Thursday, June 30, 2005

Summer Stroll #11 -- Do It in Your Head

While reading the comments of one of our readers, I realized that one of the problems of computing a valuation for any investment is the problem of complexity. It is virtually impossible to determine internal rate of return, compounded rate of return, or any other rate of return without a financial calculator. But using a financial calculator is sort of like turning water into wine: its water one moment, the next its wine. And the distance between understanding water and understanding wine is a million miles apart. I try to do all mathematical calculations related to rates of return in my head. It may seem too simplistic, but since the actual rate of return of any investment can only be calculated in hindsight, I think doing the numbers in my head is close enough, and it is intuitive instead of the water to wine abbra kadabra of using calculators. As we go, I will share with you the many rules of thumb methods for determining rates of return, etc., that I use. Let's start with the golden goose example. The goose was laying 20 eggs per month at $400 per egg. The goose was expected to live 5 years so the ultimate value of all the eggs is easy to determine: 20 X 400 X 60 = $480,000. The problem is a stream of income that totals $480,000 that we will receive over the next 60 months is not worth $480,000 today. A financial calculator can easily reveal that the present value of 60 $8000 payments is $417,000. But let's face it how many of us carry a financial calculator around with us. I have found that it is very helpful to possess a few rules of thumb methods to determine the present value of a future stream of income. The one I use most often is the following. In the case of the golden eggs, what is the average amount of money I will have during the 5 years? I start at $0 and end at $480,000. The average of the two is $480,000/2 = $240,000. That number is important because knowing it we can compute a rough approximation of the time value of money. To do so, we multiply the $240,000 times 6%, which we stated earlier was the cost of money. That means that the annual cost of money is $14,400. Since it will take 5 years to produce the $480,000, we multiply $14,400 by 5, or $72,000. We then subtract the $72,000, which is he total cost of money for the 5 years from the total amount we expect to receive of $480,000 and we have a rule of thumb present value of $408,000. Remember, the calculator computed that the present value was $417,000, so our short cut methodology is understating the present value, but in this case, I think it is close enough. Be sure to think through this way of determining the time value of money because in some of the forthcoming examples I am going to go over, I will use this rule of thumb, or short cut means of quickly determining present value. Have a happy Fourth of July and may the Lord bless you and your family.