“Price is what you pay; value is what you get”
A famous quote that every serious value investor knows. Here I’d like to extend this quote to cover my post today. To measure an investment performance, you have to answer to yourself three questions:
- How much price did you pay?
- How much value have you got?
- When have you got them?
You enter these data into a spreadsheet like Excel (or equivalent) and use a function called IRR (or even XIRR); then the internal rate of return of your investment will be approximated. Internal rate of return (IRR) is taught in textbooks as a project appraisal method. You may think of it as a special case of discounted cash flow (DCF) with net present value (NPV) equal to zero. Internal rate of return may appears in different names such as time-weighted rate of return, average compounded rate of return and more… This is an interesting topic that may deserve a separate post in future. However, today I’d like to simply illustrate how we apply it on common stock investment.
Suppose that eleven years ago you paid GBX 70 for a company ABC’s share and have held it till today. You collected cash dividends every year and sell your share today at GBX 187.5 (i.e. at 4% dividend yield). See the cash flow diagram below.
You enter this data in a row in Excel. Note that the last data should be the sum of dividend (GBX 7.5) and proceeds of share sold (GBX 187.5). Apply the function IRR and select all data. You will get 13.53% as an answer.
Suppose that it was not eleven but twenty-seven years ago that you paid GBX 70 for the same share and have held it till today. You collected cash dividends every year and sell your share today at GBX 937.5. See the cash flow diagram below.
Again, you enter this data in a row in Excel. Note that the last data should be the sum of dividend (GBX 37.5) and proceeds of share sold (GBX 937.5). Apply the function IRR and select all data. You will get 14.49%.
Finally, I want to tell you that it is a real stock with real dividend history. Make a guess which stock is it?
 In Warren Buffett’s Letters to Berkshire Shareholders: Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
 Correct, it is only an approximated value because there is no closed-form equation, so the program has to iterate many times in order to achieve a sufficiently accurate answer.