Rule #1 Finance Blog

With Investor Phil Town

THE WHYS BEHIND THE BUY

Phil Town

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Here’s an email from John, who’s been reading the site and teaching himself how to use the Excel spreadsheets to figure out whether a company is at the right price.  He still had a few questions. With his permission I’m posting his spreadsheet set up and his questions for the rest of you to reference.

To: Phil

From: John

Date: July 14, 2005

Please look at the attached file and let me know what you think.

Sticker Price and MOS Calculation
# of years 10
Growth Rate 22.0% Lower of   Historical or  Zach’s
EPS $       2.32
Actual Price $     90.00 Looks Great!!!, Check the YUMMMMY before Buying
Est Future PE              44 Looks Great – under 50!!
Future EPS $16.95
Value Per Share $745.66
Sticker Price $184.31
MOS $92.16

I think I’ve got the technicals now.  The yellow shaded cells are input and I’ve added some comment if statements to help see the results more clearly. I have a few questions though for understanding why.

1) Is the Estimated future PE really twice the Growth rate used?  Why?
2) Why do you use 10 years and not more or less time?
3) Why do you use 15% minimum and not more or less?

These questions are for me to understand the whys of what is being done here, so that I can make a more educated "buy" decision.  Any help you can provide is appreciated.  BTW — I really was affected by your Boston appearance.  It opened my eyes to some opportunities I have available to me.  Thanks man!!

John did a really nice job on this analysis but has some questions:
1) Is the Estimated future PE really twice the Growth rate used?  Why?

First, Estimated Future PE is the LOWER of twice the growth rate used OR the historical PE.  In some industries there can be a huge difference.  As far as why 2x the growth rate is a reasonable PE its because that is what lots of businesses get priced at so we can expect it sometime in the future.
2) Why do you use 10 years and not more or less time?
If you can’t feel good about a business’s prospects ten years out, either you don’t understand the business or you do and its prospects aren’t good.  Bad sign for a business that is supposed to have a big moat, right?  Ten years projection focuses us on the need for a real moat and a long term business.  Why buy stuff that could disappear when there are so many great businesses that won’t.
3) Why do you use 15% minimum and not more or less?
I use 15% because that is a good and achievable rate of return that makes it worth investing and builds in another margin of safety.  I could raise the number, but if I did, the Margin of Safety will be so big that even good deals won’t look good.  And if I drop it, the margin of safety is so low that lots of bad deal will slip through and I’ll get burned.  Its the voice of 80 years of experience saying, ‘this is just about right’.