HOW TO INVEST: MARGIN OF SAFETY- THE GROWTH RATE

Welcome to the introduction to Rule #1 course, I’m Phil Town and this is Tutorial 6: Margin of Safety (Part 1)- The Growth Rate. 

This is part 6 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 [You are Here]: Margin of Safety- The Growth Rate
Part 7: Margin of Safety- Sticker Price and MOS
Part 8: Margin of Safety- Payback Time
Part 9: Zombie Value- Tangible Book Value

Margin of Safety: The Three Most Important Words in Investing

Warren Buffett said, “The three most important words in investing are margin of safety.” That means to buy stuff on sale. That means pay less than what it’s worth. That means buy $10 dollar bills for $5 dollars. That’s the whole secret to great investing.

Buffett’s teacher Ben Graham, who wrote the Intelligent Investor, which is one of the best books on investing I’ve ever read said, “Buy stocks the way you buy groceries, not perfume.”

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing.

The Difference in Price vs. Value

Price is what you pay for something, but value is what you get. If you’re out there and pay $200,000 dollars for a $120,000 dollar Maserati, you still just got a $120,000 dollar Maserati. In that same way understanding, businesses have real value based on what’s called their future cash, or future cash flow. That’s the pile of cash this business is going to earn as long as it exists out there.

Margin of Safety: Discounted Cash Flow Analysis

We do a discounted cash flow analysis in business school to figure out what that pile of cash that’s going to happen in the future is worth today. We call that same analysis a margin of safety analysis in Rule #1 Investing. We call value, the same as intrinsic value or retail value or what it would sell for to another business in a good market and we start to figure that out by figuring out the growth rate.

Understanding Growth Rate

Warren Buffett said that figuring out or understanding the growth rate all depends on the moat. Here’s what he actually said, “The key to investing is not assessing how much the industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and above all the durability of that advantage.” That’s what we call a moat.

In fact we start with meaning, then moat, then management to make sure we understand this business well enough and that it’s got a good enough management team that it can be durable, that it has a durability that allows us to predict its future growth. This future growth rate is what we call the growth rate. The growth rate is the speed at which earnings are going to grow on average for the next 10 years.

Historical growth is only useful to predict the growth rate if the business has a big moat. If it doesn’t, then the historical growth doesn’t matter, because you never know when somebody is going to come and take away the whole business. Historical growth is useful to predict the growth rate only in big moat companies.

Finding the growth rate of the future cash is the first step to knowing the value of the business. How do we do that?

Finding the Growth Rate

Finding the growth rate is really easy. We’re going to go over to the Rule #1 Toolbox, we’re going to find a good Rule #1 score. Then we’re going to use what’s called the chart view to pick a line of growth. Then we’re going to use the numbers view to learn what the growth rate is of that line.

Let’s take a look at Darden Restaurants (DRI). I’m going to click on “stock at a glance” and it comes up with a good Rule #1 score. It’s got an 84 score, a little bit yellow on the moat there, but still pretty decent score. This is probably a pretty big moat company. Go to a chart view and see what this looks like. The chart view shows us the growth rate and slope of the four major numbers we have to follow. Earnings per share, book value per share plus dividend, operating cash flow per share, sales per share are calculated automatically by the computer at ruleoneinvesting.com.

All we have to do is pick the line that looks like most representative of historical growth. You know what, this one is awesome. Look at book value per share plus dividends. Either one of these lines would actually be okay, but let’s go for book value per share.

What we’re going to do is go over and take a look at the numbers view. Now that we know we’re looking for book value per share plus dividend growth rate and we see the long-term growth rate, the ten year rate is 12.6 percent. So that’s probably a good number for us to use and we see that sales is almost 10, it’s 10 at cash, its 12 at earnings so we can probably use anywhere in the range of 10 to 12 and be pretty accurate about the long-term growth of this company. That becomes our growth rate to go do our margin of safety analysis.

Conclusion

These are some tougher concepts to get a hold of all at once, I know we’ve gone fast so let’s review.

1) First we’re going to go to ruleoneinvesting.com/toolbox.

2) We’re going to check the rule number one score and make sure it’s a good score. That indicates a good moat.

3) Then we’re going to get the best line from the chart view. In this case we’re going to take the gold line, which is book value per share plus dividends.

4) Then we’re going to take that line and go to the numbers view and see what the growth rate is for it. In this case it’s about 12 percent and that’s going to be the growth rate we use when we figure out our margin of safety in the next tutorial.

Here’s your homework. Go to the Rule #1 Toolbox and estimate the future growth rate of your big moat company and then when you’re done head on to Tutorial 7: Margin of Safety (Part 2): Sticker Price and Margin of Safety.

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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.