THE RULE OF 72

Here's a question I get asked every day, and an answer I think will help everyone doing a 4M company analysis.

How do you calculate the equity (or book value per share) growth rate? (And I'll expand that to include sales, EPS and cash growth rates.)

I'm going to teach you how to do this in your head. Once you learn it you will understand why Warren Buffett doesn't need a computer to figure out whether he likes a business or not. Here's how:

MSN Money reports book value per share numbers for 10 years in a column under Financial Results - Key Ratios - 10 year summary. Investools puts up ten years of balance sheet info under Fundamentals - Balance Sheet. Others do it similarly.

• Start with the oldest number (and of course don't even bother unless the growth is consistent -- but at this point that goes without saying, right?), round it off to something that is easy, and double it in your head. Keep doubling until you get to a number that is as high as the most recent equity number.

• How many times did you double it? Let's say you doubled the oldest number two times. Now divide two into the number of years from the oldest to the most recent equity number. On the sites I use, it's usually 9 years. Two goes into nine 4.5 times. 4.5 is the number of years it took for the equity to double once.
  
  
• This next bit is called The Rule of 72. When you divide the number of years it takes to double your money into 72, you get the growth rate. For some unknown-to-me reason this actually works. 4.5 into 72 is about 16. Ballpark. So the equity in this example is growing at 16% a year for the last 10 years.

I use the Rule of 72 all the time. It isn't perfect but it's quick and doesn't require a calculator. Here's a real world example from EXBD using data from MSN Money: Book value per share in 1999 (the oldest number) is .40. In 2004 it was 8.41.

Start doubling .40. double once to .80. Double twice to 1.60. Double three times to 3.20. Double 4 times to 6.40 and then part of a double to get to 8.41. I look to see the number of years. 1999-2000 is one, and so on. I get 5 years with 4 doubles. That's a double almost every year.

Divide 1 into 72 and you get 72. So EXBD has a book value per share compounded growth rate of 72% for the last 5 years. That's crazy but it happens to new, fast growing businesses.

Let's do it again more recently and see how they're doing: In 2001 their BVPS (Book Value Per Share) was $4. Now it's $8. So in three years (2001-2002, 2002-2003, 2003-2004) they doubled their book value per share. 3 years to double once. 3 into 72 is 24. So more recently their BVPS is growing at 24% a year. Still phenomenal.

And how about 2003-2004? it went from 6 to 8 bucks. Thats up $2 in one year starting from $6. If they keep up that growth ($2 a year or so) then in three years they will have doubled the $6 again - probably a bit faster than 3 years. So recently they're still growing equity at 24%.

You gotta love the rule of 72 for quick and dirty calculations. After a while, you get to where you can just glance at the numbers and see consistency -- and then quickly do the doubles on the oldest number and see if the equity growth rate is high enough to make this a business worth considering. No computer required.