When you buy a stock, you are buying a company’s future cash flows. You believe that company is going to make more money in the future than you are paying for it right now. Everyone buying a stock is placing a bet on the future. The question I’m asking is, “How far into the future am I willing to look?”
Clearly, looking even one day into the future is hazardous. We don’t know what tomorrow holds, but fool ourselves that we do. Living in chaos isn’t healthy, so we just ignore the chaos. But on a day to day basis, things generally go as we’d expect. Maybe your kid gets unexpectedly sick. Most likely not. Assuming what tomorrow looks like isn’t a bad bet. However, assuming what your day looks like in ten years is a daunting task. In 2012, I had no clue how much my life would change on this day in 2022. What products I’d use, cars I’d drive, where I’d live, etc, etc.
With stocks, we can’t just look one day ahead. Companies don’t distribute cash back to shareholders every day. Even if they did, prices get bid up by people willing to look further than one day into the future. So how far into the future should I attempt to look? For me, the maximum is four years. Four years is far enough into the future to make real returns if I’m right. It is close enough to the present to protect against the exponential chaos of time. And I chose it because Peter Lynch discusses how four years was a long enough time frame for the stock market to correct pricing mistakes. A company can only grow at 20% a year for so long before the stock market has to recognize its earnings.
What does it mean to look four years into the future? Simply put, I am unwilling to assume growth beyond four years. This, in turn, limits what I will pay for a stock. Google has grown by 25% compounded annually for last ten years. One could assume it will do so for the next ten years, and in doing so, pay a very high price for Google. If we go back ten years ago to 2012, Google’s net income was $9.7B. If someone assumed Google would grow at 25% per year for ten years, and end with a PE of 25, they would have assumed 2021 net income of $90B and a market cap of $2.25T. Adjusting for share splits, this would have given a 2022 price of ~$1730. Then, since we’ve seen the future, we are OK with a 10% return on our investment. So, even though shares are trading at $310, if we would have paid $665 for Google 10 years ago, more than twice the market price, we still made 10% per year return.
If you have ten year out convictions, as I’ve shown, you can pay very high prices for stocks and do well for yourself. However, I am not blessed with such an ability. As such, four years out is as far as I generally want to go. Perhaps I’ll make exceptions in some high conviction cases. What does this “four years out” look like for me? Let’s look at a price for Adobe (ADBE). Their current net income is $4.8B. They’ve averaged 20% growth for ten years. Let’s assume four more years of 20% growth. In four years, their net income would be $10B. At a P/E of 10 for the now non-growth company, and the market cap is $100B. Adobe’s current market cap is $204B, so ADBE is twice as expensive as I would pay for it. Current purchasers are betting on eight years of sustained 20% growth. And they may very well be right! But I’m unwilling to count on eight years of growth, four is my limit even if it means sitting on my hands these day.