# investing

Payback Theory Jonathan Poland

Let’s say you live in a town with two bakeries for sale at \$1 million each. Both offer similar products with almost exactly the same type of customer and asset structure — one earns \$100,000, the other \$150,000.

Which one do you buy?

The one that makes more money! That one has the highest yield, which in this case is the second bakery. In fact, if these numbers held up, bakery number two would pay you back in less than 7 years, a full 3 years ahead of the first one. All things being equal, this is an easy calculation. All things are rarely so cut and dry.

To know whether an asset is worth buying, you have to know the profit it generates compared to the price you’re paying, otherwise you’re simply speculating on whether or not you can sell it at a later date for a higher price. Not all art or Jordan sneakers fetch higher prices.

For example, if you buy a house for \$500,000 and lease it for \$2,500 a month, the annual yield before expenses is 6%. For private businesses its the profit for the price you paid. However, in the public markets, companies listed on big exchanges like the NYSE or NASDAQ tend to remain in business a lot longer and are thus valued at higher multiples of earnings. This means looking for growth potential at a fair or discounted market price.

Very rarely will investors acquire shares in an excellent growth company at prices where payback periods are apparent. These companies must grow into the high yield prices. An example from the world’s most valuable company, as of 2023.

2008
Apple (AAPL)

Value: \$76 billion
Profit: \$6.1 billion
Yield: 8.0%

2018
Apple (AAPL)

Value: \$1.01 trillion
Profit: \$56 billion
Yield: 73.9% on 2008

#### Payback Period

The payback period is the length of time it takes for an investment to recoup its initial cost and start generating a profit. It is typically measured in months or years and is calculated by dividing the initial cost of the investment by the expected cash flows. The payback period is used to evaluate an investment and compare it to other potential investments or strategies based on their projected returns. It is calculated by discounting future cash flows to their net present value and comparing them to the initial cost of the investment. The shorter the payback period, the quicker the investment is expected to start generating a return.

The payback period is a financial measure used to evaluate the feasibility of an investment. It is the length of time it takes for an investment to recoup its initial cost and start generating a profit.

To calculate the payback period, the initial cost of the investment is divided by the expected cash flows. For example, if an investment has an initial cost of \$100,000 and is expected to generate annual cash flows of \$20,000, the payback period would be five years (\$100,000 / \$20,000 = 5).

The payback period is often used to compare different investments or strategies based on their projected returns. A shorter payback period is generally considered more favorable, as it indicates that the investment is expected to start generating a return more quickly.

However, it is important to note that the payback period does not take into account the time value of money, which means that it does not consider the fact that money has a different value over time. For this reason, the payback period is often used in conjunction with other financial measures, such as the internal rate of return (IRR) or the net present value (NPV), which do consider the time value of money.

In conclusion, the payback period is a useful tool for evaluating the potential of an investment by considering the length of time it takes for the investment to start generating a profit. It is important to consider the payback period in conjunction with other financial measures to get a complete picture of an investment’s potential returns.

More Examples

• An investor buys a rental property for \$200,000, and the property generates \$1,000 in monthly rental income. The payback period for this investment would be 200,000 / 1,000 = 200 months, or approximately 16.7 years.
• A company invests \$500,000 in a new manufacturing plant, and the plant generates an additional \$100,000 in annual profits. The payback period for this investment would be 500,000 / 100,000 = 5 years.
• An individual invests \$10,000 in a new business venture, and the business generates \$1,500 in monthly profits. The payback period for this investment would be 10,000 / 1,500 = 6.7 months.

#### Risk-Reward Ratio

Crucial to the payback theory is the risk-reward ratio is a measure that compares the potential for losses to the potential for gains for a particular action. Risk management aims to optimize this ratio, taking into account an organization’s risk tolerance, rather than necessarily eliminating all risk. The goal is often to minimize the risk relative to the potential reward. The following are a few examples of a risk/reward ratio.

Investing

Based on a proprietary estimation, an investor guesses that the S&P 500 has equal chance of going up 20% or going down 5% in the next year. The investor sees the risk/reward of 1:4 as attractive and buys into the index.

Product Development

An electronics company is considering launching a line of 3D printers. The development costs are significant and the company estimates there is an equal change of net income of \$3 billion or a net loss of \$2 billion from the product within the first 5 years. The company views the risk reward of 2:3 as unattractive and decides not to develop 3d printers.

Marketing

A luxury hotel is considering changing their pricing strategy to add a resort fee of \$33 a day. They know that such fees are unpopular and the hotel has recently experienced declining ratings on popular travel review sites. They calculate that the price change will generate revenues of \$1 million dollars but that there is a 50% chance of a customer backlash that will cost \$12 million dollars in lost revenue due to a lower occupancy rate. The resulting risk/reward ratio is 6:1 meaning that the price increase is a risky proposition that’s unlikely to payback.

Types of Risk/Reward Ratio

The risk-reward ratio is a simple mathematical equation: risk / reward that can be used to evaluate strategies, tactical actions and processes for their potential payback. For simplicity, the ratio is often expressed as gains and losses that are estimated to have equal probability. More accurate methods model risk as a risk matrix or probability distribution.

Durable Competitive Advantage Jonathan Poland

The most important aspect of durability is market fit. Unique super simple products or services that does change much if at all over time and that do not need continuous investment to stay relevant are always better than the opposite. In some industries this is impossible to do. How to spot these kind of businesses? Here are some core traits to look out for.

One.
Check the following strategic metrics against your industry or sector to see whether or not you have a competitive advantage.

• Sell a product or a service that is a basic necessity
• Be the first capture a lot of market share
• Operate in a large industry with little competition
• Sell a unique product that doesn’t change much
• Provides a unique service that’s difficult to replicate
• Be the low cost producer and/or seller of basic necessities

Two.
Check the following financial metrics against your industry or sector to see whether or not you have a competitive advantage.

• High Margins
• Low R&D Costs
• Accumulation of cash
• Consistent Growth in Sales
• Consistent Growth in Earnings
• Inventory rising with revenue
• Low to No Debt
• Retained Earnings Growth
• Book Value (Equity) Growth

Three.
When a business has a competitive advantage, their valuations are higher. Here are the factors used in that valuation.

• Weighted forecasts of growth in company revenue
• Weighted forecasts of growth in company margin
• Patterns of cash returned to shareholders
• Changes in the company’s debt-to-equity ratio
• The economic conditions in the company’s industry
• Market volatility in the geographic areas in which the industry’s major companies compete

#### How?

There are several ways companies can create durable competitive advantages:

Innovation:
A company that consistently develops innovative products or services that consumers want can gain a competitive advantage. Apple, for example, gained a competitive advantage through the continual development and improvement of products like the iPhone, iPad, and MacBook.

A company can gain a competitive advantage by becoming the lowest cost producer in its industry. By leveraging economies of scale, efficient operations, or lower raw material costs, it can offer goods at lower prices, thereby attracting cost-sensitive customers. Walmart is an example of a company that uses cost leadership as a strategy.

Differentiation:
Companies can also create a competitive advantage by offering a unique product or service that competitors cannot easily replicate. Differentiation can be based on design, brand, technology, customer service, or other features that add value for customers. An example of this strategy is Tesla with their electric cars and superior battery technology.

Strong Brand and Reputation:
A strong brand can provide a significant competitive advantage. Brands like Coca-Cola, Nike, and Google have a strong brand reputation which provides a competitive advantage. The power of their brands gives these companies the ability to charge higher prices for their products and services and ensures customer loyalty.

Switching Costs:
High switching costs can also provide a competitive advantage. If it’s costly, time-consuming, or inconvenient for customers to switch to a competitor’s product, a company can maintain a competitive advantage. Software companies that offer cloud-based services often have high switching costs. For example, it would be a significant undertaking for a company to switch all its operations from Microsoft Office 365 to a different productivity suite.

Network Effects:
Network effects occur when a company’s product or service becomes more valuable as more people use it. This can create a significant barrier to entry and a competitive advantage. Facebook and other social media companies are prime examples of firms that benefit from network effects.

If a company has privileged access to key distribution channels, it can prevent or make it harder for competitors to reach the same customers, thus establishing a competitive advantage.

Patents and Intellectual Property (IP):
Companies can also build a competitive advantage by owning patents, trademarks, copyrights, or trade secrets that prevent others from copying their products or services. Whether protected by law or secret sauce (i.e. Coca-cola), this can help brand the business as it puts a stamp of exclusivity on it. Of course, legal protection doesn’t mean what you do is relevant or necessary to the market. Many companies have trademarks, copyrights, and patents even at the small business level, which never amount to competitive advantage.

It’s important to note that the success of these strategies often depends on a company’s ability to execute effectively, and each approach comes with its own set of challenges and risks. A sustainable competitive advantage requires ongoing efforts to maintain and build upon these strategies over time.

The Power of Compound Interest Jonathan Poland

Traditional finance will explain compound interest as the interest paid on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. However, it is also the rate of return on an investment like a stock or real estate purchase.

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When interest is compounded on an investment, the interest earned in one period is added to the principal, so that the interest earned in the next period is based on a larger amount. The more frequently interest is compounded, the greater the amount of interest earned over a given period of time. For example, if an investment earns an annual interest rate of 5%, the interest earned in the first year is \$50 on a \$1,000 deposit. If interest is compounded annually, the deposit will be worth \$1,050 at the end of the first year. If interest is compounded semi-annually, the deposit will be worth \$1,025 after six months and \$1,051.25 after one year.

Historically, home ownership has produced around 5% a year while the S&P 500 has generated around 10%. Over time, that 5% difference per year adds up to an incredible advantage for stock ownership over home ownership. Let’s just use the average mortgage term of 30 years at 5%. Let’s just say you pay cash for your house and it costs \$300,000. In 30 years, with the historic compound interest rate at 5% for real estate, that home appreciates to \$1.3 million. Do the same investment amount at 10% for an investment in the S&P 500 and that asset appreciates to \$5.2 million. The difference is stark and significant. Let’s say you get 20% a year… that investment now becomes \$71 million. Let’s say you get 30% a year… that investment now becomes worth \$785 million. You get it.

There are a few key factors to consider when calculating compound interest:

• Principal: The initial amount of money that is invested or borrowed.
• Interest rate (or) Rate of Return: The percentage of the principal that is charged as interest.
• Compounding frequency: How often the interest is added to the principal (e.g., annually, semi-annually, quarterly, monthly, daily, etc.).
• Time: The length of time over which the interest is calculated.

In conclusion, Compound interest is the interest on interest, it can grow the investment at an exponential rate and can be favorable for both borrowers and savers. The calculation of compound interest depends on the principal, Interest rate, compounding frequency and time. There are many online calculators available to help with the calculation.

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