durable moat, but management (politicians) is the question. Danielle teases him for getting political and he moves on. [00:00–04:00]
- Free cash flow recap. $11 operating cash flow minus $3 purchase of property and equipment gives $8. Divide by 10% for $80. The purchase line includes growth spending, which they accept. [06:00–09:00]
- Margin-of-safety analysis is discounted cash flow, made simple. Value need not be defensible in court, because you cut it by half anyway. [09:00–11:00]
- Number 1: trailing-twelve-month EPS. For the stand it is $11, and a search for the company's name plus "earnings trailing 12 months" shows it. [12:00–14:00]
- Number 2: future growth rate, 7–10 years. Analysts (Zacks and similar sites) forecast five years, and they tend to be optimistic. Use the big four growth rates (sales, earnings, free cash flow, book value) from the past and take the lower of your figure and the analysts', which is 13% here. [14:00–20:00]
- Number 3: future P/E. Businesses sell at a multiple of earnings. A good no-growth private business goes for about 7×, public ones for roughly double (10–14×), and the long-run average for big US companies is about 15×. Fast growers get more. [20:00–25:00]
- P/E rule. Use the lower of two times the growth rate (26 here) and the top of the company's own historical P/E range (20 for the stand). Ignore freak peaks such as 46 in a crisis. Cyclical industries tend to have lower P/Es. [24:00–31:00]
- Number 4: minimum acceptable rate of return (MARR), 15% always. This is the "discount rate" of business school. It is higher than the 10% equity-bond yield because growth rates are projections and earnings can be manipulated (buybacks, bonuses tied to stock price). Phil says to keep it at 15% and not adjust it up or down. [33:00–40:00]
- Higher MARR means a lower price and a bigger cushion, but also fewer opportunities. [35:00–36:00]
- The honest gap. The episode stops with the four inputs, and the price calculation comes next time. Danielle jokes about "the discount rate" at cocktail parties. [40:00–47:00]
How it maps to RuleOne
- The four inputs map to fields on the stock pages: trailing EPS, growth estimates, P/E history and the 15% hurdle. Any sticker price on the site is built from them, so check the growth and P/E choices, not the arithmetic.
- The "lower of mine or analysts'" rule is a built-in conservative bias. If a tool offers a higher growth rate, ask why.
Buffett, Munger and Graham links
- Buffett's view that a business is worth the cash it can give you over its life, discounted to today, is the idea behind the whole method (Berkshire owner's manual).
- Munger's warnings about incentives (the 1998 Harvard speech, "Psychology of Human Misjudgment") apply to bonuses tied to stock price.
- Graham's Intelligent Investor ch. 20 introduces the margin of safety as the central idea.
Words to know
- Trailing twelve months (TTM): the latest four quarters combined.
- MARR: minimum acceptable rate of return, the discount rate.
- P/E ratio: price divided by earnings per share.
- Cyclical: earnings that swing with the economy.
Try this
On a stock page, write down the four inputs for one company: TTM EPS, a growth rate you can defend (and the analysts' figure), the top of its historical P/E range and 15%. Don't compute a price yet.
Check yourself
- What are the four numbers?
Answer
TTM EPS, future growth rate, future P/E and the 15% minimum acceptable rate of return. - Which P/E do you use?
Answer
The lower of two times the growth rate and the top of the company's historical P/E range. - Why use 15% when the equity-bond yield is 10%?
Answer
Because earnings and growth are forecasts, and earnings can be flattered. A higher hurdle builds in a cushion.
Short quotes
"We're not going to pay the value of the business, we're going to discount it dramatically." (Phil, ~09:30, auto-transcribed, lightly paraphrased)