Those of you who are using Investools Valuation Tool need to be aware that a calculator is only as good as the numbers you put in it. Garbage in, garbage out. I was curious about Greg's assessment of Dell, so I used the valuation tool and immediately saw what had his attention: Dell is priced at $29 but has a Sticker (or Target) Price of $64. Very attractive if you believe the numbers, so let's look at what's going into the calculation of value, since it's critical to knowing if we have the all-important Margin of Safety.

What follows applies to any valuation calculation we are going to do, whether you are doing this with the Rule of 72, Excel or Investools:

  1. The first number we want is the most current earnings per share. It's often called the TTM EPS: Trailing Twelve Months Earnings Per Share. Investools puts it at $1.37 on the valuation tool. On MSN Money, click on Company Report. It also says $1.37.
  2. The second number is the growth rate. Investools automatically takes the Zack's Average Analyst Estimate of 17%. At MSN I click on Earnings Estimates and then click Earnings Growth Rate, which also puts it at 17%.

    But we have to get our own number. The first reason we have to do our own thing is that analysts predict earnings on almost every business -- but many businesses are so up and down in their earnings that the prediction is just a wild guess.

    We need to do our own calculation so we can see if the raw numbers are consistent enough to base a prediction on. This is easy: just look at the last ten years of numbers and see if they pretty much go straight up. Like Dell's, for example.

    Also we need to listen to the guys who run the business to see what they have to say about their expected growth rate. So I just go to the website, Dell.com, and click on the Investors link and find the button for the latest report to the analysts.

    The new law requires that they make that available to me live (and if I missed it live, it's available on tape). Click on the link, follow the directions and listen to the analysts ask the CEO all the hard questions. Obviously these guys are going to ask stuff with all sorts of jargon. Don't worry about it. What you want to listen for is the prediction from the CEO of the growth rate of the business. His best guess.

    When you listen in on Dell's latest call, you'll hear the CEO say that he expects the business to grow at 11% per year. He says that he thinks that is a reasonable expectation for a $60 billion company. Well, if the CEO thinks the biz will grow at 11% and the analysts are projecting 17%, which number do you think you should use to figure out the Sticker Price? The lower guess or the higher guess? Hey, we're Rule #1 investors, not speculators. I don't know what you know about, but I'm a river guide. I know how to read a river a lot better than I can read where Dell's going. Personally, I'll take the CEO's word for it and go with 11%.

  3. The third number we want is the multiple of earnings that we'll use to predict the stock price. Almost no businesses sell for a price per share that is the same as the earnings per share, so you won't see a business with $1 of EPS selling for $1 per share. If you owned the whole thing and if this is a good business, you'd have to be a moron to sell it to someone for what you're going to get in earnings that year. So all good businesses sell for some multiple of earnings. This is called PE or Price / Earnings.

    The market decides the PE when it sets the price, right? We know the earnings are $1.37, so whatever the price is that minute tells you the PE. You just divide the current earnings per share into the price per share and you get the multiple. It turns out that the multiple is often about 2 times the expected earnings growth rate.That means that if Dell is expected to grow at 17%, the multiple would be around 34.

    The multiple on Dell today is actually 21. You can look at the history of the PE multiple on MSN by clicking on Financial Results, Key Ratios, Price Ratios. Dell ranges average about 35 over the last 5 years. The PE we'll use will be the lesser of this average OR twice the growth rate. 2 x the 11% growth rate = 22. 22 is lower than 35, so we'll use 22.

  4. And we need our minimum acceptable rate of return. For us that's a fixed 15%. Now we can do the calculation.
  5. Start with the $1.37 and grow it at 11% for ten years. The Rule of 72 says if you grow at 11% you double every 6.5 years. So that gives us about 1.3 doubles in ten years: $1.35 to $2.70 is one double... $2.70 plus a third is about $3.60. (I round off every chance I get to make the math easier for me.) So in ten years the EPS is $3.60.
  6. What's my multiple? My PE? 22. 3.60 (Future EPS) x 22 (PE) = $80 (Future Stock Price in 10 years) (rounded off). Okay -- so the stock is priced in ten years at $80 a share (we don't worry about stock splits).
  7. So what do I have to pay today in order to make 15%? One quarter of the ten year stock price (This is just the way it works out when you use 15% a year as your minimum acceptable rate of return -- because 15% doubles twice in ten: 1 to 2, 2 to 4.). So I divide $80 by 4 to get the Sticker Price: 80 / 4 = $20. So that's the Target Price you should get at Investools and my Sticker Price. In fact on Investools or by using Excel to do the same calculations, you get $21.
  8. We never pay Sticker. We tend to be sellers at Sticker unless this business can continue to grow at faster than 15% a year, and even then I get antsy -- because when you get above Sticker the big guys tend to dump stock rather suddenly, on just about any rumor of bad news.

    The three most important words in any sort of investing are "Margin of Safety". MOS. So divide Sticker by 2 and we get the MOS Price. In this case, $20 divided by two is $10. That's what we want to pay.

  9. Note that Dell is selling for $29. We want to buy it for $10. If you buy it for $29 and the CEO is right about the 11% growth, you will not make 15% a year. To make 15% you have to buy it for $21. If you pay $29 today and sell it in 2015 for $80 (because that's what its worth in 2015 if 11% is the growth rate) you will get an 11% return. That's below our minimum. Can't do it. That's anti-margin of safety.

So what if you love Dell? Love it. Know it. WANT it.

As a Rule #1 investor you have two choices:

  1. Be patient. It may come down enough to buy it (20% below Sticker puts it into the buy range if you really know the biz... so at about $17 you get a green light); or
  2. Do your own numbers, ignore what the CEO said (like the analysts are doing) and assume that the low growth rate is temporary and that growth will accelerate back to the norm of around 17%. In which case, this is a steal because that would put your Sticker back at $64. But you better really know the business to do that. (Remember, you'd be second-guessing the CEO.)

One way to test yourself is to ask this question: Do I KNOW that this business will be going strong in twenty years? If you can answer that about Dell then you can make your own predictions.

Personally, I have no idea if Dell or Microsoft or Google will be around in twenty years. That automatically puts them in my Risky Biz world and makes me very wary of the numbers. When the CEO of a Risky Biz starts saying stuff like 11% growth, I'm not going to feel good enough about this to contradict him or her. That makes Dell too expensive for me.

Now go play!

Phil

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