Heads I Win Big; Tails, I Don’t Lose Much

October 12, 2007 by Joe Ponzio

One of Mohnish Pabrai’s favorite quotes goes something like this: Heads I win; tails, I break even or don’t lose much. When it comes to investing in the stock market, that seems like an ideal to strive for.

Let’s examine some worst case scenarios in owning pieces of businesses.

The Strategy

When it comes to owning stocks, we have to realize that we own pieces of real businesses. I won’t harp on that because I do so in many other posts. In addition, we need to buy those businesses when they are on sale. Again, fundamental to investing. So, let’s see how that “on sale” factor protects us-the Margin Of Safety (MOS).

Your Discount Rate Determines Your Rate Of Return

When you discount cash flows, you are setting a buy price based on your expected return-your discount rate. You can set it high-say, 15%-as a minimum acceptable return. Or, you can set it lower-say, 9%-to compare the attractiveness of said investment versus alternatives (like corporate bonds) and your minimum acceptable return.

For this post, we’ll keep the discount rate at 9% so we compare apples to apples.

Wal-Mart: If Growth Slows

Poor R.J. has been asking me for a Wal-Mart worst case scenario for weeks. Let’s start there.

Wal-Mart has an intrinsic value of roughly $376 billion-assuming a 9% discount rate and 23.9% growth in owner earnings, half the rate it has grown over the past ten years. At $45.81, Wal-Mart seems to be at a 50% MOS. Of course, that’s assuming it is business as usual for the next decade or two.

If Wal-Mart slows down, we would have overpaid for value that never materialized. Let’s back through the math. First, at $45.81 a share times some 4 billion shares, Wal-Mart has a market cap of roughly $188 billion. Take out the shareholder equity, and you have about $127 billion in future cash.

So, assuming a 9% growth on our investment, at what rate would Wal-Mart have to grow owner earnings to justify a $45.81 purchase price. That is, what is the minimum growth rate it can achieve so that we would have paid a “fair” price rather than a MOS price? Answer: 9.8% for ten years, followed by 5% for the next ten.

Below 9.8% growth in owner earnings, we would be overpaying for Wal-Mart at today’s prices. At 9.8% and above, we could reasonably expect a 9% or greater return over the years.

Now, The Art Of Business Valuation

This is where you show your skills as a prognosticator. Can Wal-Mart grow faster than 9.8%? It has about ten percent market share, it blowing up internationally, and will boom no matter which way the economy goes. If our economy grows, Wal-Mart will expand stores. If it falls on hard times, more people will have less money and find themselves shopping at Wal-Mart.

I have confidence in Wal-Mart. If you don’t, stay away. There’s plenty of other opportunities.

If Wal-Mart Finds Itself In A Hand Basket

What if everything goes to hell in a hand basket? Manfred posted a no-growth scenario. What if Wal-Mart can’t grow any more and generates just $6.5 billion a year in owner earnings for the next twenty years?

Making Money When Your Company Isn’t

Again, we can make money but we have to buy at a discount or, at the most, pay a fair price. Before I dive into the numbers, consider the returns that can be generated on an investment in a CD paying 5% for two years.

If you invested $10,000 into that CD, you could expect $500 a year for two years, and then the return of your $10,000 at the end of those two years. Depending on your purchase price, you could earn much more than 5%. For example, if you were able to buy that income stream for just $8,601, you’d earn 9%. If you set your discount rate to 15%, you would pay just $7,388 and earn 15% once you collected the two $500 payments and the $10,000 at the end.

The Wal-Mart CD

So, assuming Wal-Mart didn’t grow at all for the next twenty years… First, let me make an assumption that Manfred did not: I’m going to assume that Wal-Mart can increase prices enough to cover the increases in its capital expenditures so that, twenty years from now, it is still generating $6.5 billion a year in owner earnings (as opposed to ever decreasing owner earnings). That is the value of a moat, and Wal-Mart has a pretty strong one.

If Wal-Mart never grew owner earnings, a “fair” price today would be $29.48-and you could reasonably expect a 9% average annual return over time.

In The End

What’s the worst case scenario? Obviously, Wal-Mart can close up shop, give you roughly $15 a share, and tell you to beat it. Or, it can never grow again, and you’ll lose money. Or, it can grow slowly and you’ll make a bit of coin. Or, it will grow at a nice clip, and you’ll make a killing.

Figure out which scenario is most likely, and bet (or run) accordingly.

A Note From Joe Ponzio

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