Rule #1 Finance Blog

With Investor Phil Town

QUESTION OF THE WEEK: HOW IMPORTANT ARE THE FIRST 3M’S, REALLY?

This week’s Question of the Week comes to me from Brad and his dad in Dallas. In a nutshell, they want to know if they can postpone doing the Big 5 Numbers. Read on.

Phil,

My father and I are having a discussion, which by the way, is great that you turned us on to something that we can work together on.

Pop writes:

The success of the Rule #1 method in calculating the present intrinsic value (Sticker) of a stock depends entirely upon its ability to predict the stock’s future price per share. Really, only two numbers are needed to do that analytically: (1) future EPS growth and (2) future PE.

Evidently, Mr. Town doesn’t trust our ability to accurately predict future EPS growth (else why does he use the analysts’ prediction over his own if the analysts’ number is lower?) but he has great confidence in predicting future PE (else why does he typically ignore analysts’ future PE predictions?).

If he is correct, then it is because of the first three Ms. That is, if
he considers only those companies that have meaning, a sustainable
moat, and good management, he can confidently predict the future PE
based on a company having either a historically consistent PE or a
consistently strong equity growth. Then, by using the lower of these
two numbers to predict future PE, combined with a 50% MOS, he likely
will not lose money. Instead, it is likely he will earn at least a 15%
return for a long period of time.

Does that make sense? If so, we shouldn’t waste time calculating a
company’s Big Five numbers unless the company has successfully passed
the tests of the first three Ms. Maybe I should spend more time
screening companies using the first three Ms because I’ve not been
doing that very well so far.


Kid replies:

If I understand the meaning of Forward PE (which I believe
is what you consider the analysts PE estimate to be), it appears to me
that this represents a "short term" analyst forecast of PE (1 year). I
believe it is based more on recent performance (earnings) and factors
in short-term earnings estimates. It may be that Forward PE changes
quarterly?

I’m guessing that what we are needing to work with is a more long-term
prediction of PE and because one is not available via the analysts, we
work with longer historical measures which are:

  1. 5/10 year equity
    growth (actual),
  2. 5 year equity growth (analyst projection), and
  3. 5
    year average PE (actual).

I would suspect that Town would have us
factor in or consider a long-term analyst projection of PE if one were
available.

I agree that because we are so dependent on our own PE forecast that we
will have to really be on top of the first three Ms. I don’t think it
is realistic to spend an abundance of time (because frankly, I don’t
currently have that much time that I can devote to this) on the first 3
Ms unless an initial estimation of the sticker and the price of the
stock reflect a Rule #1 opportunity. If the numbers work out, we dive
in deeper to the 3 Ms. If they pass this test, we then go back and
re-evaluate/possibly adjust our PE estimate.

I think this is a critical question that we are looking at and I don’t
want to say I know the answer. It would be good to hear from the man
himself on this one.

Can you help us here?

Here’s what I told Brad and his dad:

First:  You can’t do the Moat "M" without doing the Big Five Numbers.


The Big Five, if consistent over time and rising, confirm that the
Moat you think the business has, it in fact has.
  From the consistent
Big Five we get a growth rate.  I’m just being conservative to use the
lower of the analysts rate or my own.  Maybe they know something I
don’t know.

The PE we use is either 2X the growth rate or historical — whichever is
lower.
This is definitely NOT a "forward PE". 

A forward PE is the PE
you get when you divide expected earnings for the next 12 months by
TODAY’s price. 

See if you can make sense of that little piece of sales
magic.  The whole point of forward PE is to make the number seem small
enough to suggest the stock is a steal.  Do NOT fall for that
nonsense. 

The PE we are using is the expect PE on the TTM EPS ten
years in the future.  It is not an artificially low PE created by
comparing apples and oranges.

Don’t take short cuts, guys.  You need to verify moat.  You need to
drive yourselves to dig into the SEC filings so that you know how the
business operates, so that it Means something to you.  And you need to
dig in on the CEO.  Is he our guy or a traitor? 

And from that you get
to a place of confidence where you can predict the future without any
problem… or you don’t.  Mostly you don’t.  You should be tossing
most businesses out the door.  You’re looking for 4 or 5 that really
mean something to you and that have confirmed Moat, Management and MOS.

Now go play!

Phil