Thursday, October 7, 2010

Opportunity cost, it’s all about the returns (Internal rate of return)

We all want to invest our money where we can earn the best possible risk-adjusted returns. Before making a decision on whether or not to buy a stock, an investor should know the opportunity cost of investing his/her money in that stock. One method to help investors look at their opportunity costs is to compare the internal rate of return of the stock to the long-term return of stocks in general (From 1989 to 2009, the compounded annual growth rate of the S&P 500 was 9.26%. You can find out the historical returns of the S&P 500 here) or against the internal rate of return of another stock that you might consider investing in.

The internal rate of return or IRR is the discount rate needed to make net present value equal zero. All other things being equal, the more attractive investment should be the one with the higher IRR.  To find the IRR for a stock, I use the market cap of the stock as the cash outflow, and the expected owner earnings for the next 20 years (what I believe is the minimum timeframe for value investing) as the cash inflows. I then find the discount rate or the IRR that will make the net present value equal to zero.

I wrote about owner earnings in a previous article. You can check it out here, just scroll to the owner earnings part of the article. You can also use the calculator provided in this website to help you find the IRR of an investment opportunity.  

Some people consider the expected value of their investment or the expected market cap of the company at year x as a cash inflow with the rationale that they might be selling the stock then, but I prefer not to do so as I believe that a great investment should be held forever.

If the investor is trying to decide whether or not to invest in a stock, the investor can generally invest in the stock if its IRR is higher than the long-term return of the average stock.

Things get a little bit more complicated when an investor is trying to decide between 2 stocks as to which stock will make the better investment. True, all else being equal, the investor should choose the stock with the higher IRR, but since actual returns can be different from the IRR, the investor should also take into account things like growth, balance sheet strength, and competitive advantage, as these factors will affect how close the actual rate of return of the stock is to the IRR (these factors can also cause the stock to generate returns that are better than its IRR!).  

If you have any questions, or have anything that you would like to share, please don’t hesitate to comment. Thank you for reading, and may you always sustain good returns on your portfolio.