Boring Portfolio

Wrapping up Tenets
A Discounting Example

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (July 19, 1999) -- I'm pretty much done reviewing the tenets. The basic philosophies of what I'm doing here are pretty straightforward and aren't newfangled in any way. Therefore, more than a few people who have preceded me have explained the whole deal before me and better than I could. I named a few of those sources in the Boring Tenets Part 3.

In summary, the goal here is to try to assess how much cash a company can produce above and beyond the cash inflows necessary to produce that cash, and then buy the company at a discount to the net present value of that cash. If you haven't been introduced to the concept of the time value of money, it's discussed in most introductions to finance. At the root of the concept is the fact that a dollar in hand today is worth more than a dollar in hand one year from now, since you can invest a dollar today and turn it into more than a dollar a year from now.

Here's a simple discounting problem. Say you have a dollar and a business you know will return 11% per year (after tax, as are all examples below) on each dollar of capital invested in the business. Earnings are fully reinvested in the business each year (no other capital contributions can be made to it), but at the end of ten years, the business stops producing cash flows and you can liquidate the company for the amount of capital invested in the business.

At the end of ten years, you're pretty sure you can take $2.84 out of that business. Say you were offered a couple different prices to buy that business. You come in on Wednesday to negotiate with the seller, and she says it's worth $1.74. You tell her, "no way, I can earn that in federally guaranteed 5% notes without the risk of investing in this business. No dice."

$2.84 / (1.05 ^ 10) = $1.743; $1.743 * (1.05^10) = $2.84

You come back a couple weeks later, and now the asking price is $1. "Well, that brings up a different set of circumstances." I'm pretty confident I can do that investing in equities in general and end up with $2.84 at the end of 10 years.

$2.84 / (1.11 ^ 10) = $1.00; $1.00 * (1.11^10) = $2.84

After a couple weeks pass, you come back again, and now the offering price has been lowered once again. The new asking price is $0.70. You say, "deal," since this matches the prospective 15% return on investment that you require of new investments:

$2.84 / (1.15 ^ 10) = $0.702; $0.702 * (1.15^10) = $2.84

The world isn't so simple, however. Many times, the businesses that are such a lay-up that only an idiot could not tell you that they will be worth much more ten years from now are priced such that a 15% return isn't available. You have a couple options in that type of situation, which I'll discuss on Wednesday.

Make a Living Foolin' Around.

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07/19/99 Close
Stock Change   Bid
APCC  +  1/16  22.13
BRKb  -11      2268.00
CSL   -  5/8   49.38
GTW   -  9/16  70.00

                  Day     Month   Year  History
        BORING   -0.39%   3.74%   7.78%  44.72%
        S&P:     -0.78%   2.54%  15.09% 134.31%
        NASDAQ:  -1.19%   5.39%  29.08% 171.89%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     49.38    87.56%
  4/20/99  460 American P    14.48     22.13    52.83%
 12/31/98   12 Berkshire   2276.17   2268.00    -0.36%
   2/9/99  100 Gateway 20    72.38     70.00    -3.28%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9875.00  $4610.01
  4/20/99  460 American P  6659.25  10177.50  $3518.25
 12/31/98   12 Berkshire  27314.00  27216.00   -$98.00
   2/9/99  100 Gateway 20  7237.50   7000.00  -$237.50

                             CASH  $18091.65
                            TOTAL  $72360.15