In one sentence: Phil runs the lemonade stand through all four inputs, growing $11 of earnings at 13% to about $40 in ten years, times a P/E of 20 gives $800, which at a 15% required return is worth about $200 today (the sticker price), and 50% of that, $100, is the price to pay.
Key ideas
- What discounting means. If you will get $100 in ten years, what do you pay today? It depends on the yearly return you demand (the minimum acceptable rate of return). A bigger demand means a lower price. [02:00–05:00]
- Rule of 72 intuition. Paying $50 for $100 in ten years doubles your money once, about 7% a year. Paying $25 doubles it twice, about 15% a year. [06:00–09:00]
- 15% is an aggressive goal that makes the price conservative. Phil would not model risk with beta and so on. He just demands 15% from everything. [04:00–10:00]
- Terms. Sticker price = intrinsic value. The margin-of-safety price is a discount to it. The margin-of-safety analysis is Phil's name for the discounted cash flow. [10:00–12:00]
- Pick growth conservatively. The stand's rates are 13/13/15/20 for sales, earnings, free cash flow and book value. Phil dials the 20% book-value outlier back to 13% and takes the lower of that and the analysts' (15%). He quotes Munger that optimism is the enemy of investing. [13:00–19:00]
- Why project 10 years at all? It's an educated guess, better for businesses you understand and with a durable moat. Moats now erode faster, so keep watching after you buy. [21:00–24:00]
- Step 1: grow earnings. $11 doubles in about six years by the rule of 72 (72 ÷ 13), and roughly $38–40 in ten years. Excel's FV formula gives an exact figure, but Phil says it is approximate: "better approximately right than precisely wrong", which he attributes to Munger. [24:00–32:00]
- Step 2: apply a P/E. Two times growth would give 26, but the stand's history tops out near 20, so use 20. $40 × 20 = $800 per share in ten years. The sale only works if buyers believe the moat lasts. [32:00–39:00]
- Step 3: discount back at 15%. 72 ÷ 15 is about 5, so the value doubles twice in ten years (÷4): $800 ÷ 4 = $200 sticker price. Excel's PV formula does the same. [39:00–43:00]
- Step 4: margin of safety. Pay 50% of sticker, so $100. Phil says markets go on sale regularly, 25% or more off every few years, and certain industries (coal, oil in 2016) are always out of favour. Be patient. [43:00–48:00]
- Check against the cap rate. $11 of earnings on a $100 price is an 11% earnings yield, so this method and the cap-rate approach start to agree. [51:00]
How it maps to RuleOne
- This is the calculation behind the site's sticker price and margin-of-safety price. Each input on the stock page (growth, P/E, 15%) is one you can change. Try a lower growth rate and see how the price moves.
- The 50% discount is the cushion. If the screen shows a price within 10% of sticker, you are not getting a margin of safety.
Buffett, Munger and Graham links
- Graham's Intelligent Investor ch. 20 is the original margin of safety.
- Buffett's idea that value is future cash discounted to today underlies steps 1–3 (Berkshire owner's manual).
- Munger's "optimism" and "approximately right" lines are from Phil's recollection. The second is also attributed to others, so don't quote it.
Words to know
- Sticker price: Phil's name for estimated intrinsic value.
- Margin of safety price: sticker price cut by a cushion, here 50%.
- Rule of 72: years to double ≈ 72 ÷ rate.
- Present value: today's price that grows to a future value at the required rate.
Try this
Pick a company on /stocks/ that you understand. Redo this episode's four steps with your own inputs and compare with the site's sticker price. Note which input differs most.
Check yourself
- What are the steps from $11 to a price?
Answer
Grow EPS 10 years at 13% (about $40), multiply by a P/E of 20 ($800), discount at 15% (÷4, $200), then take 50% ($100). - Why use 20 and not 26 as the P/E?
Answer
Use the lower of two times growth and the top of the historical range, and the stand never traded above 20. - Why is a high required return called "conservative"?
Answer
The higher the return you demand, the lower the price you'll pay today.
Short quotes
"It is better to be approximately right than precisely wrong." (Phil, attributed to Munger, ~28:00, auto-transcribed)