FOOL ON THE HILL
An Investment Opinion
A knock comes at your front door. Peeking through the eyehole, you see that it is that inventor friend of yours, Bosco. You know, the wild-haired Bohemian from next door who always seems to have just spilled something on his polyester dress shirt. Quickly you consider the possible excuses you can use to avoid speaking to him, lest he try to sell you another combination rat catcher-door stop. Grandmother in the hospital? Used that last week. Overwhelming sense of ennui and existential angst? Used that the week before. Your reverie is jarred by another series of fevered raps on the door, and against your better judgment you decide to let him in before he hurts his hand -- like last week.
"Hey, glad to see you're home. Got a minute?" The excitement is literally beading on his words. The whites of his eyes are slightly more prominent than usual.
"Ummmm, sure," you mutter, unable to find an available excuse. For a moment, you fear that you may have exhausted your lifetime supply of excuses, a state guaranteed to make the rest of your life unbearable.
"Great! This will only take a minute." Bosco takes a dull metal object roughly the size of a deck of cards out of his pocket and sets it on the coffee table. A bright red button adorns the center. Obviously proud, Bosco puts his hands on his hips and beams at you.
"So, what do you think?"
"What is it?" you ask.
"Oh, yes, of course... I forgot to tell you what it does." Bosco hunkers over the device like a platoon leader diving on a live hand grenade. He presses the red button and then he quickly steps away, possibly to ensure that you can see what is going to happen. Just in case, though, you step behind the living room chair and duck.
You hear a grinding sound followed by the scraping sound of paper against wood. A few minutes pass without any kind of explosion and you look up. A crisp dollar bill now sits on the coffee table beside the bizarre device.
"You see, a dollar-making machine!" Bosco thrusts his hands triumphantly toward the device. "Once every year, you can just press the red button and a new dollar bill will spit out!"
"Once a year?"
"Yeah, once a year for ten years. It takes a while for it to pull the necessary particles from the air and rearrange the molecular structure to make the dollar." Bosco adjusts his taped, horned-rim glasses and continues. "You see, the nuclear furnace in there can only work so fast... but the good news is it never runs out of power."
At the first mention of the word nuclear, you back up. Desperately, you wish you had come up with some kind of excuse to be somewhere else.
"So what do you think I should sell it for? How much would people pay for a dollar machine?" Bosco's question goes unanswered as you dive behind the chair, hoping any stray radiation does not get through the La-Z-Boy.
Setting aside for a moment the question of whether the nuclear dollar machine is a development that is at odds with environment sanity, the question of how much Bosco's device would be worth is one of paramount importance to stock investors. Come again? Well, let's walk through the question of how to value the dollar machine and then we can examine the possible parallels to valuing stock.
We know Bosco's dollar-making machine will spit out a dollar each year for ten years. Obviously this caps the highest possible value for the device at $10, since that is all of the money that we are going to get out of it. Now, for a stream of cash payments that will add up to $10 over the next 10 years, what do you think people should pay? $9? That would be a dollar less than the amount of money you will receive, allowing you to lock in a $1 profit.
While certainly at $9 you would get a one-dollar profit on your money, that profit would only come in the tenth year. Now, if you invest $9 to get $10 over the next ten years, you will get an 11.1% return ($10 divided by $9) over that time period. Now, 11.1% over ten years might look nice at first glance, but if we determine what this will be on an annual basis (1.111 to the 0.1 power), we discover that it amounts to only 1.0% a year. Heck, passbook savings accounts beat that.
Passbook savings accounts? Yes, passbook savings accounts. One of the key things we have to consider when valuing our dollar machine is not just the absolute return, but the other places we could invest that same money and what kinds of returns we could expect from those places. Given that savings accounts are insured by the FDIC and that the average interest rate on such accounts now hovers close to 2.5%, if someone tried to sell you the dollar machine for $9 you would have to turn them down and put the money in a passbook savings account instead.
So how much should we pay for that dollar-making machine? The first thing we have to do is quantify what we could earn on that same investment in other vehicles. Let's assume here that there is a warranty on the dollar machine, guaranteeing that it will spit out the dollar or you get your money back. What other investments could you make that are guaranteed? Savings accounts, certificates of deposits, and bonds immediately come to mind. Given that you could get around 6% annual return on your money in a CD or bond over ten years, you would have to beat 6% or the dollar machine would be worthless to you.
How much money invested in a 6% bond today would become $10 in ten years? Given that you would have a compound return of 79% over ten years at 6% (1.06 to the 10th power), you can figure out that $5.59 in today's dollars will be $10 in ten years at 6% ($10 divided by 1.79). Because you know what your risk-free rate of return is, you can figure out what price to pay in today's dollars for earnings that you will receive tomorrow. So, unless you can get that dollar machine for less than $5.59, it is not even worth considering.
In order to value the dollar-making machine, we have taken the stream of income it would generate and calculated the net present value of that income stream, assuming what rate of return we could earn on that money elsewhere. Had we demanded 10.6% annual return from the dollar machine (the historical return of the S&P 500), the dollar machine would only be worth $3.65 ($10 divided by 2.74, which is 1.106 to the 10th power). Demanding higher rates of return makes the dollar machine worth less and less in terms of today's dollars relative to the future value of those dollars.
How does this all relate to investing? We take up that topic in parts two and three, linked below.