Understanding Sticker Price and How to Determine it for Rule #1 Investing
Another essential lesson in Rule #1 investing is understanding the concept of Sticker Price and how to calculate it to make informed investment decisions. In this guide, we'll delve into the details of Sticker Price, its significance, and how you can use it to your advantage when assessing potential investments.
What is Sticker Price?
At the heart of Rule #1 investing lies the concept of the Sticker Price. This is the fair value of a business, neither overpriced nor underpriced, that the market should ideally be selling it for. Different names are used in the financial world for this concept, such as "intrinsic value" or simply "value," but for the purpose of this guide, we'll refer to it as the Sticker Price.
The crucial point to grasp about the Sticker Price is that getting it right is essential. In Rule #1 investing, you treat stocks as businesses rather than mere pieces of paper, considering all the factors that contribute to a business's value. A business is more than its tangible assets – it includes the money it's expected to generate for its owners in the future. This value is influenced by various factors, and the Sticker Price aims to quantify it accurately.
Determining Sticker Price: The Essentials
Calculating the Sticker Price involves several steps and requires specific data. Let's walk through the key elements of this process:
1. Current EPS (Earnings Per Share)
The starting point is the current EPS, which is readily available on financial websites. It represents a company's earnings divided by its outstanding shares. The value of the current EPS serves as a foundation for estimating future earnings.
2. Estimated EPS Growth Rate
Estimating the future EPS growth rate requires examining historical growth rates, particularly the growth rate of Equity. This is crucial because a business's growth of surplus cash, reflected in Equity growth, contributes significantly to its value. Comparing the historical Equity growth rate with the estimated EPS growth rate will help decide which one to use for calculations.
3. Estimated Future PE (Price/Earnings Ratio)
The future PE ratio determines how much investors are willing to pay for a company's future earnings. This ratio can vary significantly based on growth expectations. A reasonable rule of thumb is to double the estimated EPS growth rate to determine a rough estimate of the future PE.
4. Minimum Acceptable Rate of Return
A critical factor in Rule #1 investing is the minimum acceptable rate of return, typically set at 15 percent per year. This rate accounts for inflation, taxation, and the risks associated with investing. It serves as a benchmark for evaluating the attractiveness of potential investments.
Putting It All Together: Calculating Sticker Price
With the four essential pieces of information – Current EPS, Estimated EPS Growth Rate, Estimated Future PE, and Minimum Acceptable Rate of Return – you can calculate the Sticker Price. Here's a simplified version of the calculation process:
Calculate Future EPS: Grow the Current EPS by the Estimated EPS Growth Rate over 10 years to determine the Future EPS.
Calculate Future Market Price: Multiply the Future EPS by the Estimated Future PE to determine the Future Market Price of the business in 10 years.
Determine Sticker Price: Subtract the Minimum Acceptable Rate of Return per year from the Future Market Price to obtain the Sticker Price.
Why Sticker Price Matters
Understanding and calculating the Sticker Price is crucial for successful Rule #1 investing. It helps you assess the attractiveness of a potential investment by determining its intrinsic value and the potential return it offers. By comparing the calculated Sticker Price to the current market price, you can make informed decisions about whether a business is undervalued or overvalued.
Conclusion
In the world of Rule #1 investing, the Sticker Price is a cornerstone concept that empowers you to evaluate potential investments accurately. By combining the current EPS, estimated growth rates, PE ratios, and your minimum acceptable rate of return, you can determine the fair value of a business. Armed with this knowledge, you'll be better equipped to make smart investment choices and embark on your journey toward financial success. Remember, in Rule #1 investing, understanding Sticker Price is a key step toward achieving your investment goals.
