What is the right price to pay for a stock? I use Chipotle valuation examples to answer this question by explaining Charlie Munger’s Margin of Safety as discussed in Danielle Town and Phil Town’s Invested book August chapter.
Charlie’s 4th principle of Margin of Safety (MOS) is all about trying to figure out the value of a business and how much to pay for a wonderful a company at a reasonable price. This principle is in addition to making sure we’re capable of understanding the business, its management, and its moat.
The Invested book did a fabulous job of explaining MOS and giving us practical formulas to figure out how to value and price a business whose stock we may wish to purchase.
The best way to think of MOS is like your favorite things being on sale, like at 50% off the retail price. Wouldn’t you jump at that opportunity right away?
You may have heard of the term Discounted Cash Flow (DCF) Analysis and MOS is a simplified version of DCF. We used a company’s earnings as part of a simple set of equations to arrive at the MOS price.
We should treat MOS like we’re valuing a whole public company, or the “whole enchilada” if you catch my drift as I’ll be using Chipotle Mexican Grill for some valuation examples.
The MOS gives us a way to calculate what we would like to sell the company’s stock for in 10 years from now and using basic math we can come up with a price we want to pay for the stock today.
This requires 4 numbers of the company’s earnings per share, windage growth rate, windage price to earnings (PE), and what we would like to have as our Minimum Acceptable Rate of Return (MARR).
MOS gives you a “Sticker Price” for the current “Full Intrinsic Value” of the company right now.
We don’t want to pay the sticker price, however, but ideally buy the company at 50% off sticker price.
MOS is a valuation method while PayBack Time and 10 Cap/OE are pricing methods. They all give us stock buy prices.
A MOS or low buy price is built into PBT and 10 Cap because the PBT method prices a public company at 50% off, getting our money back in 8 years (as if it were a private company) while the 10 Cap requires a very high return.
MOS gives a conservative public company value while PBT is often the most accurate/useful since it measures the potential of the business to grow its Free Cash Flows but the buy price could be lower than the MOS buy price.
10 Cap (Owner Earnings) is a good deal because it doesn’t require the company to grow to be a successful investment.
I share 3 examples of a MOS price to pay for Chipotle in an optimistic valuation in 2021, what I estimated it to be in 2017 in retrospect, and a more realistic valuation in 2021 because I think the stock is still a bit overpriced. But none of this is advice, it is just my guesstimate.
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