In one sentence: Phil values the lemonade stand as if you were buying the whole private business: add up eight years of growing free cash flow ($8 growing at 13%) and you get about $115, with seven years about $94 and six years about $75.
Key ideas
- Survivorship check. Danielle points out that we hear mainly about winners. Phil sends her to Buffett's "The Superinvestors of Graham-and-Doddsville" (Columbia, 1984): Buffett followed every Graham student he could identify, and all beat the market. Phil says he will check it, so treat the details as to be verified. [02:00–06:00]
- Why public stocks cost more than private businesses. Liquidity. Fund managers can't sit in cash, so they spread across hundreds of names and track the index. Phil says an individual doesn't need to do the same. [06:00–11:30]
- From cigar butts to wonderful businesses. Graham's cigar butts work in depressions. Buffett and Munger moved to wonderful companies at fair prices. [08:00–10:00]
- Reuse the same growth rate. The "windage" growth rate (13%) set for the margin-of-safety analysis is used again, not recalculated. [12:00–16:00]
- Payback time: add up the cash. Start with $8 of free cash flow per share and grow 13% a year: $8, $9.04, $10.22 and so on to about $21 in year 8. Eight years total about $115. [16:00–23:00]
- Why eight years. Phil says workshop role-play, venture capital and Danielle's M&A experience all land near 7–8 years of cash for a private business. He is comfortable with up to 10 for a strongly growing company, but sets 8 as the beginners' limit. [18:00–24:30]
- Lower is better. Subtract year 8's cash ($21) and you have a 7-year price of about $94, close to the $93 margin-of-safety price. Subtract year 7 (about $18) and the 6-year price is about $75, below the 10 cap price. [24:00–27:00]
- It is the price, not the stock's earnings. $115 is the sum of cash over eight years and the maximum you would pay today. [29:00–30:30]
- A seller won't give you two years of cash. If a car wash owner will sell for two years of cash flow, find out what you don't know (lease ending, etc.). [30:00–32:00]
- Theory becomes real when the company pays out. Dividends plus buybacks can equal free cash flow. Phil says IBM pays out almost everything it earns. Spin-offs, such as Ferrari from Fiat Chrysler, are another form of distribution. [27:00–34:00]
- Zombie value is next. The fourth method values the business as if it were dead. [34:00–36:30]
How it maps to RuleOne
- Payback time is the idea behind price-to-free-cash-flow: P/FCF 8 means the price equals about eight years of today's cash without growth. The growth version here gives a higher price than the flat one.
- Dividend and buyback yield are on the stock pages. Add them to see how much of free cash flow is actually returned to you.
- The same method prices a private business, such as a car wash or franchise.
Buffett, Munger and Graham links
- "The Superinvestors of Graham-and-Doddsville" (1984) is Buffett's answer to the claim that value investing is luck.
- Graham's "cigar butt" (via Buffett's 1989 letter) versus Munger's "wonderful company at a fair price".
- Buffett's 1980s letters use "owner earnings" as the cash a business can distribute.
Words to know
- Payback time: years of cumulative free cash flow that equal the price paid.
- Distribution: cash or value returned to shareholders (dividends, buybacks, spin-offs).
- Spin-off: a company hands shares in a division to its owners.
Try this
Take a company from /stocks/ and its free cash flow per share. Grow it at a rate you can defend for eight years, add the totals, and compare the sum with the price. Then try seven years.
Check yourself
- What is the payback-time price in this episode?
Answer
The sum of eight years of growing free cash flow, about $115 for $8 growing at 13%. - Why does a shorter payback give a lower price?
Answer
You count fewer years of cash, and subtracting the later large years removes the most. - Why be suspicious of a business offered for two years of cash?
Answer
Sellers expect around eight years of cash, so something must be wrong or unknown.
Short quotes
"How long will it take me to get the money back that I paid for this business?" (Phil, ~18:00, auto-transcribed)