The Big Secret for the Small Investor

Chapter Two

I was having a bad week. In no particular order: I dropped out of law school (understandably, my parents weren't too thrilled), broke up with my girlfriend (okay, she broke up with me, but at the time I had no idea that was actually a good thing), locked my keys in the car—twice (once in the ignition with the engine still running and once in the trunk at 11 p.m. after a Yankees game in the Bronx—and as you probably know, everybody's a 24-hour locksmith but no one really works those 24 hours all in a row), and finally, went through a toll booth with no money (after a few eye rolls and since Guantánamo was not yet taking prisoners, they let me mail it in, with the stamp costing more than the actual toll).

Luckily, the true value of a life cannot be summed up by a single bad week or even a series of bad months but by the total of everything we do and accomplish over a period of many years. I bring this up not to relive the glory days of my youth (such as they were) but because if you want to learn how to be a good investor, you're going to have to have a good understanding of the concept of “value”—what it is and where it comes from. This is pretty important because the secret to successful investing is fairly simple: first figure out the value of something—and then pay a lot less. I'll repeat that: the secret to successful investing is to figure out the value of something—and then pay a lot less.

Benjamin Graham, the acknowledged father of security analysis, called this “investing with a margin of safety.” The larger the space between current price and calculated value, the larger our margin of safety. Graham figured that if unexpected events lower the value of our purchase or our initial valuation is mistakenly high, buying with a large margin of safety will still protect us from big losses.

That's all fine, but what is “value” and where does it come from? The corner candy store might have a great location and a booming business, and at a price of $150,000 that business might be a great investment. But buy that same candy store for $50 million, same great location, same booming business, and you've pretty much guaranteed yourself a terrible investment (and created a whole mystery about how you got the $50 mil in the first place). In short, if we invest without understanding the value of what we're buying, we'll have little chance of making an intelligent investment.

In the same way that one lousy week didn't end up defining the value of my entire life, it turns out that the value of a business doesn't have that much to do with what happens each week or each month. Rather, the value of a business comes from how much that business can earn over its entire lifetime. That can often mean many years (and by many, I mean twenty, thirty, or even more—we can't just be thinking about earnings over the next two or three). While figuring out the earnings of a business over the next thirty-plus years might sound like a pretty hard thing to do, we're going to try to do it anyway. We'll start with a simple example, and by chapter's end, we should have a pretty good understanding of how this whole value thing is supposed to work. (And once we start to understand value, there's no telling what we can accomplish in the rest of the book!)

We'll even assume for the purposes of our simple example that we know (somehow) ahead of time what the earnings of our business will be over the next thirty years and beyond. To make it even simpler, we'll assume that the business in question, Candy's Candies, will earn $10,000 each year for the next thirty-plus years. So let's see what happens.

Intuitively, we know that collecting $10,000 each year for the next thirty years is not the same as receiving all $300,000 today. If we had that $300,000 right now, one easy thing we could do is to put it in the bank and then earn some interest on our deposit. The bank could take our money, pay us a few percent each year in interest, and then lend that money out to other people or businesses and collect a higher interest rate than they pay us. Everybody wins. By the time thirty years go by, we'd have a lot more than the original $300,000 from all the interest we collected. But, of course, Candy's Candies only earns $10,000 each year, and we'll have to wait thirty years to collect all $300,000. So let's break it down and see what thirty-plus years of earning $10,000 per year are really worth to us today.1

Let's assume for the sake of simplicity that we are the proud owners of Candy's Candies, that we collect all of our earnings at the end of each year, and that a bank will pay us 6 percent each year on any deposits that we make. So let's start by figuring out the value today of collecting that first $10,000 in profits from our new business at the end of the first year and then we'll go from there.

We know that collecting $10,000 a year from now is not the same as having that $10,000 today. If we had the $10,000 right now, we could put it in the bank and earn 6 percent interest. At the end of the first year, we'd have $10,600, not merely $10,000. So the $10,000 we collect a year from now is worth less than $10,000 in our hands today. How much less? Pretty much the 6 percent less that we didn't get to earn in interest. The math looks like this: $10,000 one year from now discounted by the 6 percent we didn't get to earn is $10,000 ÷ 1.06, which equals $9,434. (Another way to look at it: if you had $9,434 today and deposited it in the bank at 6 percent, you would have $10,000 at the end of one year.)

So the value of our first year's earnings from Candy's Candies is worth $9,434 to us in today's dollars. How about the second year's earnings? What are those worth to us in today's dollars? Well, two years from now, we will be collecting another $10,000 in profits from our ownership of our candy business. What is $10,000 that we won't receive for two years worth today? Well, it works out to $8,900 ($10,000 ÷ 1.062). If we had $8,900 today and deposited it in the bank at 6 percent, we would have $10,000 by the end of the second year. And so the value today of our first two years of earnings from Candy's Candies is $9,434 + $8,900, or $18,334. (This is getting really exciting!)

I won't go through the next twenty-eight-plus years, but the exercise looks something like this:

So earning $10,000 a year for the next thirty-plus years turns out to be worth about $166,667 today. Using these simple assumptions, we just figured out something incredibly important. Candy's Candies, a business guaranteed to earn us $10,000 each year for the next thirty-plus years or so, is worth the same as having $166,667 cash in our pocket today! Now, here's the hard part. If we could be guaranteed that all of our assumptions were correct and someone offered to sell us Candy's Candies for $80,000, should we do it?

Well, here's another way to ask the same question. If someone offered to give us $166,667 right now in exchange for $80,000, should we do it? Given all of our assumptions, the answer is easy: of course we should do it! This is an incredibly important concept. If we can really figure out the value of a business like Candy's Candies, investing becomes very simple! Remember, the secret to successful investing is to figure out the value of something and then—pay a lot less! In fact, it couldn't be simpler: $166,667 is a lot more than $80,000—case closed.

Of course, there's one little problem. I made the “figuring out the value of something” part a bit too easy. How? Let me count the ways.

Remember, I told you ahead of time what the earnings of Candy's Candies were going to be each year for the next thirty-plus years. But will earnings actually shrink over those years? Will they grow? Will Candy's Candies even be around in another thirty years? In practice, predicting so far into the future is pretty hard to do. In addition, many businesses are actually more complicated than the corner candy store. In fact, forget thirty years—it turns out that Wall Street analysts are actually pretty bad at predicting earnings for even the next quarter or the next year. Are you really going to trust my predictions about what earnings will be over the next thirty years? (Remember, I can't remember the keys or the toll money, and I'm not even a lawyer!)

So here's the problem. Since no one really knows for sure what earnings will be over the next thirty-plus years, whatever we use for estimated earnings during that time is just going to be a guess. Even if this guess is made by a very smart, informed “expert,” it will still be a guess. There will always be a chance that this guess is off, sometimes by a lot. So when we figure out the value of our business, we're going to have to assume that there is risk to our...