Phil Town
Phil Town

Here's Allen's second submitted question.  Yesterday we talked about whether or not he should consider dumping his Disney shares.

Hey Phil Town,

I would like to know your thoughts on selecting a growth rate when the earnings growth, (and analysts estimate of earnings growth) vary widely from equity growth. (In Disney's case, the historical PE's tend to be much closer to 2* earnings growth than 2* equity growth).


Phil Town's response:

The key to buying a business is to know it's a wonderful business for sale at an attractive price.  We can know it is wonderful if we understand the MEANING of the business, if it has a big MOAT and if the MANAGER is awesome. 

The Big Five Numbers confirm for us that the business has the Moat we think it has (assuming we think it has one.)

If the Big Five are CONSISTENT both over time and from one to another (and if we have the other two M's) then we think we have a business that is wonderful.

Note how key it is that the numbers be consistent both over time and between each other. 

If sales are flat but earnings are growing, there is a problem coming. 

If sales are growing but earnings don't grow, watch out. 

If sales and earnings are growing but cash and equity don't, something is requiring that cash be spent instead of being added to equity or delivered to the shareholders as a dividend.We want all four growth numbers going up together.

Sometimes to illustrate this I plot a graph in Excel.  You can do it easily and it will show you in a heartbeat what you might not see in the numbers. 

I did one recently for a talk I did at Amazon.  Amazon had three numbers going up nicely but the fourth, equity growth, went nowhere.  And that tells us that Amazon is eating its own equity to provide for growth of sales, earnings and cash flow.  Which means that the real value of the business may not be growing.  Or at the very least, it would be really hard to tell if the investment they are making in the future of their business is going to pay off.

All that said, and then I looked at the equity numbers.  For an old line company like Disney, you have to be sure that you look at the Cash Flow page and see if they are paying out dividends to shareholders.  They often are, especially if they want to keep the fund managers who tell the little old ladies that as long as Disney is paying, things are good... which is a load of bs, but it keeps them holding the stock. 

You should realize that paying dividends does not always mean the business is great.  Sometimes, like with GM, it means that management is trying to fake you into thinking it's in good shape.

In Disney's case (and for cases like Disney) you can add up the last ten years of dividends and put that total number in with the most recent equity balance.

In Disney's case the number is about 3.5 billion, and added to the 26 billion in equity, you get 30 billion or so. 

Since 10 years ago the equity was 16 billion, it's almost doubled once in 9 years. 

So by the rule of 72 we divide the number of years to double once into 72 (72/9) and we get 6% as the compounded growth rate for equity. 

You can do that for each shorter span of years, but it's a pain.  And since it isn't quite 6%, we'll use 5.5% and see that there is still a large disparity between earnings growth and equity growth.

Certainly, if we wanted to project a 12% growth rate for the future, we'd want to see that at least the 3 year and 1 year equity growth matched or exceeded it.  Check that for me and let me know what you get. 

If it isn't pushing up toward 12%, then you will have to really get comfortable with Disney's turnaround to justify that 12% number. That's what Buffett can do, but he's a genius and I'm not.  I've tried predicting the future of a business when it is NOT based on the past and I've done pretty good a couple of times and gotten killed a couple of times.  It made me want to not continue with the venture capital stuff I was doing. 

So do your homework and let me know what you think.  The whole point of Rule #1 is for you to get comfortable with a few businesses so that you KNOW that you are going to make money if you can buy them on sale.  Is Disney one of those for you?

Now go play,

Phil Town