HOW TO INVEST: MARGIN OF SAFETY & PAYBACK TIME

Welcome to the introduction to rule #1 course, I’m Phil Town and this is Tutorial 8: Margin of Safety (Part 3)- Payback Time. 

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 invested capital. I wrote a whole book about it, but I’m going to summarize that up real quickly right here.  By the way 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. A private company would be something an individual would do or private equity company would do. Let’s further assume this company makes $1,000,000 dollars 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 earnings of this private company in a seven to nine year period of time.

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.

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 up 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 and 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 you’ll notice we’ve shifted it over to the payback time and I’m saying submit the payback time and we will get in just a moment an idea of what this thing is worth if we want a full payback in eight years.

You can see here, 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.

  1. Go to the Toolbox and enter the symbol of your big moat company.
  2. Click on Town Valuation.
  3. Select payback time, make sure the inputs are correct.
  4. Click submit and what you’re going to get is the eight year payback time for you big moat company.

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.”

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Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.
  • Vin Nair

    I am trying to calculate the Pay Back Time. However the tutorial above must be an older version of the Town Analysis tool. There is another field called FCF Share? Its not discussed in the tutorial what we should put in here.