Last month we started big - economic theory big. Now we’re going to look at stocks and bonds. More specifically, what are they and how do you know what they’re worth?
If you’ve never spent a Sunday watching Antiques Roadshow on PBS, your life is missing something. Especially the British version. The gist of the show is that a bunch of appraisers travel around, set up shop, and then people bring all of the stuff that has been lying around their attics for the last 25 years to see if it’s worth anything. Stocks and bonds work pretty much the exact same way, just with more of an auction house component...but before we get into that, we need to discuss something called the time value of money.
Time value of money is the idea that a sum of money is worth more today than the exact same amount in the future, due to the potential earnings of the money if you had it today. Say we were going to give you $100,000 in 10 years, guaranteed. How much would you take right this second to give up the $100,000 in 10 years? Would you take $30,000 right now, today, instead of $100,000 in 10 years? What about $50,000? $80,000? How do you even start answering that question? (As an aside, this is exactly the business model of companies like JG Wentworth - you know, the one with commercials of operatic bus riders telling you to call 8-7-7-Cash-NOW!)
Step one: objectively. You can find an FDIC-insured online savings account that pays 2.0% interest right now. If your money is just going to sit there at 2.0% then you would need to start with about $82,000 to get to $100,000 after 10 years. If you were going to invest the money in the market and thought you could get 5% returns for 10 years, then you would only need about $61,000 to have the full $100,000 after 10 years. The present day value of that future $100,000 is going to depend on what kind of returns you assume your money can get in the interim.
Step two: subjectively. This is where the art comes in to the valuation process. Maybe you could get 5% returns in the market, but you personally don’t like that kind of risk. Maybe you personally would just stick the money in a 10-year CD at the bank yielding 2.5%. If that’s the case, then you shouldn’t be willing to accept $61,000 today in exchange for $100,000 a decade from now, even though Russell Robertson, Beachcomber contributor and investor extraordinaire, might think that’s a perfectly fair offer.
Step three: Clark Gable. Because frankly, my dears, sometimes life gets in the way of the purity of the numbers and just doesn’t give a damn. Same scenario as above, and you’re going to put the money into a 10-year CD at 2.5%. Or were, until you out of nowhere got appendicitis and have a $20,000 hospital bill to pay. Might you accept $61,000 today even though that’s technically, given your personal preferences, less than the present value of $100,000 a decade from now in that scenario? Might you even accept $50,000? Yes, we daresay you might. (And that’s how JG Wentworth makes money, if you were curious).
Alright, intro to securities valuation over, class dismissed. Come back next month as we move into the real world of bonds, stocks, and central bank-induced stupidity.
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