Businessman Investor

Touching base with the rational business psyche of stock market investors

Wednesday, September 14, 2011

On Realizing Gains, Compounding Value, and Equity Perpetuity

This is Part 2 of a Series. Go to Part 1: On Price, Value, Value Investors, and Equity Perpetuity

The following are excerpts from a discourse I had with a fellow investor with regards to realizing gains, compounding value, and equity perpetuity. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Realizing profits versus compounding value. On one hand, the impulse and instant gratification of realizing profits ironically brings you back to that burden of finding another bargain; on the other, you may have just held onto that stock and let compounding do its magic.
On realizing profits: If the intention is to compound value and amass net worth (i.e. to be rich), then you wouldn't worry about not realizing capital gains. That's the irony in selling stocks—on one hand, by impulse, you just want to realize your paper profits. Realizing your capital gains, however, would again bring you back to that burdening position of finding another bargain (and exposes you to taxes) if you intend to reinvest and further create value. On the other, you may have just indefinitely held onto that stock as long as the underlying business takes care of itself (which in turn takes care of the price). And what is easier and which I personally prefer is the latter case wherein you let the value compound within the business, i.e. that's why I prefer non-paying dividend companies able to retain earnings and compound them at sustainable high rates than businesses paying out all their earnings in dividends (which again exposes you to taxes) at the expense of growth.

On stocks being perpetuity annuities: I'm not saying stocks are exactly perpetuities. They are only similar to perpetuities with regards to the indefiniteness of their existence/expiration. Stocks with underlying excellent businesses can be likened to perpetuities in that they are indefinite and that they shall be producing earnings/cash profits year after year. Just think of businesses you know will not be closing anytime soon (or you know will be there even decades from now).

Again, from a value investor's point of view, earnings/cash profits need not be disbursed as cash dividends to consummate/experience or receive value—the owner mentality is always conscious on the level of the business and that's the sort of paradigm value investors try to psyche themselves into. If you start accepting that, you'll realize the relevance and applicability of the perpetuity formula in stock valuation even of businesses that don't pay out cash dividends.

But let me stress too: I am not saying that the fair value of a stock is exactly that of a perpetuity. What I am saying is: the value of a stock, if valuated using the perpetuity formula, is actually understated (because, as I've been saying this over and over again, stocks with excellent businesses actually grow their cash profits when perpetuities do not—they have flat payments forever). Thus, I only use and take advantage of the perpetuity formula to conservatively estimate a deep discount price to pay (or at least some safe baseline price figure) which would warrant capital preservation and some rational potency of earnings.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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