|Internal Rate of Return and the Cultural Divide of Cash Flows|
By Reid Holloway JUN 25, 2010 11:45 AM
Plus how John D. Rockefeller Jr. continues to exemplify success.
Editor's Note: To read more of Reid's content, visit the RLH Volatility Model.
When somebody asks me, “Hey, Reid, is ‘X’ a good investment?” I have but one invariable reply: “Compared to what?” Not because I’m a smart-ass (which I am), but because that’s the only answer there can ever be. That’s just the way life is. There are no absolute answers in finance, only relative ones.
If you like spreadsheets (I love them), the wide variety of financial calculations built into Excel for conducting “compared to what?” analyses is way beyond adequate for slicing and dicing the questions and comparisons to almost anyone’s satisfaction. Yet so is the H-P pocket calculator I've carried around in my pocket since the late 1970s, and that’s because the basic question encompassing a dollar parted with today weighed against an expected dollar coming back tomorrow hasn’t changed. That is, how much am I putting up (cash flow out, investment), how much am I going to get back (cash flow in, expected return), when am I going to get it (time frame), and how likely is all that to happen without an untoward hitch in the road (risk, volatility, and probabilities)?
First, get your head in the right place for thumb-nailing and ball-parking -- the orientation you should always establish prior to booting up the computer -- and understand Present Value (PV), Future Value (FV), cash-flow sign convention (“-” for “out” and “+” for “in”), time (t), and Internal Rate of Return (IRR).
What are we trying to get our arms around when we size up an investment? That, of course, depends on the kind of investor (e.g., passive or active, net worth, risk type, and tolerance), the general category of the investment (e.g., real estate, stocks, bonds, direct), and the time horizon and what you’re trying to accomplish (e.g., income, capital appreciation, liquidity concerns). There’s as much art as science in identifying and putting measuring sticks to work on these criteria, and then, naturally, there’s also a need for some kind of universal benchmark against which to compare and contrast the resulting evaluation.
This is what Internal Rate of Return calculations are intended to facilitate.
The Cultural Divide
The greatest psychological difficulty most passive investors bring to the table is not having experienced what it is to start, and run, a business. As with being a parent and raising kids, there’s no way anybody knows what it is to make payroll until they’ve done it. The knowledge only comes with experience. Most investors are passive. They look at buying a stock or bond as a kind of “deferred-gratification ATM,” a mindset that says, “I’ve worked hard, I’ve kept my spending under control, I have something to put away, and I’m doing that with the expectation that I’ll be rewarded for my good behavior down the road when I draw it out for retirement, a kid’s college tuition, or some other long-term goal.” Play it straight now, live it up later -- the bedrock of good middle-class values.
A lot of very wise folks will tell you that those values have carried the day for this country and the greater part of Western civilization and elsewhere for a long, long time -- having more to do with securing for us peace and prosperity than great leaders or strong militaries or just about anything else. People keeping regular hours and good habits, getting up in the morning, going to work, doing their jobs, saving, and investing a portion of their earnings on a regular timetable; being good citizens.
Problem is, the business of capitalism isn’t like that at all. For the most part, the great capitalists of history -- the people who have come up with the great, world-beating ideas, fought off the doubts of the naysayers (“Are you kidding? That’ll never work!”), hung in there when nobody was on their side, then realized their vision and capitalized on it all the way to the point of great riches -- have been anything but normal good citizens abiding by the virtues of moderation and consistency in their daily lives. Indeed, I’d even go so far to say it’s amazing most of them didn’t wind up in the mental wards in straitjackets, and some of them have even done that. I sometimes wonder if among today’s lunatic-asylum residents there aren’t cures for cancer, solutions to the Gulf oil spill, and myriad other miracles trapped in the addled brains of the dispossessed and misfits society’s conventions can’t and won’t tolerate as members of the mainstream.
And that’s whom you’re betting on when you contemplate an investment.
About the only concept in finance that’s ever come close to capturing the essence of this insane lifestyle inherent in the people who create wealth and the enterprises they’ve built in which we contemplate investing is “uneven cash flows.” This is a prosaic way of saying that most successful enterprises come about because the people behind them are so fanatically driven -- so unswervingly committed to going up against the grain of values held out to us as the foundations of successful existence according to those who impart the examples of what is “normal” -- their vision can’t be defeated by everything around them telling them they’re crazy. Indeed, being perceived that way almost seems to be their badge of honor, spurring them on all the more to rage against the machine.
Investing Is Really About Putting a Nutcase’s Insanity and Rebellion to Work for You
Unconventional people often appear to be quite conventional, especially dressed in suits and ties, and mingle with conventional people without upsetting the social apple cart all the time. You might say they hide in plain sight. Their lives behold some of the great wonders of business -- nay, human -- history.
Consider the case of John D. Rockefeller Jr., and try hard to imagine what it was like to be that man. If you’re reading this piece in some obscure cubicle that happens to be in an ordinary office building on that island known as Manhattan, cast off your current bad attitude -- you: “Ah, crap, it’s another boring day at the office doing a job I’m not thrilled with” -- grab a nice greasy falafel from your favorite pushcart vendor, and take a lunchtime stroll with me over to Rockefeller Plaza. Unless you're a hardened shell of epoxy, an unmistakable yet indescribable feeling will come over you.
- I believe in the supreme worth of the individual and in his right to life, liberty, and the pursuit of happiness.
- I believe that every right implies a responsibility; every opportunity, an obligation; every possession, a duty.
- I believe that the law was made for man and not man for the law; that government is the servant of the people and not their master.
- I believe in the dignity of labor, whether with head or hand; that the world owes no man a living but that it owes every man an opportunity to make a living.
- I believe that thrift is essential to well-ordered living and that economy is a prime requisite of a sound financial structure, whether in government, business, or personal affairs.
- I believe that truth and justice are fundamental to an enduring social order.
- I believe in the sacredness of a promise, that a man’s word should be as good as his bond; that character -- not wealth or power or position -- is of supreme worth.
- I believe that the rendering of useful service is the common duty of mankind and that only in the purifying fire of sacrifice is the dross of selfishness consumed and the greatness of the human soul set free.
- I believe in an all-wise and all-loving God, named by whatever name, and that the individual’s highest fulfillment, greatest happiness, and widest usefulness are to be found in living in harmony with His will.
- I believe that love is the greatest thing in the world; that it alone can overcome hate; that right can and will triumph over might.
At Last, Here’s an Example of an Analysis of Uneven Cash Flows
Am I attempting to say these are the driving beliefs of all capitalists shaping the great enterprises you need to look for when investing? Hardly. I’m saying they were the deepest beliefs of just one such man who did some of the most amazing things free enterprise, and philanthropy made possible through enormous wealth created by free enterprise, have ever produced, and that the organization(s) he built made a lot of ordinary people who led ordinary lives and saved and invested in ordinary ways a lot more comfortable in their post-career lives than they otherwise might have been.
Great capitalists -- and some lesser noticed ones, I'm also quite sure -- are nutcases who shun ordinary lives, and that’s why we need to know how to analyze uneven cash flows, what happens while young entrepreneurs are hanging in there through thick and thin before they’re out of the woods: the reality of yet-to-be-great enterprises when they’re in their formative years.