74: The Tale Of The Time Traveling Cash Flow
Thoughts On Growth
You’re reading the weekly free version of Watchlist Investing. If you’re not already subscribed, click here to join 1,400 others.
Want more in-depth and focused analysis on good businesses? Check out some sample issues of Watchlist Investing Deep Dives.
For less than $17/month, you can join corporate executives, professional money managers, and students of value investing receiving 10-12 issues per year. In addition, you’ll gain access to the growing archives.
Once upon a time…
The world of CashFlo is an interesting place. Its residents, all named Bill, are born as adults. All begin life as $100 Bills. The man in charge is the Viscount of CashFlo. He is endowed with special powers. Setting the Viscount Rate determines the lifespan of his subjects.
A 10% Viscount Rate, for example, means that each of his newly born subjects turns into $90 Bills in their second year of life, $81 Bills in their third year, etc. If the Viscount thinks there are too many Bills in his Fiefdom he can raise the Viscount Rate and shorten their life, or create more Bills by lowering the rate.
The Bills of CashFlo aren’t completely helpless to the Viscount’s ways. By hitching a ride on a special time machine called a Com-Pany, they can escape the ruthlessness of the Viscount and maintain their present value. In fact, if they choose the right machine they may even increase their lifespan.
A Bill finding a Com-Pany with a Rowick speed (a technical term for the qualities of the Com-Pany’s in CashFlo) of 10% under a Viscount Rate regime of 10% can arrive back a year earlier in time with his denomination intact — no better and no worse than he was the year before.
The lucky Bill who finds the rare machine with a 20% Rowick will see himself transformed into a $110 Bill upon return to the present. Should such a Bill hitch a second ride he may arrive — to the envy of his friends — as a $121 Bill.
But risks abound in CashFlo. Choosing a broken Com-Pany with a Rowick of just 5% destroys a Bill’s life. Such an unfortunate Bill will find he arrives back at the present not as the $100 he started but as $95. His friends ask him why he didn’t just stay in the present and enjoy his life.
Such are the two choices facing Bills in CashFlo. They can choose to spend their days in the present, fully enjoying their value, or hitch a ride on a time machine hoping to maintain or grow their value. Time in CashFlo never stops; a choice must be made.
Back to reality…
I’ve been thinking about the story of CashFlo for a while, trying to convey my thoughts about the growth of companies and how to value them. The made-up terms I used are easily-identified for their real-world analogs. The Viscount Rate is the discount rate; a Com-Pany is a company; and Rowic is ROIC (return on invested capital), the “speed” of a company’s ability to compound money.
Let me translate the story into how I think about growth. To start, I dislike DCF models even though I embrace their reality. I find it much simpler to think in present value terms, and I have a sneaking suspicion that Warren Buffett does too (see the two videos below). Rather than project growth into the future and then discount it back, why not just think in present value terms?
For example, a 10% return under a 10% discount rate clearly creates no present value. Why not just distribute that dollar today? A company with the ability to earn 20% has the special power of taking $100 today and turning it into $110 in present value terms through its 20% - 10% = 10% return.1 Of course, it has to actually execute and invest the capital, earn the return, etc. But assuming a 20% return, $100 will turn into $120 a year from now, which is the same as $110 in present value terms right now.
This type of analysis simplifies things. If I pay $1,000 for the business earning $100, that’s a 10% return. But if it can deliver a 20% ROIC (and importantly it doesn’t pay a dividend), that’s the same thing as saying it can earn $110 for me today, or an 11% return (20% forward, 10% back). The company’s future ability to generate returns above the discount rate increase today’s going-in return. That’s how Buffett’s seemingly expensive investment in Coca-Cola turned out to be a steal.
Taking the analysis one step further, a company earning 25% could payout 5% today, and invest the remainder just like above. In the end, it comes down to what’s your return on invested capital and how much can you reinvest. For the investor, the additional factor is how much you pay as a multiple of the company’s underlying capital which determines your going-in return.
Your thoughts?
Clue #1: Buffett: “It isn’t a multiple of today’s earnings that’s primarily determinative of things.” … “The current multiple interacts with the reinvestment of capital and the rate at which that capital is invested to determine the attractiveness of something now.”
Clue #2: “It’s the framework but it’s not applied in the sense that we actually fill in all the variables.” Note: Video starts at 2:00.
Stay rational! —Adam
The math isn’t quite as clean as the numbers I’m using here due to the effects of compounding, but the basic notion holds. I’d rather be roughly right than precisely wrong.
hmm, a discount rate of 10% seems a bit steep? the interest given by banks on a savings account is no more than 5%
My first thought upon seeing the Viscount Rate was that it was "inflation"