In one sentence: Phil reverse-engineers Amazon's $42 by finding the growth rate that makes the Rule #1 formula equal $42 (about 16% at a 15% required return, or about 13% at 10%), compares it with analysts' 6%, and shows that picking the growth rate is easiest for a simple, steady business such as See's Candies.
Key ideas
- Reverse-engineering the price. Start with trailing-12-month EPS of about $1.26. Keep raising the growth rate (with a P/E of twice the growth rate) until the discounted result is $42. That takes about 16% and a P/E of 32, giving $178 in 10 years and about $44 today. [01:00–05:00, 15:00–16:00]
- Analysts say 6.2%. The website and a public forecast page agree on about 6.2% for five years. At that rate EPS reaches about $2.30 and, at a P/E of 12.4, the price in 10 years is about $28.50. Phil describes this as "dead money". Discounting that at 15% would give a today value far below $42, so by this method $42 only works with much faster growth. [06:00–10:00]
- Year-by-year EPS growth was erratic. About +50% in 2006, −10%, −37%, then +26%, +67%, +40%, +35%, +19%, +5%, then −7% and −5%. Phil says an analyst figure of 6% might even be generous on that record. [10:00–12:00]
- Look at the smoother numbers. Sales, equity (with dividends added back) and cash flow each grew about 9.5–10% a year, while ROE was about 16% (15.7%). Phil says this steadiness, not EPS, is the better clue to long-term growth. [12:00–15:00]
- Change the required return. If the buyer needs only 10% a year (because of strategic benefits to Amazon), the same 16% and P/E 32 gives about $68. At 13% growth and a P/E of 26 it gets back to about $42. [16:00–18:00]
- Free cash flow is the hidden value. Phil says Whole Foods' free cash flow was about 163% of net earnings. A 12–13% growth path gives a payback of about 10 years at $42, and his own target is 8 years (about $28, roughly what Danielle paid). [19:00–26:00]
- Phil's own estimate before the deal. He used about 12% growth and a P/E of 24, about $36 sticker on the new lower EPS, or about $50 on the older $1.80 EPS, and a margin-of-safety price of about $18–25. [21:00–24:00]
- Why $42 was needed. To get holders at $32 to say yes, Bezos has to pay a premium. Phil also says the hedge fund that bought at about $28–31 hoped for the $40s–50s. [24:00–25:30]
- The windage growth rate is a judgement call. Danielle says it feels like picking a number. Phil's answer: the training wheels are staying within your circle of competence, so the growth path is obvious. [25:00–27:00]
- See's Candies. A 100-year-old brand growing about at inflation, with no sign the owners want to change. If you understand why it grows 4.5%, you can guess the next 10 years. Choose steady "six-inch bars" and not turnarounds. Then halve the answer. [27:00–32:00]
- Next topic: management. A Wall Street Journal page on a badly run company sets up the management series. [32:00–33:00]
How it maps to RuleOne
- This is the screen's sticker price and margin-of-safety price worked on a real example. The growth input has three obvious defaults on the stock page: analyst estimate, historical growth and ROE.
- Use the idea of reverse-engineering: from a market price (or a takeover price) back to the growth rate it implies. Ask whether that rate is plausible. The screen can only do this if you move the growth input by hand.
- Payback time (8 years target) sits beside the margin of safety as a second check on the stock page.
Buffett, Munger and Graham links
- Buffett on See's Candies: the Berkshire 2007 letter and Munger's talks describe it as the example of pricing power and a wonderful business at a fair price. Phil's detail about growth at inflation is his own recollection.
- Buffett on forecasting: the "librarians" quip is quoted by Phil from memory, and it echoes Graham's warning against extrapolating past growth in The Intelligent Investor (chapter 11).
- Margin of safety: Graham, chapter 20 of The Intelligent Investor.
Words to know
- Trailing twelve months (TTM): the last four reported quarters, used as the current earnings figure.
- Implied growth rate: the growth you must assume to justify a price.
- P/E ratio: price divided by earnings per share. Phil uses twice the growth rate for the future multiple.
- Windage: a shooting term, used here for judging how the future will drift from the historical numbers.
Try this
On /stock/TICKER/ for any stock, set the growth rate until the sticker price matches the current price. That is the implied growth rate. Write whether you believe the company can grow that fast and compare it to the analyst estimate and the 10-year average of sales growth.
Check yourself
- What does it mean to reverse-engineer a price?
Answer
Hold earnings and the required return fixed, then adjust growth until the formula gives the price, so you can see what growth the buyer was assuming. - Why did Phil trust sales, book value and cash flow growth more than EPS growth for Whole Foods?
Answer
They were steady at about 10% a year while EPS swung wildly, so they better show the long-term path. - Why is See's Candies an easy growth-rate call?
Answer
It is a stable, understood brand whose owners aren't trying to change its growth, so the past rate is a fair guide to the future.
Short quotes
"We're not trying to jump over six-foot bars. We're just jumping over six-inch bars." (Phil, ~31:30, auto-transcribed)