Before you invest, you have to ask yourself three questions:
- How much value would you expect to get?
- When would you expect to get them?
- How much price should you pay now?
Average investors focus very much on guessing answers to question 1) & 2); and they do not pay much attention to 3) which, in my opinion, is at least as important as 1) & 2) combined. These three questions define the expected average compounded rate of return of your investment. So, if you do not have any idea how much you should pay for an investment, it is equivalent to say that you do not know how much rate of return you expect to get. Consider the cash flow diagram below.
Imagine, you have done some research and come to conclusion on the estimated future cash dividends of your stock investment and estimated selling price after 11 years holding. You may 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. You may do sensitivity experiment by changing the first cash outflow (price you pay) from 70 to, say, 50. The rate of return increases from 13.53% to 17.86%. It’s a 4.33% significant gain! I want to emphasize that you could not ignore the importance of the purchase price when you make investment decision.
What is certain in an investment?
Yes, there is one thing certain in your investment:
The price you pay
Once you pay for an investment, the price will not change. And even you can control the maximum price you pay for it! Yet, it is interesting to observe that many investors, including myself sometimes, rather pay much more attention to future cash inflows which are uncertain and uncontrollable. Is there any behavioral explanation behind it? Human being is keen to predict the future?