Perhaps you’ve noticed that I switch between discount rates. Maybe you’ve seen me throw the past out the window and use future owner earnings assumptions that differ from past median growth rates. Or, you may have noticed that I’ll use 8-year timeframes on some companies and 15 year timeframes on others.
I think it is human nature to seek out the perfect spreadsheet or formula to predict the future of the markets. It doesn’t exist, so it is best to understand various methods and assumptions so you can draw your own rational conclusions based on reasoning and data.
In this Wall Street Journal article, Buffett explained that he did not need exact numbers for most investing decisions.
“I deplore false precision in math”
He went on to say that he does most of the calculations in his head. Is this possible for the average investor?
It’s Always The Same Formula
If your assumptions remain the same, you can quickly determine the value of a business using some simple math. For example: You expect owner earnings to grow at 14% for years 1-3. In years 4, 5, and 6, you expect that your company will grow at 12.6% (10% slower). In years 7-10, you expect growth to slow another 10% to 11.3%. After that, you expect growth to hold at 5% for years 11-20. Finally, you want to use a 9% discount rate.
Though the above calculation reads difficult, the math is simple. You simply need to find a multiplier that sums up that calculation. That is, what number could you multiply owner earnings with to get the value? Answer: 23.5.
Multiplier Vs. Precise Math
Using the above assumptions, let’s look at XYZ company that has $100 of owner earnings this year. If we plug all the above assumptions into a spreadsheet and project, and then discount, the next twenty years of owner earnings, we’ll end up with today’s value of $2,349.04.
If we use the multiplier: 23.5 x $100 = $2,350.
I like to break things down into simple examples, but this works for all businesses and all numbers. Calculate value for a company with $8,453 million in owner earnings, and you’ll get $198,546.60 Mil on the spreadsheet and $198,654.50 Mil with the multiplier. The difference? $80 Mil, or 0.04%.
Precision In Predicting The Future
Don’t get hung up on using exact figures. You’re predicting the future. No matter how good your spreadsheet is, no matter how many decimal places you use, you’re still relying on assumptions.
If your company has to perform a certain way in order for you to be right, you probably shouldn’t own it. Are you buying companies that have to grow at 10% (or 12% or 83%) or more to justify your purchase price?
A Quick Reference Guide
Below you’ll find some multipliers I use on a daily basis, using the above assumptions. It makes the math quick and painless and requires little more than a quick brain or a $2 calculator:
10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Multiplier 18.3 19.4 20.7 22.0 23.5 25.0 26.6 28.3 30.2 32.1 34.2
Just remember to add in shareholder equity when you’re done!
And On A Personal Note
Yep-I’m going out of town again. This time I’ll be heading to northern Minnesota to fish one of the fishless lakes. Other people say they catch stuff on Lake Winnibigoshish, but I don’t believe it. At any rate, I’ll have very limited access to e-mail and won’t be posting or responding to comments until I get back after September 10 (though I may surprise you if the weather stinks).
And as always: No, I won’t be watching the stock markets! I have a sneaking suspicion that all the people at Johnson & Johnson will still be working their tails off for me while I sit on a pontoon and drink red wine (maybe that’s why I don’t catch anything). Now that’s not a bad way to make money.
Filed under: How to Value a Business
Joe,
Awesome post. This is exactly the kind of information that has been missing in my daily readings. I think the obvious question now is, how can I figure out the multipliers myself when looking at different returns during different time periods? I don’t really see how you’re doing it just by looking at the figures. It would be wonderful to be able to construct my own table of multipliers to commit to memory. Is there a tutorial somewhere??
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Joe,
Awesome post. This is exactly the kind of information that has been missing in my daily readings. I think the obvious question now is, how can I figure out the multipliers myself when looking at different returns during different time periods? I don’t really see how you’re doing it just by looking at the figures. It would be wonderful to be able to construct my own table of multipliers to commit to memory. Is there a tutorial somewhere??
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MikeR: Believe me, I’ll miss it too. I’m having a heck of a lot of fun here. I’m outta here.
Hey Nick,
Great idea and I appologize for not explaining that. Take a look at the top right of the navigation, just under the “Subscribe” link, and you’ll see I just posted a spreadsheet based on your recommendation.
Hope that helps!
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Hi Joe -
Over the last couple of days, I reviewed all the posts on your blog. Great information and thanks for sharing it with us.
One of my challenges has been creating screens to filter stocks. What items would you consider for this? I can understand basic things like industry, size of company etc but what about other tech and non-tech indicators?
I would really appreciate it if you could post and share your comments and ideas on this topic.
Hope you had a good vacation.
Cheers.
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Hi Hemel,
I don’t use any technical (charting) indicators. Unfortunately, most stock screeners limit you to Wall Street ratios and conventions (P/E, EPS, etc), so we are stuck with the tools we’re given.
I look for companies in a number of ways – this is a perfect topic for a post as it would be a long-winded comment. I’ll put something up this week.
Hope all is well and thanks for stopping by!
Joe
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In the example below…..I do not understand how you got 23.5 and…where in a company’s stock information do I find owner earnings? Additionally, why and wheere did you get this 9% discount, and why and where do I find the share holder equity number and what do I add it to?
I just didn’t get it….help!
If your assumptions remain the same, you can quickly determine the value of a business using some simple math. For example: You expect owner earnings to grow at 14% for years 1-3. In years 4, 5, and 6, you expect that your company will grow at 12.6% (10% slower). In years 7-10, you expect growth to slow another 10% to 11.3%. After that, you expect growth to hold at 5% for years 11-20. Finally, you want to use a 9% discount rate.
Though the above calculation reads difficult, the math is simple. You simply need to find a multiplier that sums up that calculation. That is, what number could you multiply owner earnings with to get the value? Answer: 23.5.
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You can download the spreadsheet and look at it. In Excel, it is the NPV formula. To actually do the full formula in your head is quite difficult, but you can check out the math here.
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Hello Joe,
In an attempt to check for example Apple’s value I took last quarters EBIDTA 5.56 billion and multiplied by 23.5 the value of the shares
when based on this method came out to $149.99, which would mean that apple trading at $161.04 Friday’s close is currently to high based on the expectations of the 23.5 formula growth parameters. Did I do that correctly? anyone of the board can answer that and I would appreciate it.
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Michael: Take a look at the posts filed under Valuing a Business. There are a million and one ways to make money in stocks; there are only a handful of rational ways to value a business. Hope that helps!
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Here’s an interesting article about how Buffett might quickly calculate the value of future cash flow (it’s exactly the same principle as Joe described in this post):
At first glance, it seems a little simplistic to use a single earnings multiplier like that, but think of it this way: future earnings are pretty darn uncertain even for the best of companies, so the biggest factor in your estimate is not going to be your multiplier but rather how confident you are in the company’s continued profitability. So I think it makes sense not to sweat about the exact multiplier, since there’s a snowball’s chance in hell you’ll be exactly right, and instead use it as a rough guide.
(note: I don’t think I agree entirely with the article I linked– I’d assume Buffett uses owner earnings, for instance– but I think it has the right idea.)
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Hey I live in Minnesota while your here you could visit me! I know it sounds blunt, but I just picked up your book and read the entire thing while laying by the pool today. I wish I could just reach through the book to give you a super duper kiss right now for opening my eyes to the reality of mutual funds, how I got suckered in three years ago and its not too late to start over. what youve written makes sense!! thanks so much. And if you can come over for a visit. would love to talk more. leslie in plymouth Minnesota.
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Joe,
I hope you have a great time fishing even though I will go through withdrawal without your daily blog postings!
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