Welcome to the introduction to Rule #1 course, I’m Phil Town and this is Tutorial 7: Margin of Safety (Part 2)- Sticker Price and Margin of Safety.
This is part 7 of a 9-part series on How to Invest using Rule #1 strategies
Part 2: Meaning- The Three Circles
Part 3: Moat- A Durable Advantage
Part 4: Moat- The Big Four
Part 5: Management- Owner Oriented
Part 7 [You are Here]: Margin of Safety- Sticker Price and MOS
Part 8: Margin of Safety- Payback Time
Never Pay the Sticker Price
We’re going to talk about finding the sticker price. Sticker price is what I call the value of the business.
Why do I call it the sticker price? You know how you have a sticker on the window of a new car and it tells you what the price of the car is, and you never pay the sticker price? That’s why we named the value of the business the “sticker price.” We never pay the sticker price. We always want to buy it at a significant discount to its true value.
Finding the Sticker Price
How do we find the sticker price? That’s the critical part of this whole equation of understanding what businesses to buy. First you have to make sure it’s a business that you understand the meaning of. You understand it has a big, durable moat and it has a great management team. Now you can start looking for the value.
The first thing we’re looking for is the trailing twelve months earnings per share. Now I talk about this in my book, Rule #1. You can go through that book and it will show you how to do these things at MSN Money.
Then we want to find the growth rate, we talked about that in Tutorial 6: Margin of Safety (Part 1): The Growth Rate. We also want a PE ratio, which is a multiplier of the earnings. Finally we want the minimum acceptable rate of return.
Finding the Trailing Twelve Month Earnings Per Share
Go over to the Rule #1 Toolbox and I’m going to go through the process of finding the sticker price. Let’s use Darden (DRI), and we’re going to go to “Town Analysis” which is our evaluation page. Now, the website automatically loads the numbers that we need over here in this left hand column of numbers.
Remember we wanted trailing twelve months EPS? Well, there it is automatically placed in there. We needed the future growth rate, well the analysts think it’s going to grow at 12.20% percent. The website grabs that number and we happen to also think it’s going to grow at 12% percent, this number is from Tutorial 6, so we’ll leave that alone. Then down here we have the future PE. This is the lower of historical high PE or two times the growth rate. We see the high PE’s are about 18.3% percent, so that’s the most we can go. Finally, the minimum acceptable rate of return of 15% percent is automatically loaded in and that’s all there is to it.
Now we’re just going to submit. It will run these numbers and get back to us with a value, or what we call the sticker price.
Now we can see the sticker price is $50 dollars and that’s all there is to it. We start with good assumptions, a company that we understand well, that’s the meaning, has a big moat, it’s durable, it has a great management team and it now has a value or sticker price of fifty dollars. Now what?
Finding Margin of Safety
Well now we look for the margin of safety. It tells us the margin of safety price is $25.00 dollars, that’s one half of the sticker price so make a note that the margin of safety price is 50% percent discount to the real value of the business.
Pro tip: use my investment calculators to crunch the most important numbers when searching for an attractive business in which to invest!
Let’s review, first, we have the trailing twelve-month earnings per share. The future growth rate is the lower of the historical growth rate which we found in Tutorial 6, or what the analysts think the growth rate is going to be. The future PE is two times the growth rate, which would be twenty-four in this case. It can’t be higher than the high PE ratio, which is 18. Finally, the minimum acceptable rate of return is 15% percent all of the time and that calculates a sticker price of $50.22 and a margin of safety of $25 dollars.
Go to ruleoneinvesting.com/toolbox.
Enter the symbol of your big moat company.
Click on Town Valuation.
Choose the lower of your historical growth rate from Tutorial 6, or the default number (that’s right on the page that’s from the analyst’s growth rate).
Choose the lower of the historical PE or the default PE.
Make sure the minimum acceptable rate of return is 15% percent.
Find the sticker price and the margin of safety price of that big moat company you’ve been looking at.
Congratulations you just figured out something pretty darn cool. Now time to move on to Tutorial 8: Margin of Safety (Part 3)- Payback Time.