RULE MAKER PORTFOLIO
Step 7: Assessing Valuation

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11 Rule Maker Steps

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
--Warren Buffett

Warren Buffett has a way with words, and we couldn't agree more. As Rule Maker investors, we're interested in buying wonderful companies at reasonable prices. Learning how to do so is the challenge we'll take on here in step seven.

But before moving on, you may need to take a quick detour and get some just-in-time education on an important basic financial concept -- the time value of money. Here's the litmus test: If the words "present value of future cash flows" reads like gobbledygook to you, please take 15 minutes to read "The Dollar Machine," a classic Foolish tale that explains business valuation using an easy-to-understand metaphor. (Don't worry, we'll wait right here until you're finished.)

Onward. So what qualifies as a "reasonable price" for a Rule Maker company? Here's how we look at it: We want to buy at a price that allows us a good shot at achieving 2x/5y -- that is, doubling our money (2x) over the course of five years (5y), or a 14.9% annual return. Why 14.9%? To accept much less than that would be foolish (lowercase f) considering the availability of the S&P 500 index fund, which has historically returned around 10% to 11% annually.

The 2x/5y pursuit is not so much a matter of stock valuation, but rather of business e-valuation. Let me explain. In order to assess the likelihood of a stock price doubling in the next five years, you need a rock-solid understanding of the underlying business and its future prospects. That is, you need to know the company's competitive advantages, management quality, and expanding possibilities. Only if a company measures up on those three criteria should you bother assessing what a reasonable price might be for its shares. Assuming you do have a strong understanding of the business, the 2x/5y analysis process boils down to three steps:

Step 1: Double today's market cap to arrive at the required future market cap.
Step 2: Determine a range of required future free cash flows (or earnings, if you prefer).
Step 3: Critically assess the required growth and consider downside risk.

Learning to apply this technique takes some time. In our thrice-weekly Rule Maker articles, this is a topic we frequently tackle. Here's an article in which we assessed eBay (Nasdaq: EBAY) according to the 2x/5y rule.

In closing, here are five take-aways that sum up what you need to know about applying valuation principles to Rule Maker investing:

1. Business quality is more important than valuation. If it's not a top-notch business run by top-notch managers... well, the ocean is wide, move on to better fishing grounds. The Rule Maker -- an investing strategy that focuses on simplicity, pushes investors to think like business owners, and hold shares for the long term -- wants to identify dominant companies with sustainable advantages.

2. The goal is to avoid overpaying, not to get the "best" or "perfect" price. Because Rule Makers are superior businesses with sustainable growth prospects, they will usually be selling at premium prices. So, expect to pay up for a Rule Maker. But be cautious -- paying too dear a price, even for a phenomenal company, jeopardizes your chances of achieving 2x/5y.

3. Apply the Zen of Rule Maker -- that is, take what the market gives you. If everybody hates pharmaceutical stocks because of "what Congress might do," then give those companies a close look. If everybody loves Cisco and is calling it "the greatest stock ever," consider steering clear of it for the time being. Warren Buffett explains it like this: "I will tell you the secret of getting rich on Wall Street. You try to be greedy when others are fearful, and you try to be very fearful when others are greedy."

4. Stay fully invested. Be selective in your individual stock investments, but do not try to time the market overall. If there are no attractive individual stocks at a given time, invest your long-term savings in a good index fund (e.g., Vanguard Index 500) or index share (e.g., S&P 500 Spiders on the AMEX, symbol SPY).

5. Don't sell based purely on valuation. If you bought at a reasonable price, and if your company is continuing to create value, then your best bet is to enjoy the economic bliss of tax-free, commission-free compounding wealth. Ideally, when you buy a great company, you'll never have to sell. But do be sure to re-evaluate your holdings at reasonable intervals (at least quarterly). If a company's business quality shows signs of permanent deterioration and/or if the company is extremely overvalued, consider selling.

Step 8: Company Ownership and Partnership »