Welcome back to my Foolish quest. It's an honor to have you in the expedition party.

Yesterday, I laid the groundwork for a proposal. I'm seeking to unravel the riddle of Rule Breaker valuation by developing the patented Rule Breaker-Specific YGBFKM Valuation Method. I'll be assuming, in today's effort, that you are familiar with the following terms as they were defined yesterday:

  • The acronym YGBFKM (You Gotta Be Freakin' Kidding Me!)
  • Selection risk vs. market risk in Rule Breaker investing

The focus of tonight's digital journey, ironically, is market risk. I say "ironically" because we Rule Breakers generally eschew traditional measures of market risk and focus on the harder to measure, but more relevant (for us), topic of selection risk. Not tonight. This one is all about market risk.

So, we left off last time thinking about the only Rule Breaker valuation question that matters. Since we aren't market timers, we aren't too concerned about potentially undervalued holdings. If our Rule Breaking business model is still sound -- if the selection risk hasn't changed dramatically -- then we just wait, confidently. "Doubling down" and "buying on dips" just isn't our style.

So the YGBFKM method is specifically designed for potentially overvalued Rule Breaker candidates. And hence the riddle, since being labeled "grossly overvalued" by mainstream financial media is a prerequisite for Rule Breaker status in the first place! If some pros are using "grossly overvalued," it's safe to assume that any short-term "fair" valuation will undershoot our Breaker's true potential. We expect price to lead current business value by a country mile in the near term.

So with this setup, I propose the following four principles for the YGBFKM method:

1) I'm not Warren Buffett

Unlike the famed Oracle of Omaha, I'm not seeking to create value into perpetuity, the only noble goal of any public company. No sir. Barring exceptional talent or sloth on the part of my offspring, I'm going to sell some stock to finance their college education. It may be in the distant future but, some day, stock price will matter to me.

Given this fact, it is crucial that I get specific about two criteria for my Rule Breaker picks:

  • What is the most likely date that I will first encounter the need to sell?
  • What kind of annual return am I counting on between today (point A) and this first likely sell date (point B)?

In this relevant discussion board post, howardroark makes a persuasive argument that many more stocks are richly priced as potential Rule Breakers these days, in a relative sense. Unless we expect a higher proportion of true Rule Breakers to emerge in the future than we've seen in the past, our Breaker selection risk may now be higher than ever. For this reason, we are compelled to set lofty annual return targets. Our true Breakers will have to do more than just beat the market average by a little to compensate for this increased selection risk.

2) I'm a B minus A guy

I don't give a hoot about the price path from A to B. I'm not going to bother with attempts to profit by buying low and selling high along the way. Period. Study of past Rule Breaker market pricing shows that I'd be crazy to speculate on how far the current price point is ahead or behind the smooth path from A to B. Even if the price gets to B in advance of my sell date, I'm not going to automatically sell (although I might do another YGBFKM valuation exercise!).

3) I'm not your one-number DCF man

To head off the e-mail storm, let me cite this excellent post that delves into discounted free cash flow and Amazon.com (Nasdaq: AMZN). Thanks to this discussion board exercise, I have an improved insight into Amazon's less-than-stellar performance, recently, in managing inventories. Like everyone else, I think discounted free cash flow is a very powerful metric. I just don't think it's too relevant to what I'm trying to do here.

To elaborate a tad, I see the current inventory troubles at Amazon as a selection risk issue, not a market risk issue. Obviously, this inventory trend will have to be reversed if Amazon is to fulfill its Rule Breaker promise into Maker-hood. If the trend is not reversed? Well, then we've got one of those branches rotting in the mud I talked about yesterday, and discussions of market risk will no longer be very relevant.

In the long run, if our Breaker is successful, the difference between free cash flow and earnings will get smaller and smaller. Given that we'll be talking in terms of wildly speculative future estimates anyway, I don't think it'll matter much for our purposes here if we substitute a greatly simplified model based on reported earnings. This substitution will result in a more intuitive model that is linked to the market in the most familiar way -- via P/E ratios.

As for my prejudice against single-number summaries, I think this one is pretty obvious. The result of any exercise that attempts to peer a long way into the unknown, across a number of influential variables, should be reported as a range, not a single number. To do otherwise represents a gross over-sell of anyone's ability to estimate these future results.

4) I'm joyfully optimistic about my Breaker

When I lose this optimism about my Breaker's business potential, I sell. I don't bother with some namby-pamby valuation exercise. There is too much selection risk tied up in the underlying strategy to hang on when my Breaker can no longer shoulder a buoyant business outlook. So, I'm not concerned if most people think my future estimates are nuts. If they weren't nuts to a lot of people, I wouldn't be holding this stock as a Rule Breaker (point officially beaten to death).

My YGBFKM Valuation of Amazon

Although everyone has an opinion these days, no one really knows if current Rule Breaker Amazon.com deserves today's extremely rich valuation, a price that clearly leads current business results by a whopping margin. The future hasn't served the results yet, but it's fair to say, today, that few stocks have sparked more controversy over the sensible pricing of optimistic speculation. In this limited sense, then, Amazon provides a nice test case of YGBFKM, one that may push the limits of the business-focused approach. To paraphrase Ol' Blue Eyes: If business-focused investing can make sense here, it'll make sense anywhere, it's up to you, Am-a-zon dot-com.

Three quick comments and we get to the numbers. First, the Years-till-you'll-need-the-money variable (below) is a crucial one and one that will change from investor to investor (you can't do Rule Breaker valuation in a time vacuum). To be concrete, here, I selfishly chose my personal timeline. Second, Amazon's cost of capital is largely ignored in this simple model, although I do increase my early share dilution estimates to account for the existing debt repayment load. Finally, even such freewheeling animals as YGBFKM estimates require a reality check (a reality check on the reality check, in this case). I used a range of analyst projections as well as 10 years of past Wal-Mart (NYSE: WMT) data for this purpose. I won't ramble on about the comparisons here, but you can count on some rambling on the discussion boards if you ask a question.

OK. I'm up to one-and-one-half day's worth of preamble now, so I'm just going to stop and lay down the numbers without further comment. I look forward to my painful and complete limb-from-limb intellectual dismemberment on the Breaker Strategies discussion board.

(All revenue, income, and share data in millions)

Baseline Amazon Data

Initial revenue (FY99):          1640
Initial shares:                   327
Yesterday's close:             $48.56

Investor-specific parameters

Years till I'll need the money:    15
RB-expected Annual Return:         20%

YGBFKM Estimates

                       1-5  6-10  11-15
Annual revenue growth  50%   30%    20%
Annual share dilution   6%    2%     1%
Final net margin                     6%
Final P/E                            30

Impact of YGBFKM Estimates

                         Shares   Net
Years    Ending Revenue   Out   Profit
1 to 5    2005  12,454    437
6 to 10   2010  46,240    483
11 to 15  2015 115,060    507    6,904

Year 15 EPS:          $13.60
Year 15 Price:          $408
Average Annual Return:   15%

The YGBFKM Annual Return in context

  • Table number is average annual return
  • Row Heading is assumed annual revenue growth i.e.,+5% = add 5% to all YGBFKM estimates e.g., +5% uses 55%, 35% and 25%
  • Column Heading is Final P/E (at sell date) Revenue Ending P/E Ratio Growth 10 20 30 40 50 60 -15% -5% 1% 2% 4% 6% 7% -10% -1% 4% 7% 9% 10% 12% -5% 3% 8% 11% 13% 15% 16% YGBFKM 7% 12% 15% 17% 19% 21% +5% 11% 16% 20% 22% 24% 25% +10% 15% 21% 24% 26% 28% 30% +15% 19% 25% 28% 31% 33% 34%

  • Conclusion: Even using YGBFKM estimates, I'm on the edge of meeting my 20% expectation. Not good. Given our lack of focus on valuation, selling Amazon at this point would smack of heresy. There may be some rational optimists out there who could see YGBFKM +5% at a P/E of 40 without resorting to extraterrestrial intervention.

    But to use yesterday's metaphors, if the vine and branch get separated much further, we might want to start serving fish on Fridays.


    Related Link:

  • Fool on the Hill, 5/25/00: Some Amazon.com Risks