Monday, June 06, 2005

Summer Stroll #7 -- Of Golden Eggs and Geese

Did you every stop to think what the goose that was laying the golden eggs was worth before the farmer killed it? Remember in the folk tale, the goose was laying one egg per day of fine, pure gold. The greedy farmer wanted more than one egg per day, so he killed the goose and opened her up expecting to see a belly full of gold. But on the inside the goose was just like all geese: there were no eggs, and the farmer's foolishness has lived on in infamy. We consider many of our Rising Dividend companies to be similar to the goose in their abilities to produce golden eggs in the form of earnings and dividends growth. Having learned from the farmer's folly, we are content to take the eggs as they come. We consider ourselves to be in the business of collecting the golden eggs. We are not about to kill the goose to see if we can squeeze out a few more eggs. We think the goose is doing just fine. Furthermore, we do not jump from goose to goose trying to pick up an extra egg here and there. We have studied the ways of the goose we own, and we think she is the real thing. If we were in the business of trading geese, the next goose, or the one after that might be a turkey that is painting her eggs, and we would lose all that we have gained. We work hard at valuing the goose's future stream of golden eggs. The market for golden eggs comes and goes, and every once in awhile a fool, on the order of the farmer, comes along who thinks he can squeeze more eggs out of the goose; and he is willing to pay us far more for the goose than our calculations say she is worth. This is the great benefit of being in the golden egg business instead of the goose trading business. It is relatively easy to calculate the present value of the eggs over the remainder of the goose's life, while it is very difficult to figure out what the goose is worth based on its color, size, type, or beauty. In these matters of style, our guess is no better than anyone else's. But when it comes to valuing the future stream of golden eggs, we have that down to a science. Let's say the average goose lays 20 eggs per month and produces eggs for 5 years. Each egg weighs about one ounce and gold is selling for about $400 per ounce. Figuring what the goose will be worth over its expected life is easy. It is just the number of eggs per month (20) times the price of gold ($400) times the number of months the goose will lay eggs (60) = $480,000. But things get a little tougher when we realize that it will take us 5 years to produce the $480,000, and to calculate a present value, we need to take into consideration the time value of money. We all know that a dollar we get today is worth more to us that a dollar we will receive 5 years from now because if we get the dollar today, we can invest it, and in 5 years it will be worth much more than one dollar. Because of this, we must discount the $480,000 that we expect to receive by some appropriate interest rate. Let's use 6%. The present value of a monthly stream of gold over the next 5 years totally $480,000 is approimately $417,000. The market for geese can careen all over the place but we don't care because we know what our goose is worth on the basis of the stream of golden eggs. There are only about three things that can affect the value of the stream of eggs: 1. the health of the goose, 2. the price of gold, and 3. the interest rate we are using to discount the future stream of income. Certainly one or all of these things will change, but as they do, we will just change our formula and recalculate the present value of the golden eggs. But, there is a guy in the yard, who say he wants to make an offer on our goose. We'll see what he has to say next time.