Predicting the Future

Predicted annual compounding rate of return

In other words - predicting the future (In a reliable way).
The title pretty much sums it up. We need to be able to predict the future in a reliable way. Now let me tell you a story. I have little idea about maths, really, I don't deal with maths on daily basis so what I will say now might be utter nonsense. Still to me it seems reasonable. By the way, neither do I play darts (yes, this is relevant to the story). Once I went out to a PUB with a couple of friends and everyone started to play darts I joined and tried to win, being the competitive person that I am. Now, try as I might nothing would come of my effort to beat the experts. So I started strategising and picking only portions of the board which had the most points in 3 triangles. Could not hit the right triangles either, which made me miss the board. Finally, I got an Idea, Let's just stop trying to hit any particular number and just start throwing randomly at the board! In this way, I would every time hit at least around 30 points on average, since triangles are numbered from 1 to 20, so in the long run I would get around 3X 10 on average i.e. 30? How did a fare with such a logic, Yup you guessed it I started winning while everyone was trying to hit the big numbers and ended up missing the board pretty often. I just hit my sure numbers 28, 17, 45, 31... you get the Idea.

The same thing apples to Buffett's method of picking sure stocks / bond proxies / equity bonds / consumer monopolies you name it. He just picks them up when they are cheap and keeps them while they work for him. They all grow nicely and the returns keep on compounding.

The thing is that it IS possible to predict with reasonable probability the growth of decent and reliable companies! No so much the case with lousy companies with random earnings - we avoid those.

When the projected annual compounding rate of return starts to look attractive due to the fall of the company's price - we buy the stock. The falling price might be caused by a news event, a bad year, or a depression. These news events do happen. I experienced them. From now on you will also know how to profit from them. Just make sure you buy the right stock.

We need to be sure of the earnings potential of the company.

The Intrinsic Value - our magic price that determines if the company is a buy or not constitutes the company's future earnings discounted to the present date. We also compare that price to the treasury bonds - they are our measuring stick.

Buffett projects the future per share equity value ten years in the future using the return on equity the company had thus far as well as deducting from it the dividend payout rate.

At this point we can do to several things (points from a to f sound a bit technical, dont get too hung up on it, they are by no means crucial - everything will be clear as you read on):

a) approximate the shareholder's equity value in ten years time (calculating future shareholder's equity value)
b) multiply the per share equity value by projected rate of return ten years out (calculating future per share equity value)
c) we can project future per share earnings
d) then using this number we project future trading value of the stock
e) the current price is the present value (PV) we calculate the estimated annual compounding rate of return
f) we compare the compounding annual rate of return with investments having similar risk profile (bonds)

What we can also see, in the way described below, how to determine if we want to buy Berkshire at the current price. Berkshire Hathaway had shareholder's equity of 2,073 USD in 1986. Return of shareholder's equity was 23,3%
We want to project the per share shareholder's equity in 2000.
We can click at the calculator links I provided, or use TI calculator, which we switch to financial mode.
PV- 2,073 then N - number of years 14, then % - 23,3% and we find the FV of 38,911 USD

What we need to do now is to think how much we want to pay in the future for 38,911 USD.
Well, let's say we want to have a desired rate of return like Warren Buffett i.e. 15%. So we need to figure out how much should the company be worth now, if it grew at that 15% rate.
We do the calculator clicking - FV is 38,911, rate is 15%, number of years 14, we calculate the PV drum roll...and we get 5,499 USD a share. So if in 1986 Berkshire cost more than 2000 USD, then it is far less than 5,499! We buy that stock! Moreover if we buy it for 2000 or so, we get a much higher rate of return on our invested money = and that's what we are after!

Lets do another exercise, in 1999 Berhshire had per share equity value of 37,000 and was growing at an annual compounding rate of return of 23%. Now we can project the future per share equity value in ten years time i.e. 293,260 USD. In 1999 Berkshire's highest price was 81,000 USD, you could buy it far cheaper at its low of 50,000. But even if you bought it for that high price you're annual compounding rate of return would be 13,7%, If you bought it at its low for 50,000 you would get 25% of annual growth. Now you can see the magic of cheap buying at work.

Even if in the 10 year period the stock market crushes, it will more than recover in the appropriate amount of time and the company will be valued at its proper price.