No. of Recommendations: 0

Tom, Paco
I always find it useful to put numbers to things so please bear with me. I think you will find
the results fairly interesting.
Lets suppose I buy a stock at $100 and the next day (this frequently happens to me) it drops
to $50. Let's assume that the intrinsic value of the stock was in fact $50 and from there it
grew at a compound rate of 30 percent each year for the next 10 years.
After 5 years it would be worth $50 times ((1 + .3) to the power of 5), which I work out
to be $186.
But I paid $100 for the stock so my return will be ((186/100 to the one fifth power) minus 1),
which I calculate to be 13 percent. Some of you might want to double check
my equations and math.
Similarly, you can work out what the returns would be after 5 and 10 years, if you bought
in at $100, $75 and $50, assuming that the intrinsic value was $50 and the stock
compounded at an annual rate of 30 percent from that base price.
Here are the results of my calculations:
Return if I bought
Stock In At In At In At
Price $100 $75 $50
After 5 years $186 13% 20% 30%
After 10 years $689 21% 25% 30%
For example, after 5 years, the $50 dollar stock would be worth $189 if it grew 30%
per year. If I paid $75 for the stock and it then dropped to $50, my return, if I hung on for
5 years would be 20%. And if I hung on for 10 years the stock would be worth $689
and my compound return it would be 25%.
That's not too bad. It supports Tom's argument that even if the price drops 50 percent
the day after you buy it, provided the stock continues to grow at a healthy rate for the next
5 to 10 years, you can still expect a reasonable return.
Now let's see what happens if the company stock price only grows at 10 percent per year
for the next 10 years. (It unfortunately turned out be a Tier Four stock instead of a Tier One
stock, because there was a widespread and completely unexpected grassroots rebellion
against using the internet).
Return if I bought
Stock In At In At In At
Price $100 $75 $50
After 5 years $ 81 -4% 2% 10%
After 10 years $130 +3% 6% 10%
These are not the kind of results which warm a Foolish heart, but on the other hand, it is not
a complete disaster. For example, if instead of buying the stock you had put your money in
T-Bills, you would have achieved about the same returns.
These theoretical calculations indicate that unless that stock is way over-valued, and
provided you have the confidence to withstand that first day's gut wrenching loss, you
will still be OK, provided the company continues to grow at an above average rate and you
hang on for the long term.
The calculations show, however, that if you really want to be successful, you should try and
make the best possible estimate of the intrinsic or base value of the stock, its expected rate
of growth off that base value, and the period of time over which you expect that rate
of growth to continue.
Gentlemen you are both excellent debaters and I look forward to any comments you have.
Tom – I know you are very busy these days, so don't feel you have to reply.
However, if you are riding along in your limo some day and you pass Paco and I selling pencils
in the street, I hope you won't stop, roll down the tinted window and
shout “I told you so, but you Fools just would not listen!”.
What do you say Paco – ready to lay down some hard cash on Cisco? :>)
A Calculating Fool!
Bruce Smith