Do The Math In Your Head

August 30, 2007 by Joe Ponzio

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.

A Note From Joe Ponzio

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