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.
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.
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.
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!