Answers To Our Investment Puzzles
We recently posted a couple of fun investment puzzles. We are about to show the answers, so if you haven’t yet had a moment, go now and try to answer the two multiple choice questions we posed.
For those who were brave enough to post their answers publicly – well done! We love the high engagement of Montgomery clients and readers. Remember, the goal is always one of continual learning and education, so we hope you get something of value out of our blog posts, one way or the other.
Ok, now for the answers.
- Stock A, which pays no dividends, but is expected to be worth 30 per cent more than it is today in three years.
- Stock B that is fair value today.
- Stock C, which also pays no dividends, but is expected to double in 10 years.
If you could only buy one stock, which stock would you buy in order to maximise your return on investment?
The answer: Stocks A or B – as they’re roughly the same.
- For Stock C, the words “expected to double in 10 years” are equivalent to the words: “growing at seven percent per annum.”
- For Stock A, the words “expected to be worth 30 per cent more than it is today in three years” are equivalent to the words: “growing at nine percent per annum.”
- Finally, for Stock B, the words “is fair value” in the context of the equity markets are equivalent to the words: “is expected to grow with the average return of the equity market (which is around, say, 9-10 per cent pa).”
Isn’t it interesting that a business that is expected to double in 10 years is a less attractive investment than a business that is at fair value today?
Puzzle 2: Four years ago you may buy:
- Investment X: The Coca-Cola Company (NYSE: KO) at a 7% discount to the market price at the time – which equates to 17.5x P/E ratio.
- Investment Y: Facebook (NASDAQ: FB) at a 130% premium to the market price at the time – which equates to 290x P/E ratio.
- Investment Z: MSCI World Total Return Index at the time – which equates to a 19x P/E ratio.
Which investment option would you buy in order to maximise your return on investment?
The answer: all three investments are roughly about the same.
Isn’t it interesting that a hypothetical investment in Facebook four years ago – at a gigantic premium to the market price at the time and a P/E ratio of more than 250x – did as well as an investment in the global market index?
This is one problem with P/E ratios. For high-growth businesses, such as Facebook (which has grown revenues by more than 50% per annum for the last four years), a fair P/E ratio is enormous. Most investors see such high P/E ratios as a sign of overvaluation – but when growth rates are high, this rule of thumb is completely incorrect.
Roger's step-by-step guide to valuing the best stocks and buying them for less than they're worth, Value.able, is available exclusively at rogermontgomery.com. Skaffold is an online stock-picking application that rates ASX-listed stocks from A1 to C5. Watch a demo of Skaffold at www.skaffold.com.