It’s possible to compound your money at 15% from a business that is only growing at 3% per annum. How? First, you’d have to pay a price that is less than its intrinsic value; that is, the net present value of all future cash flows discounted at an appropriate rate – usually the long-term U.S. Treasury bond plus an
inflation kicker. Second, management would have to pay out large
dividends or undertake substantial
share repurchases. For a stock trading at 10x earnings, this would increase
earnings per share (EPS) by 10% plus the organic growth of 3%, leaving the investor compounding at roughly 13%. Of course, the ride is going to bumpy and it won’t at all look like a gradual upward slope. But if your analysis is correct, your results are likely to be good.
The inverse is also true; were you to buy a company growing at 25% per annum for 100x earnings, it’s highly unlikely that you would do as well. Not only is there an enormous risk of a single glitch in execution destroying much of the stock’s value, but also you are relying on a hope and a prayer for things to work out satisfactorily. True investing is about banking on things that are likely to work out in your favor, even if everything doesn’t go according to plan – which it rarely will.
