The Stock Price Tag being Dictated by Your Required Rate of Return

Stock Price Tag. The price a rational investor pays for a
stock would have an implied rate of return. Because the 
price one pays dictates his rate of return. Or put in another 
way, one's required rate of return dictates the fair price to pay. 
A price tag is not appraised just for the sake of it.

When someone appraises a stock and assigns a fair price tag for it, what exactly does that imply? To most of us, it's fairly intuitive: it just means that it should be bought at or below that price. Simple enough, isn't it? But let's say you are indeed able to buy it at that price, what's next? What should be the expectation?

My criticism of simply appraising a stock for the sake of it is that it loses track of why one is appraising it in the first place. My personal view is: a fair price should be appraised based on an expected rate of return. I cannot further stress the importance of this point.

A rational investor and capitalist buys a stock because first and foremost, he expects a certain rate of return from it. So yes, that is where it should all begin. A rational investor, even before buying into a stock position, should have a set required rate of return. This is the very basis of stock appraisal. Because the price one pays dictates his rate of return. Or put in another way, one's required rate of return dictates the fair price to pay.

Money-Weighted Rate of Return: It's All About Absolute, Actual Returns

This is Part 3 of a Series. Go to Part 2: Time-Weighted Rate of Return: It's All About Relative, Simple Yields

Note: The following is a letter addressing my partners which clarifies the money-weighted (MW) and time-weighted (TW) measures of performance. I would recommend that you read first the earlier letter before proceeding.

March 6, 2011

TO MY PARTNERS:

The Money-Weighted Rate of Return. This rational measure of performance tries to capture the internal rate of return (IRR) of the portfolio. It is therefore sensitive to the timing and size of cash inflows (outflows) and accurately depicts absolute returns per actual fund results.

My January 12, 2011 letter presented how my personal portfolio has yielded since its inception in 2008. My number-crunching, while honest and innocent, failed to mention two ways in which fund returns maybe measured: the money-weighted (MW) and time-weighted (TW) approaches. For everyone’s information, the 17.15% rate of return previously presented considered the time-weighted method. Through this letter, I intend to further delve into this issue of measuring performance. I cannot overemphasize the importance of this matter to the investing partner; although I have to apologize in advance should this presentation be too technical.

Essentially, TW captures this scenario: had I started the fund with a pioneer partner in 2008 and that partner did not make any deposits to and withdrawals from the fund, he should be earning a 17.15% compounded annually. In reality, however, this may often not be the case: he may be making additions or withdrawals (these can dramatically magnify his profits or losses depending on how the fund performed after the additions/withdrawals)—this is the essence of the MW approach; it captures and weighs the timing and money amounts committed for any given period and pinpoints the real absolute returns per actual fund results.