MOHNISH PABRAI 00:00
Then commandment five, "Thou shall never use Excel." So this actually kind of goes hand in hand with commandment four and even goes hand in hand with not having an investment team.
But basically if you can figure it out in your head, so the investment process is really quite simple, you know, if a company let's say has a market cap of a billion dollars and let's say it’s trading at 20 times earnings so its trailing earnings are 50 million for example, and let’s assume those are owner earnings that you can withdraw as dividends and such to keep it simple.
Well, the billion dollar market cap whether that is undervalued or overvalued or fairly valued, one can only make a judgment of that if one can figure out the cash flow that are coming out of the business over the next – I mean its from now to judgment day but you can approximate that to be now – between now in the next 10 or 20 years because after that it really doesn't matter, the terminal value become too small.
And so if this business is trading at 20 times earnings and if earnings are expected to grow at, let’s say, 10 or 15% a year then what you can do and if you have a very high degree of conviction that 10 or 15% rate of earnings growth is sustainable for a very long period of time maybe 15 or 20 years.
Then you can actually, you know, run the math you can say, okay, year one the earnings are 50 million, year two the earnings are 60 million, year three the earnings are, you know, I mean if you’re growing at 20%.
But if you are growing at 10%; 50, 55, 60.5, you know, 66 and change and just keep going from there. And then you have to discount each of those by your expected rate of return, you know, so for example if I want a 20% rate of return on this investment, I have to start discounting those future cash flow at that 20% rate and then I have to – because if I'm getting 55 million a year from now, my cost of capital is 20 million so that 55 million is really worth like 44 million because I'm not getting it today.
And so as I discount all those future cash flows and run those numbers, it would be very hard to get to 1 billion because, you know, the earnings are growing at 10% but your expectation is 20% so it will be a kind of a declining future stream every year will be less than 50 million in effect and in present value and so the math just doesn't work.
Now if you reduce your return expectations to something like 8%, it may work, if you said, I only want a 7 or 8% return that may work.
But even then there are some heroic assumptions and we already saw what Templeton said that you’re gonna be wrong one third of the time, and capitalism are brutal so unless this is a fast growing funeral services operation, it's not going to be there clocking 20% or 10% a year for 15 years because it's just difficult in business to have that much of a runaway without people coming in to take you motorway.
And so the thing is that how do we get around that?
Well, the way we get around that is making the math really simple. And the way we make the math really simple is we go back P/E of 1 and when we go back to P/E of 1 all the math become really easy because then if I want to make like 25% a year, well, I get my money back in 2 or 3 years and I still have the business, it's still producing cash and you’ll find that it’ll deliver that return and it might deliver that return at P/E of 2 as well or 3 as well.
And but once you start getting to high single digits or double digits, generally speaking, the math doesn't work so well, it’s a lot harder to make it work. And I think like, for example, if we were to look at, I mean I think like a simple cases if we look at a business like Apple.
So let’s take a simple case that Apple is worth exactly a trillion dollars – I haven't been tracking it, I think it's a little bit above that – but let’s say its exactly a trillion dollars and let’s say I want a, you know, I'm an unreasonable guy and I want a like 25% annual return on my capital for example.
You know, Arvind knows my license plate says compound 26 so if I want a 25 or 26% return on my money, the first year that business has to produce 260 billion in owner earnings. And I don't think that is what Apple is producing right now, I'm not quite sure but maybe someone in the class knows? Or maybe you can look it up Arvind?
Arvind what is the trailing P/E of Apple approximately, is it like 10 times or something?
ARVIND NAVARATNAM 06:30
I think it is higher than that, but I can get it for you.
MOHNISH PABRAI 06:34
Yeah, so but let’s be generous, let's say it's trading at 10 times earnings, let's say that – what it’s saying is that Apple is making 100 billion a year. Okay, so I need 260 billion for my 26%-25%, it's making let's say a 100 billion.
And then a year from now, let's say it's 115 billion, let's say I give it that, you know, they've got a rocking market position earnings grows by 15% equals to 115 billion and let’s say for the next 10 years it's compounding at 15% even with a 100 billion in earnings compounding at 15% for 10 years which means that in the 10th year it will be 400 billion because in 5 years it will double to 200 billion and 10 years it will double again to 400 billion.
That 10th year 400 billion is not worth 260 billion today because you know when I discount that at the 26% rate I have to – it will go down below 100 because it’s just, you know, needs to be doubling every 3 years and such.
So anyway the bottom line is that if your return expectations are something like 7% a year and Apple is growing is at, you know, 6-7% a year or something, it may work. So one of the things that you can do with just playing with these 2-3 numbers which is market cap, current earnings and what you expect earnings to grow at.
And of course, you know, I think a lot of people would have difficulty getting to assumption that Apple will grow 15% a year bottom line for 10 or 15 years without any hiccups. That may happen, it’s a very dominant company in dominant position but we’ve seen a lot of past dominant companies have problems in these areas.
So the thing is that when I look at something like Apple, it doesn't even take a femtosecond to take a pass. And now if we had Apple at like something like 3 times earnings you know, like trillion dollar market cap making 350 billion a year, growing at whatever you know, 15% or something. Even someone like me might get interested, you know.
So the thing is that P/E of 3 on Apple might then get me excited and a P/E of 10 not quite as exciting. And so –
ARVIND NAVARATNAM 09:35
Mohnish, my computer is saying that (Apple) P/E is closer to 20 times so you going to be a lot less excited.
MOHNISH PABRAI 09:42
Ouch man, that’s so hard. (Laughter)
And so you know the thing is that, you know, so if you run the same math starting at 50 billion which is where trailing earnings are, and even if you take heroic assumptions of 20% growth unabated, I still can't get to the promised land. You know, as you know with the commandments I've been to the promised land but I can't get to the promised land with it.
So that was the 5th commandment, "Thou shall never use Excel."
And as you saw with all the math we did, you know, we didn't even need a calculator. Forget Excel, we just did it in our hands, so there is no need for Excel and if you find yourself reaching for Excel what that means is you take a pass. It's an automatic pass the moment you feel, "oh, I need Excel to figure this out."
If you need Excel it means you need to take a pass, if you can't do the math on the fingers in one hand, you need to take a pass. If you're going to 2 hands if there’s a problem, you need to be doing the math with 1 hand and no calculator and watch between your ears, that's it.
Like I said, these are all things that Arvind will never talk to you about it, it's only me and you that can talk about such things. (Laughter)
5th Commandment of Investment Management: "Thou shall never use Excel."
Invest in companies that are simple and obvious. If the math gets too hard, it is a pass (skip) to put your money in because this shows that you do not understand the company enough to do the math, so continue to study and learn about the business.