Investing can feel like a leap of faith sometimes, can’t it? We all want to know we’re making smart decisions with our hard-earned money. That’s where the concepts of margin of safety and payback time come in.
Welcome to the introduction to Rule #1 course, I'm Phil Town and this is Tutorial 8: Margin of Safety (Part 3)- Payback Period.
This is part 8 of a 9-part series on How to Invest using Rule #1 strategies
Part 1: Rule #1 Strategy- Overview of the Basics
Part 2: Meaning- The Three Circles
Part 3: Moat- A Durable Advantage
Part 4: Moat- The Big Four
Part 5: Management- Owner Oriented
Part 6: Margin of Safety- The Growth Rate
Part 7: Margin of Safety- Sticker Price and MOS
Part 8 [You are Here]: Margin of Safety- Payback Time
Part 9: Zombie Value- Tangible Book Value
What is Payback Time?
Payback time is the amount of time it takes before you get the return of your initial investment. I wrote a whole book about it, but I'm going to summarize that real quickly right here. You should know that the book became a New York Times Best Seller and it's available to you guys as a resource if you want it.
Let's assume for a second that you want to buy a private river touring company in the Grand Canyon. Let's further assume this company makes $1,000,000 every single year that you get to take home in your pocket. If you want to own it, you got to figure out how much you're going to bid for this company.
This company makes $1,000,000 dollars a year. What would you pay for it? If you've never done anything like this before, let me give you a little bit of advice. In the private equity industry, the investors in it, like venture capitalists and people with a lot of money, expect to get their money back from the earnings of this private company in a seven to nine year period.
The reason they do that is because this is not a company they can sell to someone else easily like a public stock. They're going to be very careful about how much they pay for it. When you get your money back after you own the company, and it pays off your investment from earnings, it's like putting your original stake away after you've gone out to the casino. You've put the money in the pocket. Now you have no downside. You're playing with house money and from that point on you can't lose. That's like payback time.
Why Use the Payback Time?
So why bother with the payback time at all? The answer is that it's simple and intuitive. It is especially helpful for quickly comparing different investments or when you need to break even fast. For example, if you’re deciding between two projects and one pays you back in two years while the other takes five. That’s a meaningful difference—especially if you need liquidity.
How the Payback Time Works
The payback period formula is straightforward: Payback Time = Initial Investment / Annual Cash Flow
But real life isn’t always so neat. Sometimes, your cash flow isn’t the same every year. Maybe you have higher cash outflows in the first year, or maybe your savings grow over time. That’s where a detailed cash flow analysis comes in handy.
Calculating the Payback Time
There are a few ways to calculate payback periods, especially when cash flows aren’t consistent:
Simple Payback Time: Divide the initial investment by the average annual cash flow.
Cumulative Cash Flow: Add up cash flows year by year until you reach your initial investment.
Subtraction Method: Subtract each year’s cash flow from the initial cost until you hit zero.
Each method gives you a slightly different perspective. I find the subtraction method particularly helpful when cash flows vary a lot from year to year.
Payback Time Goal: Eight Years or Less
Our payback time goal is to buy a great business that pays itself off in eight years or less. The trick with that goal is that we want to do it with a public company. Public companies tend to have payback times that can go up to around 11 or 12 years, so we're going to have to look for a real deal in order to get an eight-year payback time. If we find it, that's an awesome opportunity for us.
How do we know if we're going to get an eight-year payback time? We're going to go over to the Rule #1 Toolbox on the valuation page. Right at the bottom, it says the payback time price for this company is $49.63. That means you'll get all your money back if you buy this company for $49.63. You'll get all of your money back in 8 years out of earnings. Then if you own the whole thing, you'll be free and clear.
How to Find Payback Time
Back on the Rule #1 toolbox, we're back again with Darden Restaurants (DRI). You can see we have the same earnings per share, the future growth rate, the EPS, the PE, and we have the same future value, minimum acceptable rate of return and margin of safety.
What we're going to do a little different this time is that we've shifted it over to the payback time. Submit the payback time and we will get an idea of what this thing is worth if we want a full payback in eight years.
You'll see on the toolbox that that's where we got the number $49.63 with an eight-year payback time. At that point in time, this thing was on sale, because the price is very close to the $49.63. We have a bit of a margin of safety by virtue of the payback time. Let's take a look at some homework.
Go to the Toolbox and enter the symbol of your big moat company.
Click on Town Valuation.
Select payback time, make sure the inputs are correct.
Click submit and what you're going to get is the eight-year payback time for you big moat company.
Comparing Payback Methods and Other Factors
You might be thinking, “So if the payback time is shorter, does that automatically make the investment better?” Not necessarily. A short payback time usually means less risk—you get your money back faster, which is nice. But here’s the kicker: sometimes the investments that take longer to pay you back are the ones that deliver the biggest rewards in the end. The key is knowing the business well enough to tell the difference.
That’s why you have to consider both the payback time and net present value when making investment decisions. For example, solar panels and energy-efficient appliances may have a longer payback time, but the cumulative savings and positive cash flows over time can be substantial.
Let’s revisit our previous example of buying a river touring company. If you manage to achieve a two-year payback time, that’s a good payback time by most standards. But remember, every potential investment is unique. At Rule #1, financial analysts will often use a combination of methods—including net present value (NPV) and discounted payback time—to assess which project or investment is best.
Also, don’t forget the importance of the payback method you choose—whether it’s the payback formula, averaging method, or subtraction method. Each has its place depending on the project or investment.
The Time Value of Money: Why Sooner is Better
Here’s where things get interesting. Money you receive today is worth more than money you’ll get in the future, thanks to the time value of money. That’s because you can invest today’s money and start earning returns right away. This is a key concept in personal finance and financial planning, especially for long-term investments.
Discounted Payback Time: A Smarter Approach
To account for the time value of money, smart investors know won't just look at dollars in the future as if they’re worth the same as dollars today. That’s where the discounted payback time comes in. This method discounts each future cash flow back to its present value using a chosen discount rate (think of it as the return you could get elsewhere, or your opportunity cost). The discounted payback time tells you how long it takes for the present value of your cash flows to cover your initial investment. This approach is often used in capital budgeting when evaluating potential investment opportunities.
Suppose your investment returns $2,000 per year, but you discount those future payments at 5%. The discounted payback time will be a bit longer than the simple payback time, reflecting the fact that future dollars are worth less than today’s dollars. This discounted cash flow method ensures your investment breaks even at a more accurate breakeven point.
Payback Time: Making Sense of the Numbers
At the end of the day, investing is about making choices that align with your values, goals, and comfort level. The payback time and margin of safety are just tools to help you make smarter, more confident decisions.
If you’re ever in doubt, remember: it’s normal to have questions. Take your time, run the numbers, and don’t be afraid to seek advice. After all, the best investment you can make is in your own financial education.
Now you're ready to move on Tutorial 9: Zombie Value- The Tangible Book Value of the Company, or what we sometimes call “the living dead.”
Related reading:
How to Invest Money: A Simple Guide to Grow Your Wealth in 2019
