How Much Would You Pay For $1 Forever?

Hello Guys 👋,

A few of my readers informed me that they loved the theoretical/fundamental valuation of stocks but at times, some things go over their heads 😅.

They complained that, at times, I don’t provide enough explanation.

I apologize for this.

Going forward, I will try my best to explain most things in as much detail as possible 😁.

In today’s post, I wanted to cover a high-level concept of expected returns/ask (cost of capital/investment ) when you carry out any investment activity.

Let’s begin.

---

Note: I am valuing Unilever at the moment. I will make the post available this week. My last valuation post was on Rainbow Children’s Hospital. Click here to read.

---

I have an offer for you.

I will give you $1 per year, forever, with certainty. How much would you pay for such an offer? This offer is available to all your friends, family, neighbours, colleagues etc.

You are competing with them for this offer.

So tell me, how much would you pay?

Think about it for a few minutes.

Take your time. Don’t rush.

🤔💭

🕜

So you might have the following thoughts:

1. “I will pay $0.1”. LOL! (You crazy bruh?!) What if someone offers me $0.2 for the offer? or

2. “I am getting $1, forever, every year, and I have roughly 40 years of my life remaining (Expected life of 75 years). Given that others are competing as well, I will pay $39. I will make $1 in my last year then”.

Fair enough.

But by that logic, someone in his 20s might pay $40. His remaining life is ~50 years, and you might lose the offer since I will take $40 from him instead of your $39.

You see the issue here, right? The cost of this offer would be different for everyone.

Do we need a better way to get the cost of this offer? A cost that should be equal for all or at least a cost from which deviation should be non-optimal.

So you might now wonder, what would be the closest equivalent example/offer in the market that can help me with the cost for the offer?

We need something that assures us that we will get our dues just as the offer assures us that we will get $1 per year forever.

How about Government bonds?

What are Government Bonds?

Well, it is like a debt which the government takes from you. The government will say - “buy my $1000 bond, and I will provide you 4% per year for sure bro”.

Do you trust your government? Haha.

But let’s assume your government is the Swiss Government 🤑 and a perpetual bond (running forever) is giving a yield of 4% (What is a yield? Well, think of it like an amount which the government will pay you per year. In this case, it will be $40).

So, if $40/4% = $1000 (cost of bond).
Then, $1/4% = $ 25 should be the cost of the offer.

Now, you might say what if I pay $20 instead? What if I deviate?

Suppose, you wish to pay $20 for this offer, you are expecting 5% as the yield. But, why would I accept your $20? Some other rational investor would apply the same bond logic and will give me $25.

You could say you will pay $30 for my offer, but then $1/$30 = 3.33%. You are accepting a lower yield on the offer. Why would you shortchange yourself like that?

So, the ideal cost would be around $25, with no incentive to deviate for anyone involved in this transaction.

Now, here is the twist. What if I change the offer a bit?

Tell me.

How much would you pay for $1 forever per year, but with uncertainty?

What does this even mean? Well, I will pay you $1 but I cannot promise I will pay you $1 every year. I might skip a few years.

so, How much would you pay now?

You could say - “ I was getting a surety for $1 forever at $25, for uncertainty, I would pay $20”.

If you pay $20, you are expecting 5% as the minimum expected return on investment (or cost of investment).

So, 4% was the risk-free rate(RFR) + 1% premium over and above the RFR = 5%. In this case, You are expecting a premium of 1% from me for the offer.

But what if you are in your 60s? You would say I can only afford to pay $10 for such an offer.

$1/$10 = 10% is the cost of investment.
In this case, your risk premium is 6%.
(10% of minimum expected return - 4% of RFR = 6% risk premium).

The premium changes according to our fears and anxieties. They are reflected in our minimum expectations. These fears and anxieties are also based on what stage we are in our lives. Are you just out of college? Are you expecting your first baby? Are you old now? Are you about to retire?

There is no single risk premium for everyone.

This variation of risk premium is why we have people buying and selling at the same time in the market.

In this case, My offer with uncertainty is nothing but a stock giving you a $1 dividend per year ( A dividend is a part of the profit shared with shareholders. Now, you might get a dividend for the year or you might not.)

When fears are high and everyone is panicking, the risk premiums increase (Remember- “I am 60 years old” case from above?). When the risk premium increases, the cost of investment increases, and the stock prices fall (the offer cost in our case falls). Once the stock starts falling, people panic more, thereby increasing the risk premiums and causing the stock prices to fall more.

When everyone is in exuberance, the risk premium decreases, and the cost of investment decreases. This causes the prices of the stocks to increase. At this stage, you will see markets reaching new highs daily.

And guys, this is how the markets dance every day.

I hope you have found this post useful.

If you did, do consider subscribing.

Thank you for your time and see you in the next post.