Lets say youre willing to have Vinnie pay you 100000 five years from now in

Lets say youre willing to have vinnie pay you 100000

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Let’s say you’re willing to have Vinnie pay you $100,000 five years from now, in return for lending him $60,000 today. You lend him $60 large today; the deal is he pays you back $100 large in five years. The reason you’re willing to do that deal is because your financial calculator tells you that if you want to get at least a 10 percent compounded return on the money you lend Vinnie for five years, you’ll have to get back close to $100,000. You get your sixty grand back plus interest— plus interest on the interest when he pays you about $100,000 in five years. Simple. I mean compounded. (Sixty grand compounded at 10 percent over five years equates to just under 100 grand; at 10.8 percent, however, you reach 100 grand.) As a lender, the less you lend him up front for the same backend payoff, the higher your compounded return. If you lend him $50,000 and he pays you $100,000 in five years, your compounded return jumps up to 15 percent. Lend him $25,000 and get paid $100,000 in five years and your compounded return explodes to 30 percent per year. The less you lend him for the same payoff down the road, the higher your compounded return and the quicker you get rich. (By the way, this is the way zero coupon bonds, like U.S. Treasury bonds, work: you pay a price that is discounted off of the face value of the bond, in return for getting the face value of the bond back in a fixed amount of time. The size of the discount determines the compounded rate of return you’re getting paid to lend your money to the bond’s issuer.) You do exactly the same thing when you stockpile stock at a big
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discount to its value, only better. There’s a limit to what you can get a borrower to pay you for a loan, unless you’re ready to get violent. But there’s no limit to how high your compounded returns can get by stockpiling. The less you pay to buy a set value, the higher your compounded rate of return. The lower the price goes as you are stockpiling the stock, the more your compounded return goes up and the faster you get rich. EXPLODING RATES OF RETURN Assume that you find a business you know is worth $20 a share but is selling for only $10. You have $60,000 to invest. You decide to stockpile the business rather than lend the money to Vinnie. You start by using $20,000 to buy 2,000 shares at $10. A few months later the price is $5. There is no change in the long-term value. (How do you know that? Well, you’ve done your homework, which I’ll be showing you how to do later.) It’s still worth about $20. You invest another $20,000 at $5 per share for 4,000 more shares. The stock market keeps dropping like a brick and the stock drops to $1. The business hasn’t changed at all. Things have slowed down some but the business will pick up again with the economy. It still has a $20 per share long-term value. So you invest another $20,000 at $1 per share and buy 20,000 more shares.
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  • Spring '20
  • Warren Buffett

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