I'm completely envious of high school students. And not just because they're young and energetic while I'm old and broken. No, I'm envious because they have both the open-mindedness to be receptive to successful investing ideas and the time to implement them. In fact, given the right knowledge and a willingness to use proven investing strategies, every high school student today has the opportunity to become a millionaire.
The first step to your millions
The path to wealth begins with an understanding of two simple lessons that I believe all teenagers should learn in high school. The primary lesson is that compounding is the most powerful force in the financial universe. If you invest $2,000 when you're 20 and achieve a 15% compounded annual return, that small investment will become more than a million dollars by the time you hit 65.
If you don't understand the power of compounding, you should definitely learn about it. If you do, then you should recognize that over the long term, small changes in the rate of return make a huge difference in your final haul. And that brings up the second lesson -- one that can substantially increase the return on your investments.
Price vs. value
The key to superior investing performance is understanding the difference between price and value. Here's the short version: Price is what you pay to buy a stock; value is what the stock is actually worth.
For example, suppose that I have an envelope with $500 in it, and I offer to sell it to you for $250. You'd quickly take me up on the offer. In that case, you bought an envelope with a value of $500 for a price of $250 and have made a nice profit. On the other hand, if I offered to sell you the envelope for $700, you'd probably laugh in my face.
Strangely enough, in the stock market, people are willing to do both sides of this transaction every day. And that means huge opportunities for investors who understand the difference between price and value.
Seriously ... it's true
Take Kmart, Sears, and what is now Sears Holdings (NASDAQ:SHLD). Eddie Lampert, a well-known value investor, looked at Kmart and Sears and recognized that not only did these retailers have potentially profitable businesses, but they also owned real estate. Even better, that real estate alone was worth more than the price at which the shares were trading. The market was beginning to recognize this fact -- Vornado (NYSE:VNO), a real estate investment trust (REIT) with particularly adept management, had actually purchased 4.3% of Sears. But Lampert really stepped up. He bought a majority stake in Kmart and used it to purchase Sears, transactions that resulted in spectacular profits for investors.
Similarly, back in 1999, many REITs were trading below their net asset value, including CBL & Associates (NYSE:CBL) and General Growth Properties (NYSE:GGP). Subsequent returns in these two have been excellent, not just because of the booming real estate market but also because in 1999 these companies were trading at stupidly cheap prices.
The future is now
While valuing businesses based on their assets is conceptually easy, most companies are better valued based on the cash that they generate. Take software companies such as Microsoft (NASDAQ:MSFT) and Adobe Systems (NASDAQ:ADBE). These companies don't require costly assets like factories to operate, and really, if their assets were simply sold off, the businesses wouldn't be worth much. The real value in these companies is that they generate boatloads of cash and are likely to continue to do so for a long time. So it makes more sense to value them based on their future cash-generating potential than their assets.
To do this, value investors use what's called a discounted cash flow equation, which determines what a company's future earnings are worth today. The tool can help you both identify cheap stocks and avoid poor investments. For instance, if back in 2000, Cisco Systems (NASDAQ:CSCO) owners had used such a tool to calculate the company's fair value, they would have realized that the stock was overpriced. They could have sold it and avoided its huge subsequent fall.
Discounted cash flow calculations are tricky to do by hand, so we have a discounted cash flow calculator here that all subscribers to our Inside Value newsletter can use. (Non-subscribers can try it out with a free pass that's available here.)
The lesson
By avoiding the bad bets and focusing on the opportunities that are most likely to pay off, you substantially improve your potential returns. That's why it's important for high school students to learn the distinction between price and value. Over the course of their lifetimes, such knowledge can vastly increase their wealth. In fact, the lesson applies to anyone.
If you're looking to jump-start your portfolio with undervalued companies, I invite you to look at our Inside Value newsletter, free for 30 days. Our returns are beating the market because we focus exclusively on stocks trading at prices significantly less than their fair values.
Fool contributor Richard Gibbons gets schooled whenever he plays ultimate. He owns Cisco calls but does not have a position in any of the other securities discussed in this article. Microsoft is an Inside Value recommendation. The Fool has a disclosure policy.
