Yesterday, I posted a discussion of several interesting aspects of Phil Town’s book Rule #1. One of these points was Phil’s requirement that any stock you invest in have a Margin of Safety. To determine this margin, Phil offers up a formula that calculates a stock’s “sticker price,” which can be calculated by retrieving some data on a company from any financial site.

When I checked the site for new comments, I found this comment from Jim Lippard:

Can you give a more specific and clear description of Town’s suggested calculation for price for Margin of Safety?

Since my description was fairly terse, I decided to write out a longer description of how to calculate the sticker price of a stock using Phil Town’s formula from Rule #1.

Here’s how I described the calculation:

Dig into a company’s data sheet on Yahoo! Finance and get the current EPS, the 10 year equity growth rate, and the average of the high and low P/E ratio. Take the current EPS and figure that it grows for ten years at an annual rate equal to the 10 year equity growth rate. Once you have that future price for ten years down the road, shrink it by the rate of return you want (say, 15%) ten times to return it to today’s values. If this calculated price is more than double the current price of the stock, you should buy in.

Let’s break it down piece by piece. I’m going to use one of my favorite companies, Whirlpool, in this example (I like Whirlpool for somewhat sentimental reasons related to my passion for cooking). You can get all the numbers you need for Whirlpool by visiting their page at Yahoo! Finance and also clicking on Key Statistics on the left hand side, which will give you this page. For the ten year numbers for equity growth rate, you must visit MSN’s Whirlpool data.

Here, we’re looking for the current EPS, the ten year equity growth rate, and the high and low P/E ratios. From Yahoo!, the current EPS is 6.09 and the trailing P/E ratio is 13.46 (good enough to use for this type of “back of the napkin” calculation). From MSN, I took their annual book value per share data, figured out the change each year (I subtracted the book value per share one year from the previous year, then divided that by the value of the previous year), then averaged all of these percent changes to get a ten year equity growth rate of 4.76%.

So, now I want to take the current EPS (6.09) and multiply it by the average of the high and low P/E ratio to get a current estimate of the stock value (not just today’s finish). We figure the “low” P/E ratio by just doubling the current EPS, giving us 12.18. We already have the “high” P/E ratio: 13.46. The average of the two is 12.82. If you want be extremely conservative, you can just stick with the lower of the two ratios, of course. So, multiplying 6.09 by 12.82 gives us 78.07.

Now, we take that estimated value of 78.09 and calculate what the stock would be if it grows annually at a rate equal to the ten year equity growth rate. You can do this pretty easily in Excel by multiplying 78.07 times 1.0476 to the tenth power (meaning an increase of 4.76% a year for ten years). In Excel, this would be =78.07*(1.0476^10) . This gives the estimated value in ten years as being 124.29.

How much do we want as an annual rate of return? Town advises 15%, so we reverse the above calculation in a sense. We divide 124.29 by 1.15 to the tenth power (1.15 meaning that we expect the stock to go up 15% a year). In Excel, this would be =124.29/(1.15^10) . This calculation says that the stock should be at 30.72 today if we want to earn 15% a year on the stock.

Of course, we want a margin of safety, so we want to buy the stock at half of our calculated price. In other words, if Whirlpool’s stock is at 15.36 (half of our 30.72 calculated value), we should buy in immediately.

So should we buy? As of this writing, Whirlpool is priced at 82.03, far above our “buy in” price of 15.36. We should leave Whirlpool on the shelf at this point.

I should point out that very few companies will register a “buy” with this test. If you actually do find a “buy,” you definitely should buy in because you will make strong money in the investment. Personally, I would buy any stock that even comes close to a “buy” with this test.