In one sentence: The third valuation method is a discounted-cash-flow style sticker price (grow earnings 10 years, apply a future P/E, discount at 15%, halve it), and Phil recommends using it as an upside check against 10-cap and Payback Time.
Key ideas
- Avoid first, buy second. Phil reads a 2008 letter from Allan Mecham (Arlington Value) saying their mentality puts a premium on figuring out what to avoid and quickly discarding the complicated. Rule #1 is the same. [01:00–03:00]
- "Value investing" is the wrong label. Phil would buy Amazon at the right price; the aim is a $10 bill for $5, whether the company is glamorous or dull. [00:30–01:30]
- The sticker price is the "Wall Street seats" view. It is a discounted cash flow, the only method here that tries to put an intrinsic value on the business (chapter 8 of Invested). [03:00–06:00]
- Checklist: growth rate "bullish but not crazy". This method asks how big the pot of gold could be, like a free lottery ticket bought at a big discount. [06:00–08:00]
- No industry ceiling. Check that projected earnings and cash flow, even at year 10 to 15, are nowhere near what the industry can absorb. Dominant firms can still pass if the growth rate is modest. [08:00–10:00]
- Future P/E. Pick a multiple a bull market would pay, at most twice the growth rate, and check it against what the industry and company have ever received. [10:00–12:00]
- Use a historically reasonable current earnings figure. Strip out outliers (a COVID year, for instance); also adjust for cyclicality (CF Industries is highly cyclical, Facebook is not). [12:00–17:00]
- 15% minimum acceptable rate of return (MARR). Higher MARR means more conservative. Phil says Wall Street probably uses about 8%. He would only lower 15% if long rates changed permanently. [13:00–16:00]
- The arithmetic. Grow $10 of EPS for 10 years to $100, times a future P/E of 40 gives $4,000. Discount at 15% (divide by about 4) gives a $1,000 sticker price, and half of that is $500. Phil seeks 50% off; Buffett has recently bought some holdings at a smaller discount, such as Bank of America in Phil's view. [17:00–21:30]
- Triangulate. 10-cap needs no growth rate or P/E; Payback Time needs growth only; the sticker price needs both, so it is the most speculative. The best case is all three landing in the same ballpark. [22:00–24:30]
- What's left on the checklist: the values match, the event creating fear, and above all the story inversion (argue against your own story). Work through it as a spiral, so you reach the inversion early and can drop a company cheaply. [24:00–27:00]
How it maps to RuleOne
- The stock pages' sticker price and margin-of-safety price follow this method; a useful habit is to compare them with a 10-cap or payback price before trusting either.
- The "spiral" fits the screen-then-agents flow: shallow passes first, deep work only for survivors.
Buffett, Munger and Graham links
- Graham's margin of safety (The Intelligent Investor, ch. 20) is the basis for the 50% rule.
- Buffett's definition of intrinsic value as discounted future cash (1994 and 2000 Berkshire letters) is the DCF logic.
Words to know
- MARR: the minimum yearly return you require, used as the discount rate.
- Sticker price: Phil's term for intrinsic value from the DCF-style method.
- Inversion: arguing the case against buying.
Try this
On /stock/TICKER/ for a company you know, compare its sticker price with a 10-cap price and a payback price. Do they agree to within a factor of about 1.5? If not, which assumption (growth, P/E, capex) explains the gap?
Check yourself
- What discount rate does Phil use, and why is higher more conservative?
Answer
15%. A higher required return shrinks today's value of the same future cash. - Why is this method the most speculative of the three?
Answer
It needs a 10 to 15 year growth rate and a future P/E, both of which are guesses. - Walk through $10 EPS to a buy price.
Answer
Grow to $100, times 40 gives $4,000, discount at 15% for about $1,000, then halve it for $500.
Short quotes
"What to avoid rather than what to buy." (Phil, quoting Allan Mecham's letter, ~02:30, auto-transcribed)