The Forsaken 50%!

What if I told you that 99% of investors (professional and individuals alike) were missing out on a large chunk of the analysis in measuring the value of an investment? How can that be given how quickly news and data flow around these days? What am I smoking?

Well, that is essentially what happens when viewing an investment as a series of discounted cash flows.

As I have mentioned in previous posts, the value of any security or investment is the Net Present Value (NPV) of all future cashflows from the instrument into peretuity, discounted at an appropriate discount rate. While the definition makes a lot of sense, the actual application is much more difficult. What growth rate do we use? What discount rate do we use? We can't use infinity in the number of cash flow periods for the calculation you know. How are we going to do it?

Well, typically, the discounted cash flow (DCF) analysis employed by Wall Street and others (who have the confidence to actually project these numbers--which I have obvious reservations about given that reality is not that simple) use a 10 year model. They tend to take the current EPS or cashflow and put a growth factor of say 10% per year over the next 9 years. For the 10th year they apply a multiple (or a price earnings ratio) of that 10th period cashflow to estimate the "terminal value". Here's an example:


Earnings in year 1 is $100 growing at 7% per annum with a terminal earnings multiple of 15 times earnings (pretty standardised assumptions).

Yr1 100.00
Yr2 107.00
Yr3 114.49
Yr4 122.50
Yr5 131.08
Yr6 140.26
Yr7 150.07
Yr8 160.58
Yr9 171.82
Terminal Value: 2757.69 (171.82*1.07 *15)
Terminal Value Discounted @10%: $1,063.21
Total Value: $3955.49
Total Value Discounted @ 10%: $2,170.24

Now notice how much the discounted value is accounted for by the terminal value....a whopping 49%! ($1,063 / $2,170)

In other words, almost 50% of the "value" of this security is based on what occurs AFTER a 10 year period. Again, 50% of the value is based on what occurs after a 10 year period.

So, why does Wall Street and CNBC and others get mesmerized by quarterly earnings, when the results only really account for a fraction of the actual value of a real business? Beats me, but it sure makes my job as a value investor that much easier. For me this speaks volumes about thinking about investing for the long-term.

Think in Terms of Total Return

Another key component for successful investment management is to think in terms of the total return expectation for each and every investment one makes (including cash).

• the price you pay determines your return.....therefore the lower the price the better the returns
• Graham: "Buy stocks like you buy groceries, not like you buy perfume."
• Example: Buying Coca Cola stock at 50% off today's price will enhance returns nicely over a long timeframe (say 20 years, until the time you really need to "liquify" the holding if at all).
• Again, when you look at your statement each month and see the $ figure of your portfolio, that represents ONLY the amount you would receive if you liquidated your portfolio TODAY. It DOES NOT represent the VALUE of the ultimate liquidation date (which is more than likely many years ahead). Seeing that you are likely to be a NET PURCHASER of holdings until liquidation is required, you want a LOWER price , NOT a higher one.
• SO if I am able to buy Coca Cola stock at a 50% discount today, I love it because it enhances my TOTAL RETURN expectations until I will want to sell (which includes the dramatically increased dividend yield as a result of the lower price)

Simplify

A key component for long-term investment success is in keeping things simple. The markets can actually be quite complex, however there are ways to see things from a more simplistic level, particularly as an individual investor. Here's an example:

Suppose you are a baby boomer who will retire in about 15 to 20 years time and have an investment account where the proceeds will not be required until AFTER that particular date. Then realistically one should NOT be concerned about what happens with the movements (either up or down) of the portfolio during that 15-20 year period or longer. They should only be concerned with what the investments will look like after that period of time. Psychologically it can be quite difficult NOT to be concerned to see an investment portfolio decline in value (like many portfolios did in the crash of 2008).

However, should an individual really be THAT concerned if the $$$ is not required immediately? In fact, an investor SHOULD be happy with such an occurrence because he or she is a NET BUYER of securities so they are able to buy investments at a discounted price. Like Munger says: "Invert, always invert."

• the value of a business today should only be concerning if you are a BUYER....in other words you want a lower price, not a higher one!
• for individual securities: the value of any business is the net present value of future cash flows, so if an investor won't need the $$$ for the next 15-20 years, the value of the their investments will be discounted based on the subsequent long-term discounted FUTURE cash flows AFTER 15-20 years......SO, really the value of one's portfolio should only be viewed based on what an investment's future cash flows are over a 30 year timeframe....how many companies have THAT kind of staying power??? Not many , but there are some :)
• compounding matters more and more as the time frame gets extended.
• therefore, as a 30 year investor, DURABLE competitive advantage of a business is the most critical.
• a finite competitive advantage is a death sentence because people end up overpaying for an advantage that only lasts a short time. DURABLE competitive advantage, on the other hand, is like heaven on earth...paying a reasonable price for such a business and waiting for compounding to do its work is what it's really all about.
• the bottom line is that only a few businesses are required to make one successful as a long-term investor. Buy only the ones maintaining DURABLE advantages at reasonable prices....it's really as simple as that!