Friday, September 07, 2007
It seems all of my past articles are unusually long and with minimal need to squeeze a little bit more of the juice out of the brains that is essentially needed for a true intelligent investor. So this writing will require some thinking that draws upon the ideas from the past writings. The two following examples are constructed for investors to think about how much they should pay with the restrictions as placed.
A big retailer who has a past record of a far-above industry return on invested capital and equity of over 20%. As such, its past performance in share price also compounded at a rate of over 20%. At its high two years ago in 2005, the stock price went to almost $60 and at this price the valuation then was 25 times of earnings. However, in the past two years, the rate of growth on invested capital and equity slowed to a pace of slightly below 20% - a few percentage points drop. Similarly, the share price tracks the slight drop in return on capital and it is traded at $44 today at a valuation of about 16 times earnings. On the outlook, this would seems like a steal to most intelligent investors provided if the variables - return on capital, and valuation level - remain the same.
However, every investors will have a different take on a business. The question is if an investor should pay $44 today if he wants an average of 12% return on stock price for the next 20 years.
Assume in circumstance 1, if Investor A thinks that the business economics will slow over time to 12% return on capital over the next 20 years on average, should he then pay $44 today if he expects an average of 12% return on stock price over the next 20 years?
In circumstance 2, Investor B thinks that the business economics will maintain at about 18 to 20% return on capital over the next 20 years on average, is $44 today a steal and thus be able to gain him at least 12% return on stock price over the next 20 years?
Under both circumstances, if you stand in these investors' position:
Under circumstance 1, a) what price would you pay if you want an average of 12% return on stock price for the next 20 years, and b) if you pay at today $44, do you think you would be able to achieve 12% return over the next 20 years and if not, what return would you think by paying $44 today would likely return in 20 years?
Under circumstance 2, what price would you think the stock price will be in 20 years time?
Consider this example, the odds of throwing a 12 with a pair of dice - a 1 in 36 odds. Now assume that the dice will be thrown once a year, and that an insurer agree to pay $50 million if a 12 appears. And for underwriting this risk, the insurer takes in an annual premium of $1 million. Over 10 years, not a single 12-event appears, and the insurer appears to make $10 million of profit. However, the question is is this $1 million premium sufficient for undertaking the $50 million payout odds? If not, what would seems to be a more reasonable premium to cater for the odds?