In the book “Investing the Templeton Way”, the author, Lauren C. Templeton writes on John Templeton’s value investing style.
“To tilt the probabilities of success in your favor, you should search for a stock priced exceptionally low relative to the earnings of a company that has better than average long-term growth prospects and better than average long-term earnings power. Your best chances of executing this strategy most likely will occur in stocks that have been sold off and are out of favor, unknown to wider audiences, or misunderstood by the market. To give you some idea of what his benchmarks of value were, John Templeton often looked for stocks that were trading at no more than five times the current share price divided by his estimate of earnings five years into the future. In other words, his calculation of the company’s earnings per share in year 5 divided into the stock price was less than or equal to the number 5. Likewise, he has remarked that occasionally he was able to pay only one to two times his estimate of earnings to be reported in the coming year. That, of course, is dealing in an extreme situation of depressed value. However, this is exactly what bargain hunters must be on the lookout for: extreme cases of mispricing.
You may ask, how can anyone be certain about what a company will earn five years down the road? Well, few people can with any precision. Most analysts tackle this question by forecasting a reversion to the average historical results of the company, provided that no substantial changes appear to be on the horizon for the company or its industry. Put another way, if the long-term average net profit margin over the last 10 years is 5 percent but the company has made 7 percent in the last year, the bargain hunter may be wise to use a 5 percent margin over the coming five years unless, of course, the company has accomplished something that will alter its earning power permanently and it is therefore reasonable to expect 7 percent to be the norm going forward. A conservative bargain hunter may forecast with the 5 percent margin, just in case, as the future is uncertain after all.
This method of applying conservative assumptions in one’s forecast creates a “margin of safety.” The margin of safety is a concept developed by Benjamin Graham that represents a bread-and-butter staple in bargain hunting. One way to apply the basic concept is to utilize assumptions in one’s projections that allow for less than ideal circumstances. The idea is to forecast the results for an entire “cycle,” normally about five years, in which a bargain hunter contemplates good times as well as not so good times. Long-term bargain hunters know they must consider both scenarios. If the stock price is still low relative to these less than ideal or average results, you have located a stock with a margin of safety.
Using a medium- to longer-term five-year projection may not be the easiest task, but it forces -you into a virtuous line of thinking that focuses your thoughts, questions, and discussion on topics that are more relevant to the business. For instance, what kind of competitive advantages does this company possess? If they are going to maintain their earnings power over a long period, there should be a competitive advantage for the company. Do they have a lower cost of production? Do they have a better brand and therefore command higher selling prices as a result of a perception of quality? If the answer to any of these questions is yes, you may be more comfortable forecasting that their profit margins will be sustainable in the future. If so, this gives you a better basis to judge the company’s future earnings. The simple truth is that if you are going to take a shot at projecting the future, you will need to have a more dynamic understanding of the company and its prospects. The way you obtain a dynamic understanding of a company is to ask questions about its long-term prospects. Long-term prospects are measured in years, not quarters. All the questions and answers that you will generate in your attempt to calculate earnings well into the future will provide you with a superior perspective on the company relative to the other buyers and sellers in the market.
Another important edge that accompanies looking at earnings five years down the road is that it should force you psychologically to tune out any near-term noise that has taken hold of the market. This goes back of taking advantage of near-term volatilities created by quick movements in a stock price caused by temporary setbacks at a company. Taking a long-term view of a company is not a fanciful idea or marketing phrase used by fund managers in their advertising. When practiced correctly, it represents a psychological edge that good bargain hunters use to take advantage of temporary problems in a business.”