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No. of Recommendations: 6
Hello,

I recently became familiar with the BMW method and find it quite interesting. For some time now, I've been investing based on the Rule#1 method as explained in the following book by author Phil Town:

http://www.amazon.com/Rule-Strategy-Successful-Investing-Minutes/dp/0307336131/ref=pd_bbs_2/104-1836039-4850312?ie=UTF8&s=books&qid=1184994615&sr=8-2

I'm posting this message to encourage some discussion to contrast the two approaches. First, I'll briefly introduce the Rule#1 method for people who may not be familiar with it.

With Rule#1, you evaluate the fundamentals of a company using what are
called the Big 5 numbers: ROIC, Equity Growth, EPS growth, Sales growth,
and Free cash flow growth. You look at data for the last 10 years and a company is considered suitable to be considered further only if all these numbers are at least 10% historically.

Once a company passes the above criteria, a sticker price (or intrinsic value) for the company's stock price is computed as follows:
Sticker price = EPS * (1 + Estimated-EPS-Growth)^10 * (Estimated-Future-PE) / (1 + 0.15)^10

where:
Estimated-EPS-Growth = min(historical equity growth, analyst expected future growth)
Estimated-Future-PE = min(historical avg PE, 2 * Estimated-EPS-Growth)

In other words, Rule#1 analysis takes the current EPS, and estimates
an EPS 10 years from today by growing the current EPS by an estimated growth rate. It multiplies that value by the expected future PE to obtain the stock price 10 years from now. It then discounts this resulting stock price by 15% to arrive at the present value. Said another way, if one were to buy the stock at its sticker price, Rule#1 estimates a 15% annualized return for the next 10 years from that stock.

Once a sticker price for the company is known, Rule#1 suggests applying
a margin of safety to it. That is, divide the sticker price by a factor
of 2. If the present stock price is less than the resulting value, you can buy the stock. This gives further protection in case any of the estimations we did turn out to be incorrect.

Now for a comparison between Rule #1 and BMW method. I think a stock
would qualify under both methods if the stock has been performing
consistently and is underpriced. However, lets take SBUX as an example.
The historical equity growth in the last 10 years for SBUX has consistently been slowing down. The annualized equity growth for the last 10 years for SBUX is 15% while for the last 5 years its just 10%.
However, the avg CAGR for SBUX is around 23%. Now Rule#1 says that future growth of the stock would more closely follow the historical equity growth not the avg CAGR for the stock. If this is true, SBUX stock price shouldn't catch up to its avg CAGR line unless the equity growth also improves.

I'd be real interested in hearing what people experienced with the
BMW method of investing have to say.


- Mohit
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No. of Recommendations: 1
Phil Town claims to have turned $1,000 into $1,000,000 in five years in the early 1980s. That's a CAGR of 297%. From August 1982 to August 1987 the Dow had a terrific bull run but it only managed to have a CAGR of 28%.

By 1992 Phil Town should have $1,000,000,000

By 1997 Phil Town should surpass Buffett at $1,000,000,000,000

In the early ‘80s, Town’s life changed radically. He was guiding trustees from the educational program Outward Bound down the nastiest rapid on the Grand Canyon’s Colorado River, when his split-second decisions saved a boatload of people from a whitewater disaster. A grateful and financially astute client returned the favor by guiding Town into serious, successful investing using the first rule of investing as ascribed to by Warren Buffett: Don’t lose money. Within five years, Town had built a borrowed $1,000 into $1 million. His fortunes improved radically, and rapidly, from then on.

http://www.ruleoneinvestor.com/about.htm

Denny (skeptical) Schlesinger
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No. of Recommendations: 8
I once read a very curious science fiction novel. Some extraterrestrials were inspecting our cities. In their report they said that they found some very interesting features but that these structures were, unfortunately, invaded by some sort of parasites. it's all a matter of your perspective, of your point of view.

Accounting was invented in Italy about 600 years ago so that the merchants could keep track of their business. Nothing really useful has been added to accounting in the last few hundred years. But since they invented income tax, accounting has been going downhill.

As I said above, accounting was invented so that merchants could keep track of their business. If you are doing the accounting for your own benefit, it makes perfect sense that you should do it as exactly as possible. But once governments use your accounting to take your money away from you, there is a very strong tendency to start cooking the books. You can play all sorts of perfectly legal games such as increasing or decreasing the time you take to depreciate assets. Also, there is no need to revalue a lot of a company's assets such as land. In the current case of highly illiquid debt instruments, you can use any kind of formula to state their value (until an auction happens).

Over the past two years, at the urging of luminaries such a Warren Buffett, they really screwed up accounting by "expensing" stock options. Changes in the capital structure of a business have nothing to do with its earnings. If I cut up a loaf of bread into 20 slices and give you a slice, I have only 19 slices left and you now have one. But the value of the 20 slices of bread (the company) has not changed, it's still 20 slices of bread. It is my job as an owner to keep track of how many shares exist but artificially changing the value of the slices, I mean shares, because the owners decided to give away a few of them, makes no sense at all.

In other words, all the numeric due diligence based on a company's accounting is, mostly, a waste of time. The data is mostly garbage mandated by law. That is why you hear experts saying that you should follow the money, i.e., the cash flow, which is much harder to "massage."

But I have good news for you! You know with a lot more certainty at what price the shares of your company sold for today. The FASB can't screw around with that number, the IRS can't screw around with that number. It's a number arrived at by public auction. Somebody actually put his money where his mouth is and paid that money for that share.

What is one to do? I think Peter Lynch had the right idea: go shopping, sleep in the beds, eat the food, count the discarded cigarette packs in the gutter... No, that was not Peter Lynch, That's our very own BuildMWell! :-))

Once you understand the basics of the business, you can look at the accounting, taking into account which numbers are hard to massage: Revenues, cash in the bank, debt. Every other number can be massaged since a lot of them depend on "fair value" estimates (how much to reserve for bad debts?). If on top of that you trust non-GAAP, well...

Knowing how unreliable accounting is, why not use some other system that depends on more reliable numbers?

Denny Schlesinger
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No. of Recommendations: 1
One thing that I've realized about the BMW method is it works because of all of the different valuation strategies people use. It works because there are enough people who are constantly evaluating the stock based on its potentials, and valuing it accordingly. They might get it wrong sometimes, but over the long haul they get it right. As long as all valuation methods can come to an agreement on a consistent valuation for a company, the BMW method works.

Now that is interesting.

-Tim
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No. of Recommendations: 1
<<<In other words, all the numeric due diligence based on a company's accounting is, mostly, a waste of time. The data is mostly garbage mandated by law>>>

Another way of saying this is "GAAP is crap". I forget who first said this, but a long time ago he wrote a number of books with this as their main theme.
Norm
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No. of Recommendations: 2
The method described is similiar to a method that was presented in a MF seminar several years ago. I'm speaking from memory. I haven't looked it up, but one of the lessons of this seminar was on stock evaluation.

It basically involved taking earning and predicted earnings growth and projecting this for a number of years. A P/E multiple was assumned based on the estimated S&P multiple. The product was the future fair value of the stock which was then discounted by the desired return.

This method was certainly appreciated by me. At that time, I had no idea how to arrive at a reasonable stock price. Maybe, I still don't.

To quote the King of Siam, " It's a puzzlement." The puzzlement to me, is the asumption of a P/E multiple at the end of the time frame.

Could I ask the source of your historical P/E multiples? Do you have a subscription to ValueLine or do you go to the library and get the information from ValueLine? Or do you use some other source?

I thought this was an interesting post, regardless of the success of the book's author.

Delwin
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No. of Recommendations: 4
"However, lets take SBUX as an example. The historical equity growth in the last 10 years for SBUX has consistently been slowing down. The annualized equity growth for the last 10 years for SBUX is 15% while for the last 5 years its just 10%. However, the avg CAGR for SBUX is around 23%. Now Rule #1 says that future growth of the stock would more closely follow the historical equity growth not the avg CAGR for the stock. If this is true, SBUX stock price shouldn't catch up to its avg CAGR line unless the equity growth also improves." - mohitaron

This is a great point and it shows the difference between a typical BMW stock and a new high growth company stock.

Starbucks is a relatively new high growth company that is maturing into a solid lower growth, profitable corporation. It is hard to lose money selling flavored water for $3/cup. The business is still expanding but it is not going to be able to continue it's old patterns. Thus, the above observations make complete sense to me.

The analysis using the BMW Method needs to take this into consideration because the future for a SBUX has to be more volatile than for a more stable business like 3M. The BMW Method worked for us to perfection with MMM because it has a very predictable earnings growth and the CAGR is also well defined. Any price decline shows up very quickly and demands a correction to the average CAGR or even above since the trend is toward over-compensation on the rebound.

I hope this answers the question.
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No. of Recommendations: 5
"One thing that I've realized about the BMW method is it works because of all of the different valuation strategies people use. It works because there are enough people who are constantly evaluating the stock based on its potentials, and valuing it accordingly. They might get it wrong sometimes, but over the long haul they get it right. As long as all valuation methods can come to an agreement on a consistent valuation for a company, the BMW method works." - jlyer

BINGO! That is why the BMW Method has to work...it cannot fail to work because it relies on millions of very intelligent people doing the right thing over the long haul. Why reinvent the wheel when so many are already working on it?

Now, in the short-term, people can be railroaded into doing the wrong things for many wrong reasons. I am reminded of the huge drop last year in 3M's share price due to the stories about the World Cup and the lower than expected Big Screen TV sales. That made no sense to me, but it did to millions of investors who did not take the time to actually think for themselves. Instead, they took the easy way out and just sold their 3M shares. Of course the price had to drop. But, the old exponential growth curve was there to bring reality back into perspective. We have picked up over a 40% gain today because we chose to THINK for ourselves.

What led me to the BMW Method was exactly what jlyer posted. I realized that there were thousands of people doing their dedicated due diligence every day to determine the value of every business. However, there are also a larger number of people who do absolutely no due diligence and are in the market just to make some money. Those people can be manipulated by any good story. They will buy or sell on any reasonable tip. This is what creates short term volatility.

So, if we merely watch for the anomalies, we can spot the right times to buy and sell. The BMW Method looks at a particular stock or at a whole market and determines when the manipulation has gotten out of control. Our charts are of companies or indices, but we are really graphing the irrationality of the uninformed "investor". Actually, we are graphing the interface between the "Real Investors" and the "Speculators." By seeing the markets in this perspective, we move from one side of the phenominon to the other. We can only become investors by understandng the inherent weakness of the speculator. Before we can properly understand this, we all must be speculators ourselves. The BMW Method is a painful experience because we must admit to our own stupidity before we can take the leap from "speculator" into the rhelm a "real investor."

What better way to understand this than by graphing this phenominon over time? We are applying good engineering to the stock markets and really understanding what makes it tick. I never understood this until I sat down and really pondered the problem for several weeks. It took me that long because I kept refusing to admit what a dolt I had been in reality. Once I saw it, the real problem was finding a way to teach it to others. The BMW Method is the teaching method that I decided upon. I Call this the University of Hard Knocks and you are presently sitting in my BMW-205 class.

BRINNNNNGGGG. My how time flies! There's the bell. OK, study your lessons and I will see you folks tomorrow.
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"Another way of saying this is "GAAP is crap". I forget who first said this, but a long time ago he wrote a number of books with this as their main theme." - Norm

That is not true. GAAP may not be as accurate as it might be, but the accountants mostly still present reasonably accurate figures. Due diligence is about sorting through the data to determine what you choose to believe.

As Denny said, "In other words, all the numeric due diligence based on a company's accounting is, mostly, a waste of time. The data is mostly garbage mandated by law."

That is true unless you can figure out how to properly interpret all that data and figure out if there is fraud involved.

The nice thing about the BMW Method is it ignores all of this and cuts to the chase. It assumes that the market is able to sort through all of the bull and that, in the long run, the values of companies will be determined correctly.

One major factor is out of the control of all business and all accountants. That is the underlying competition for the investor's dollar from other investment types. Those affect the multiple that an investor will offer for equities. Thus, a stock, or an entire market can drop in price even as the underlying earnings are soaring. Heck, look at 1965 to 1982. Business was moving ahead while the bond interest rate went to over 15%. How could stocks compete in that environment? And, of course, they did not.

Anyway, the BMW Method is my way of dealing with all of these hugely complex issues. I like to keep it simple because it really is in reality.
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No. of Recommendations: 0
> Could I ask the source of your historical P/E multiples? Do you have a
> subscription to ValueLine or do you go to the library and get the
> information from ValueLine? Or do you use some other source?

I typically use bigcharts.com which can plot the P/E ratio for the last
decade.


- Mohit
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> The analysis using the BMW Method needs to take this into
> consideration because the future for a SBUX has to be more volatile
> than for a more stable business like 3M.


How do you recommend evaluating a stock's fundamentals to see whether
the BMW method can be applied to it. That is, how can one know that the fundamentals of the company haven't changed in some way so that expecting the stock price to follow the historical avg CAGR is no longer reasonable. I'm new to BMW and while I've read quite a bit about the method by now, I still don't know BMW's methodology on evaluating a stock.

We no longer hear about most of the companies that existed 100 years ago. I'm sure there were solid performers at that time that followed an avg CAGR curve consistently for a several decades. But most companies falter at some point and then vanish into oblivion - even if the business was simple. If a company's current CAGR lags behind the avg CAGR, could it be because of temporary weakness, or is it because the company is nearing its end of life.


- Mohit
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No. of Recommendations: 2
> Phil Town claims to have turned $1,000 into $1,000,000 in five years
> in the early 1980s. That's a CAGR of 297%. From August 1982 to August
> 1987 the Dow had a terrific bull run but it only managed to have a
> CAGR of 28%.

There is always some hype behind such marketing. But in his book Phil
doesn't claim or offer any such phenomenal returns. He aims for 15% and claims to be consistently getting 20%.

My own experience with the Rule#1 method has been quite good. I only started investing last year, so I certainly cannot claim any consistent historical returns. But all I can say is that I have not lost any significant money on a single stock I have bought using Rule#1. And here are some of my Rule#1 successes: AAPL, NVDA, NTRI, CRDN, FCX, RIMM, MTW, GRP. Admittedly, I applied Rule#1 to some of these companies over a much shorter historical time span than what Phil recommends in his book. And I sometimes even buy stocks when the margin of safety isn't quite 1/2. Even so, the strategy seems solid.

My thoughts are that Rule#1 is quite good on consistent performers. But BMW may be better on old businesses that are going through some temporary weakness. Rule#1 wouldn't permit buying a stock whose numbers
are showing inconsistency. For instance, MMM had negative equity growth
in 2006. So its not a Rule#1 stock. But obviously, the BMW method has been quite successful on it. On the flip side, the BMW method would have considered AAPL to be overpriced when it was at $80 - given that the historical avg CAGR was just 6.9%.


- Mohit
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Another way of saying this is "GAAP is crap". I forget who first said this, but a long time ago he wrote a number of books with this as their main theme.
Norm


J. Edward Ketz?

Excerpt - page 148: "... The acronym is fitting. As I tell my MBA students, "GAAP is CRAP!" More energetic investors should consider using ..."

Hidden Financial Risk: Understanding Off Balance Sheet Accounting
by J. Edward Ketz (Hardcover - Jun 13, 2003)

http://www.amazon.com/s/ref=nb_ss_gw/102-7210345-5880953?initialSearch=1&url=search-alias%3Dstripbooks&field-keywords=gaap+is+crap&Go.x=10&Go.y=11&Go=Go

--------------------------------

Please, don't get me wrong, I'm not saying that accounting is entirely useless, you just have to know what to use and what to ignore.

For example, the top portion of the income statement tends to be reliable:

Sales
Less: Cost of Product Sold
Gross Profit

As you move further down the income statement things get a lot more fuzzy. For example, GAAP tells M$ to expense all the R&D they do on Windoze. The net result is that M$ carries Windoze on the books at ZERO value. That is an incredible amount of GAAP-crap. Even people who hate Windoze know that M$ earns tons of money on the thing so it has to be worth something above $ZERO. I'm using this example because not all the GAAP-crap is bad. In this case, the value of M$ is understated, not overstated. But, if the procedure is consistent year in and year out, it makes no difference because you have an Apple-to-Apple comparison. :-))

What I really hate are the one time events that they take out of the middle of the income statement and move it lower to the extraordinary items section. A company that has extraordinary items every year does NOT have extraordinary items at all. They are yearly occurrences and should be moved back to the operating section of the income statement.

One extremely important item to watch for is the growth in the number of "diluted" shares. If the company's earnings grow by 20% and the share count grows by 10%, your EPS grows is a lot less than 20%. Also if revenue grows by 20% but expenses (GS&A) grows by 25%, you have achieved nothing useful. This is the reason to watch margins:

Gross margin: Sales less cost of product sold
Operating margin: Gross margin less GS&A
Net margin: Operating margin less all the bad stuff

What you should inspect carefully are all the items between Operating margin and Net margin. That tends to be the place where they sweep the garbage under the rug except they call it "Extraordinary Items," "Discontinued Operations" and other aliases for "Money We Lost."

As Sgt. Phil Esterhaus of Hill Street Blues used to say: "Let's be careful out there."

Denny Schlesinger
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Hello, Mohit!

I believe that the method you are describing has merit, regardless of whether you believe the author's hype or not. I would consider rules like this a part of the "Due Diligence" that one is expected to do on BMW stocks. While the BMW method shows when stocks are undervalued, we are supposed to do our own due diligence to avoid the "Falling knives".

-- adiabatic
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How do you recommend evaluating a stock's fundamentals to see whether
the BMW method can be applied to it.
mohitaron


Good question! The simple answer is to understand the basics of the BMW Method: a stock that is selling at low CAGR should revert to the mean CAGR. But this statement assumes that there is a meaningful "mean CAGR."

A company like 3M has a very steady growth history and that makes for a reliable "mean CAGR" which makes MMM a BMW Method stock when at low CAGR.

A company like Starbux is slowing down in grow rate and a company like Apple is starting to grow like weeds so both have unreliable "mean CAGRs" and are not BMW Method stocks.

Or take the newspaper business which is being negatively impacted by the Internet. They used to be BMW Method stocks but with the current transition of their business model, they are currently excluded as BMW Method stocks.

To have a reliable "mean CAGR" you also need a fair amount of price history. Thirty years seems to be the consensus of plenty of data. Twenty years is seen as adequate by some and not adequate by others. Less that 15 is usually quite marginal. But, beauty is in the eye of the beholder.

Denny Schlesinger
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"We no longer hear about most of the companies that existed 100 years ago. I'm sure there were solid performers at that time that followed an avg CAGR curve consistently for a several decades. But most companies falter at some point and then vanish into oblivion - even if the business was simple. If a company's current CAGR lags behind the avg CAGR, could it be because of temporary weakness, or is it because the company is nearing its end of life." - Mohit

I believe you have underestimated the survivor bias of most companies. There are hundreds of great companies around today that were great companies in 1900. They often change names, get bought by other companies or morph into completely different businesses over time.

I believe it was Denny Schlesinger who researched this fairly well in the past. He surprised me with the number of great corporations that are still around after a century. GE is just one example and they have grown at well over a 12% average the whole time.

We think about the Amalgamated Buggy Whips and Studebakers that were left behind by technology but forget the American Expresses and GEs that weren't. Even Woolworths is now Foot Locker and Western Union Telegraph is now just Western Union. After 150 years they don't do much with Morse Code, but they still provide needed services and make money. After all, that is what business is all about. The business has to change with the market.

Apple is a prime example of that. They reinvented themselves and their new CAGR is totally different. The BMW Method was useless in spotting that change, but it now allows us to see the new CAGR rather dramatically. The question is, what will AAPL's CAGR be after the "new" wears off?

Instead of worrying about the unknown, I stick with the known like GE, HD, ABT, JNJ, WAG, DUK, or MMM. Why mess with speculation when we have so many great choices that can give us 30% plus returns in a few years of patience? That is how I use the BMW Method to my advantage.
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> Could I ask the source of your historical P/E multiples? Do you have a
> subscription to ValueLine or do you go to the library and get the
> information from ValueLine? Or do you use some other source?

I typically use bigcharts.com which can plot the P/E ratio for the last
decade.


- Mohit


I don't think a decade is nearly enough time to evaluate P/E movement. Just look at WMT. After about 5 minutes with an SRC 35-year chart book, I think anyone would agree with me on this.

In general, and I think this is a really persistent truth, a 15 P/E is very cheap for a steady, mature company. A good worst-case estimate for a BMWm pick trading near a 15 P/E against steady EPS growth is that the company will return its current CAGR. A good target estimate for the same company is that it will return to the P/E at which it last traded on its average CAGR line.

Therefore, you can calculate that P/E, estimate EPS based on historical EPS CAGR, and come up with a future target price. But buy the stock or not based on whether you'd be willing to hold the stock x years from now if it continues to trade on its current EPS CAGR.

Again, consider WMT. Earnings are growing at about 8%, it's near a 15 P/E, so a reasonable worst case is 8% price CAGR plus a couple percent yield (not too bad for a worst case scenario that doesn't even account for yield growth) against the possibility of twice that return for a 3-year return to average CAGR.

John
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> I don't think a decade is nearly enough time to evaluate P/E movement.

That might be true. But generally speaking, a company's avg P/E doesn't rise over time - it either stays the same or declines if growth is declining. Thus, looking at just the last 10 years is likely going to give me a conservative P/E estimate - which is primarily what I'm interested in. A conservative P/E would result in a conservative future stock price computation, and a conservative computation of current sticker price as per Rule#1 method.

That said, it is certainly good to look at more data. But given that I don't know of any free Internet sites that provide P/E ratios for longer than a decade, and I'm not particularly enthusiastic about paying extra for this information, I'll just stick to what the free sites provide.

> Therefore, you can calculate that P/E, estimate EPS based on
> historical EPS CAGR, and come up with a future target price. But buy
> the stock or not based on whether you'd be willing to hold the stock x
> years from now if it continues to trade on its current EPS CAGR.

Agreed. Rule#1 achieves this in a slightly different way. It advises to
estimate future EPS growth as the minimum of the equity growth and analyst projected growth. I think if the current EPS CAGR is low, it'll possibly be reflected in the equity growth, and so you'll only estimate future stock prices based on this conservative equity growth.


- Mohit
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I believe it was Denny Schlesinger who researched this fairly well in the past. He surprised me with the number of great corporations that are still around after a century. GE is just one example and they have grown at well over a 12% average the whole time.
BuildMWell



Nokia:
http://boards.fool.com/Message.asp?mid=25365250

Colgate-Palmolive, Johnson & Johnson, DuPont, General Electric:
http://boards.fool.com/Message.asp?mid=25366597


BTW, Studebaker existed for about 110 years, 50 making horse drawn wagons and 60 making automobiles:

Professor Donald Critchlow shows how a family-owned company built wagons and coaches successfully for fifty years, and how a quiet coup in 1902 ended family control and enabled Studebaker to risk building automobiles as well. He wants to know what enabled Studebaker (the only nationally-known wagon manufacturer to survive the transition from horses to horsepower) to do that. Studebaker stubbornly survived for sixty years as an automobile manufacturer against growing competitive odds: becoming the next-to-last smaller U.S. automaker to surrender to the "Big Three" of General Motors, Ford, and Chrysler.

http://muse.jhu.edu/login?uri=/journals/reviews_in_american_history/v026/26.2mcquaid.html

Studebaker Lark Daytona Wagonaire TV Commercial
http://www.youtube.com/watch?v=eOm5P1AkUi4

Denny Schlesinger
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"I don't think a decade is nearly enough time to evaluate P/E movement. Just look at WMT. After about 5 minutes with an SRC 35-year chart book, I think anyone would agree with me on this.

In general, and I think this is a really persistent truth, a 15 P/E is very cheap for a steady, mature company. A good worst-case estimate for a BMWm pick trading near a 15 P/E against steady EPS growth is that the company will return its current CAGR. A good target estimate for the same company is that it will return to the P/E at which it last traded on its average CAGR line." - TwinDeltaTandem

I like more P/E data than 10 years too, but often that is all that I have readily available. BigCharts very often goes back 20 years though.

Your example of WMT is an excellent case where 10 years is a gracious plenty. Back in 2000, the P/E was 60:1...today it is 15:1. Before 1997 the P/E fluctuated between 20 and 40, but suddenly it soared to 60. What justified that surge except irrational pricing by Mr. Market? The stock was terribly over-valued in 2000 and needed haircut. Sure enough, it got one!

Since 2000, WMT's P/E has steadily dropped to the present low level. The stock is due for a return to more sane valuations, but MR. Market is spooked due to the long-term price decline. So, as usual, he under values the shares due to his over-concern for price rather that the underlying earnings.

However, if we draw our lines of constant CAGR lines onto the earnings curve, we find a very consistent pattern that belies the share price gyrations. The problem is absolutely the market and not Wal*Mart. Thus, it is just a matter of time until the truth is accepterd by Mr. Market and some astute investors will see an above average CAGR by owning WMT. At least, that is what I see using the BMW Method.

We bought WMT here in our play BMW Method portfolio at about $42/share. That proved to be too early because the rebound is slow to take form. But, we have WMT at a very attractive price. Time is on our side. Be patient...that is the key. It is very hard to lose money buying great businesses at the 30-year low CAGR price.
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<<<J. Edward Ketz?

Excerpt - page 148: "... The acronym is fitting. As I tell my MBA students, "GAAP is CRAP!" More energetic investors should consider using ..."

Hidden Financial Risk: Understanding Off Balance Sheet Accounting by J. Edward Ketz (Hardcover - Jun 13, 2003)>>>

Mr. Ketz either wrote a lot of books 20 some years ago, or he stole it from someone else. I first heard it from a college teacher about 25 years ago. At the time he named a number of books the author wrote, but I can't remember the author or any titles.
Norm
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For some time now, I've been investing based on the Rule#1 method as explained in the following book by author Phil Town:

FYI -- just in case you haven't run into it yet, there is an independent discussion board for the method at:

http://www.roicommunity.com

They do have an EXCEL calculator for the method -- enter the ticker symbol and it uses Web Queries to grab the necessary data from MSN:

http://www.roicommunity.com/forum/automatic-margin-safety-calculators/1186-margin-safety-calculator-msn-money.html

You can override the numbers as you see fit. Unfortunately, I've seen too many people TRUST the numbers spit out by the calculator without giving them any kind of "reasonability check". For example, if the historical P/E values have varied up and down and between -153 and 86 over the past 10 years, it probably doesn't make sense to come up with an "average" P/E for forecasting a future P/E.
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> FYI -- just in case you haven't run into it yet, there is an
> independent discussion board for the method at:
>
> http://www.roicommunity.com

Thanks - I'll check it out. I didn't know about it.

> You can override the numbers as you see fit. Unfortunately, I've seen
> too many people TRUST the numbers spit out by the calculator without
> giving them any kind of "reasonability check". For example, if the
> historical P/E values have varied up and down and between -153 and 86
> over the past 10 years, it probably doesn't make sense to come up with
> an "average" P/E for forecasting a future P/E.


I've seen other automated calculators, and they almost always get the
historical P/E wrong. So far, I only trust computing the historical
P/E by myself looking at a P/E chart and then making a conservative
estimate of what the future P/E might be. For example, there are times
when the P/E is simply too high (e.g., the late 90's) - I just filter out those regions when making my judgement.


- Mohit
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I've seen other automated calculators, and they almost always get the
historical P/E wrong. So far, I only trust computing the historical
P/E by myself looking at a P/E chart and then making a conservative
estimate of what the future P/E might be. For example, there are times
when the P/E is simply too high (e.g., the late 90's) - I just filter out those regions when making my judgement.


Yeah, BMW does filter out outrageous region too. Some similarity there ;-)

-Tim
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That is why you hear experts saying that you should follow the money, i.e., the cash flow, which is much harder to "massage."
----
GAAP tells M$ to expense all the R&D they do on Windoze. The net result is that M$ carries Windoze on the books at ZERO value. That is an incredible amount of GAAP-crap


So, first you emphasize cash accounting because its supposedly harder to manipulate.
Then you attack GAAP because its expenses R&D, which is effectively cash accounting.

You aren't being internally consistent (which is the worst insult I can think of for an analyst).
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You aren't being internally consistent (which is the worst insult I can think of for an analyst).
WuLong


Luckily for me, I don't feel insulted, just misunderstood. ;-)

When you give a man a fish, you have incurred in an expense. If you teach him to fish, you have made an investment that will pay for itself every time the man catches a good eating fish. Clearly, that investment should be capitalized, not expensed. For some reason that I ignore, GAAP wants you to expense that investment. But, if you buy a building or a machine for production, GAAP want's you to capitalize it. Now, that is inconsistent!

Now, about following the money, an analyst and an investor should be very careful about interpreting the financial statements. Where easily verifiable dollar amounts appear, he does not need to dig too deeply, the figures probably can be trusted. Not so the rest of the items. For example, when R&D is expensed by fiat, the investor does not have the guidance from management about the future value of that R&D, it might be the same value as that of a three martini lunch by members of the BoD. On the other hand, if the R&D is capitalized, the investor has management's guidance about its future value. That does not mean that the analyst or investor must take it as a definite and exact number, on the contrary, he has to make a critical analysis of it and form an opinion about its accuracy. But hiding the future value of that R&D has not been helpful to the investor or analyst in their search for information. On the other hand, it does lower current income tax so the investor might feel that he finally has won one round with Uncle Sam.

I don't see any inconsistency in my original post, just a misunderstanding that probably arises from the economy of words used. Maybe in the future I should be more verbose in my posts. What do you think?

Denny Schlesinger
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For some reason that I ignore, GAAP wants you to expense that investment
I'm not entirely sure how to respond to this. You don't care about the conflict between the Matching Principle and the Principle of Conservatism?

Maybe in the future I should be more verbose in my posts.
No, that one sentence made it clear. Analysts have to explain the data, they aren't allowed to merely ignore what they don't like. Dogmatic rhetoric like GAAP is crap is under no such burden.
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<<<When you give a man a fish, you have incurred in an expense. If you teach him to fish, you have made an investment that will pay for itself every time the man catches a good eating fish. Clearly, that investment should be capitalized, not expensed.>>>

And if you give a man religion he starves to death praying for a fish.
Yet another version of that famous quote.
Norm
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You don't care about the conflict between the Matching Principle and the Principle of Conservatism?
WuLong


I have no idea what the Matching Principle and the Principle of Conservatism are. :(

I take it you went to Liautaud Graduate School of Business and have a graduate degree in accounting. I have taken a few basic accounting classes at the request of my boss at NCR. Since then I have designed a few accounting systems in Venezuela and now I use my knowledge of accounting for evaluating my personal investments. With that background, my comments are aimed at my fellow investors who, like me, mostly are not certified CPAs.

Having been a business owner and having granted stock options to my partners, I know that there are at least two GAAP rules that I find absurd, expensing R&D and expensing stock options -- both distort reality, IMO. But then, I'm no CPA. :-)


Dogmatic rhetoric like GAAP is crap is under no such burden.

I think you best address that to the person who said it, not me, since I didn't say it. Here is what I said:

Accounting was invented in Italy about 600 years ago so that the merchants could keep track of their business. Nothing really useful has been added to accounting in the last few hundred years. But since they invented income tax, accounting has been going downhill.

As I said above, accounting was invented so that merchants could keep track of their business. If you are doing the accounting for your own benefit, it makes perfect sense that you should do it as exactly as possible. But once governments use your accounting to take your money away from you, there is a very strong tendency to start cooking the books. You can play all sorts of perfectly legal games such as increasing or decreasing the time you take to depreciate assets. Also, there is no need to revalue a lot of a company's assets such as land. In the current case of highly illiquid debt instruments, you can use any kind of formula to state their value (until an auction happens).

Over the past two years, at the urging of luminaries such a Warren Buffett, they really screwed up accounting by "expensing" stock options. Changes in the capital structure of a business have nothing to do with its earnings. If I cut up a loaf of bread into 20 slices and give you a slice, I have only 19 slices left and you now have one. But the value of the 20 slices of bread (the company) has not changed, it's still 20 slices of bread. It is my job as an owner to keep track of how many shares exist but artificially changing the value of the slices, I mean shares, because the owners decided to give away a few of them, makes no sense at all.

In other words, all the numeric due diligence based on a company's accounting is, mostly, a waste of time. The data is mostly garbage mandated by law. That is why you hear experts saying that you should follow the money, i.e., the cash flow, which is much harder to "massage."

But I have good news for you! You know with a lot more certainty at what price the shares of your company sold for today. The FASB can't screw around with that number, the IRS can't screw around with that number. It's a number arrived at by public auction. Somebody actually put his money where his mouth is and paid that money for that share.

What is one to do? I think Peter Lynch had the right idea: go shopping, sleep in the beds, eat the food, count the discarded cigarette packs in the gutter... No, that was not Peter Lynch, That's our very own BuildMWell! :-))

Once you understand the basics of the business, you can look at the accounting, taking into account which numbers are hard to massage: Revenues, cash in the bank, debt. Every other number can be massaged since a lot of them depend on "fair value" estimates (how much to reserve for bad debts?). If on top of that you trust non-GAAP, well...

Knowing how unreliable accounting is, why not use some other system that depends on more reliable numbers?


http://boards.fool.com/Message.asp?mid=25706856


Denny Schlesinger
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Norm:

First you upset our CPA friend with "GAAP is Crap" and now you are upsetting our religious friends. I don't think that is a good idea. :-(

Denny Schlesinger
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1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.


http://www.accountingcoach.com/online-accounting-course/09Xpg01.html

The same way that a "sole proprietorship" is distinct from "business owner's personal transactions," a stock company is distinct from the stockholder's personal transactions. That is why stock options should not be expensed. Stock options are personal transactions between stockholders that do not affect the business's transactions, only the ownership of the business.

Denny Schlesinger
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I'm not a CPA. I took enough accounting to be able to analyze financial statements and create valuation models. Otoh, I'm certified under SOX to sit on an audit committee.

I'll FA my prior posts. I wasn't aiming at creating an argument.
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First you upset our CPA friend with "GAAP is Crap" and now you are upsetting our religious friends. I don't think that is a good idea. :-(

Hahaha...that is too funny, Denny ;-)
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So, first you emphasize cash accounting because its supposedly harder to manipulate.
Then you attack GAAP because its expenses R&D, which is effectively cash accounting.

You aren't being internally consistent (which is the worst insult I can think of for an analyst).


I'm not one to spam for products, but Hewitt Heisermann's book (It's Earnings that Count) covers this in excellent detail. It is worth the read to see different methods for accounting for GAAP's inefficiencies.
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I'll FA my prior posts. I wasn't aiming at creating an argument.
WuLong


That's really not necessary. There is nothing wrong with a bit of arguing as long as it is kept civil -- which this one has certainly been.

Stick around and let's hear your investing ideas! :-)

Denny Schlesinger
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I'm not one to spam for products, but Hewitt Heisermann's book (It's Earnings that Count) covers this in excellent detail. It is worth the read to see different methods for accounting for GAAP's inefficiencies.

I would also highly recommend G. Bennett Stewart's "Quest for Value". It is the primer for economic value added (EVA) analysis and does a marvelous job explaining how to translate from GAAP to cash-based accounting. It is somewhat dated (1991), but I think it still has great utility.

Warning to CPA's. Stewart is not a fan and does poke some fun at the accounting profession.

Regards,
Tom
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I would also highly recommend G. Bennett Stewart's "Quest for Value". It is the primer for economic value added (EVA) analysis and does a marvelous job explaining how to translate from GAAP to cash-based accounting. It is somewhat dated (1991), but I think it still has great utility.

Yep - that is one I need to read. Note that in Hewitt's book he uses three accounting types (defensive, GAAP, and enterprising) to make decisions. The "enterprising" one is EVA.

I should go back and read the original source, though.
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Just a quick comment, books like It's Earnings that Count and Quest for Value assume you can discover future stock prices by looking from inside out. I hold this inside out look as valid if you are doing an economic study for the owner or for an investor group to determine the profitability of the enterprise. One alternative would be to look at how well or how poorly the competition is doing. But going from an economic feasibility study to stock price in public companies there is the huge hurdle of investor sentiment which can value the shares at 5 or 50 times earnings.

Since 2004, for example, AAPL's P/E ratio has ranged from 22 to 98 while FMD' has ranged from 9 to 50. AAPL pays no dividend while FMD has a dividend yield of 2.7%. Both have a huge pile of cash, AAPL $14.54 per share (10.7%) and FMD $3.10 per share (8.6%). on Management Effectiveness FMD outstrips AAPL by a mile:


Management Effectiveness AAPL FMD
Return on Assets (ttm): 14.06% 41.30%
Return on Equity (ttm): 26.63% 54.35%


yet AAPL gets the higher P/E ratio.

I'm reminded of a chapter in Parkinson's Law, how long does it take to approve an item in a BoD meeting. If the presentation is about building a nuclear power plant, no one at the meeting is likely to be an expert so they accept the expert's recommendation and the item is dispatched in 15 minutes. The next item on the agenda might be about serving coffee and that is so far below their dignity that it gets dispatched in 5 minutes. The last item on the agenda is about parking space for bicycles in the parking lot. Now, that is something they all can understand and they all likely have experience with bikes so the discussion might go on for hours.

In 2007 we all know about computers, portable music players and cell phones while very few understand the delicacies of securitizing student loans. That should be reason enough to give AAPL twice the P/E ratio of FMD even while FMD is outperforming AAPL in Return on Assets and Return on Equity by very health margins (3::1 and 2::1).

The more I slice it and the more I dice it, the more the BMW Method makes sense.

Denny Schlesinger
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I have no idea what the Matching Principle and the Principle of Conservatism are. :(
Fwiw: http://www.bookkeeperlist.com/gaap.shtml

I know that there are at least two GAAP rules that I find absurd, expensing R&D and expensing stock options -- both distort reality
You are using the Matching Principle when you suggest capitalizing R&D. GAAP suggests that Reseach in general has no specific output, and therefore is an ongoing expense like maintenance rather than a depreciable capital outlay.
W/R/T expensing stock options, does the employee not recognize some value at the time of the grant? Could that option not have been sold on some market rather than given to the employee? Is it not effectively compensation? Should that compensation not be recognized somewhere? If it is not an expense, then what is it?

I suggest that both rules force management to recognize certain situations that might otherwise be easily ignored.
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http://www.vanguard.com/bogle_site/sp20061027.htm

"Crucially, these expectations are set by numbers, numbers that are to an important extent the product of what our managements want them to be, too easily manipulated and defined in multiple ways. We have pro-forma earnings (reflecting the magical earnings growth that can be created by merging two firms, as well as a certain dissembling). We have operating earnings (absent all those write-offs of previous bad investment decisions, bad debts, and bad operations that were discontinued). And we have reported earnings, conforming to Generally Accepted Accounting Principles, GAAP accounting which itself is riddled with its own substantial gaps in logic and implementation that permit all sorts of financial shenanigans by those who are so inclined. John Bogle

the key is to differentiate what's the reality of thee business...
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GAAP suggests that Reseach in general has no specific output, and therefore is an ongoing expense like maintenance rather than a depreciable capital outlay.
WuLong


When R&D is done to produce Windows and Oracle there is a very specific and valuable output with brand name and trademark attached to it. Of course, shareholders love the ruling because they get to save on taxes. But the day you have to value Microsoft or Oracle, the value of their mainstay intellectual property is not on the books. It could very well be that the ridiculously high P/E ratios investors are willing to pay for high tech shares takes this hidden value into account the same way as you often mentally lower the P/E to take into account the cash per share the company has.


W/R/T expensing stock options, does the employee not recognize some value at the time of the grant?

Of course he does, that's the whole idea behind the transaction, but that is irrelevant. What is relevant is who took part in the transaction. The company qua operating company, did not. It was a transaction between shareholders. One group of shareholders gave another person some shares of the company, just like a purchase/sale on the stock market. The only difference is that the shares did not come out of some person's portfolio but out of the company's treasury. Now that the operation is perfectly described, how do you treat the sale of securities to the public, for example, in an IPO? Does the company expense the IPO shares? It does not, the two bookkeeping entries are a debit to the bank account and a credit to the shareholder (capital) account. NO expense account is affected.

Quite simply, Buffett and others wanted to punish management for granting themselves options. While I disagree with the options abuse that led to this ruling, I find that the solution is worse than the sickness because it makes the accounts less meaningful that they were before. Pressured by a lobby, FASB was forced to shoehorn options grants into a "principle" where it does not belong. If you expense IPOs then you can expense stock option grants. :-)

Suppose the following situation, a bunch of buddies form an association which becomes a successful business. For whatever reason they decide to convert the business association into a stock company but they will not sell shares to anyone but to themselves. Would you expense those shares? Does the fact that the buyers also work in and for the business make any difference? I don't think so. And the reason is that the shareholders as shareholders are separate entities from the business even if they are also employees of the business.

The whole point of legislating stock corporations was to separate the investor's personal fortune from his investment in a business. That separation is not being respected in the expensing of option grants.

But this argument won't make FASB change its mind and I will not change mine on this point. I think this is a dead horse, no need to flog it any further. :-)

Denny Schlesinger
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