Imagine that you had just inherited $100,000 and you wanted to invest it in a savings account to get a return on your money. Further imagine that your town had two banks from which to choose. The first paid 8%, but you could not reinvest it. The second bank paid 5% on your initial deposit, but, unlike the first bank, it would let you reinvest your earnings at a rate of 12%. Finally, assume that each bank required a 25 year commitment and that your investment was insured and safe.
Which would you choose? Buffett used this example at the 1992 Berkshire Hathaway shareholders meeting to illustrate the way we should think about growth and value when considering a prospective investment. Buffett acknowledged that the example was a simplification, but that it nevertheless underscored the importance of understanding the basic mathematics of investing. (1)
So which would you choose? What if you needed to pay a $20,000 sales charge to gain access to the second offering?
(Pause, and think about your answer.)
It turns out that the net present value of the second account is double that of the first. Even though the initial rate of return at the first bank is 60% higher than that of the second, over time the ability to reinvest your earnings at 12% makes a huge difference.
If we equate these bank accounts to stocks, we can imagine the first bank being a stock selling at 1x book value with an 8% return on equity that pays out all its earnings in dividends. We can liken the second bank account to a stock selling at 2.5x book with a 12% return on equity. Because you would need to pay a premium to net worth of 2.5x, your earnings on your average carrying value would be reduced to 5%.
However, all retained earnings would earn a much more generous 12% and the compounding of those retained earnings at 12% would really add up over time.
The takeaway here is a greater insight into the power of investing in businesses that can generate a high return on incremental reinvested capital over the long-term (which are rare), even if you need to pay up to do so. It also illustrates the potential pitfalls of relying on a single valuation metric such as price to book ratios as a substitute for thinking deeply about the net present value of the dollars you lay out when you make an investment.
Finally, Buffett may not actually do a discounted cash flow analysis when evaluating an investment. Charlie Munger has said he’s never seen Buffett do one. Nevertheless, it seems likely, based on this example and others, that Buffett has done the math and has these types of models committed to memory which he can immediately draw upon when sizing up an investment.
Via: http://www.gurufocus.com/news.php?id=101042
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