You’re offered a deal that will double your investment. Sounds good, right? But there’s a drastic difference between having your money doubled in three years versus 15 years. Today, Travis Watts shares the time value of money and how to calculate if the returns on a deal will fit in with your desired timeline.
Want more? We think you’ll like this episode: JF1957: Save Time & Make Money By (Smartly) Putting Your Money To Work with Dan Kryzanowski
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TRANSCRIPTION
Travis Watts: Hey everybody and welcome back to another episode of The Actively Passive Investing Show. I’m your host, Travis Watts. This is going to be a very short episode, but a very impactful one if you really take it to heart. Please give me your attention for about – I don’t know, five to ten minutes; I’ll make it as short as I can. What we’re talking about as understanding the time value of money. It’s a more sophisticated topic, but it’s definitely an important topic to understand fully if you’re going to be an investor long-term. Not to be confused with previous episodes I’ve recorded where I talk a lot about the velocity of capital and keeping your money turning over. This is an entirely different concept that I’m sharing with you today on the show.
First, let’s consider this. If we could all live to be let’s say 200 years old, then most of us would become millionaires or multimillionaires. Let’s say we’re 50 years old today, we have $50,000 to go invest; even if we went in one of the most conservative investments out there and it paid us about 2% a year, well, in 150 years, you’re going to have a million bucks. That’s great, but the problem obviously is most of us aren’t going to live to be 200 years old. But the ability to recognize that kind of concept and timeframe is important for anyone who’s maybe putting money in the bank, or buying a Treasury bond at 2%, just kind of be a realist on what that means long term. And that’s what I want to talk to you guys about here today. On paper that may have sounded like a really nice investment, to take $50,000 and turn it to a million, and it would be if the timeframe wasn’t a factor, the time value of money.
Let me give you a different example. Several months ago, my wife and I purchased a house and I did some research and digging on what the previous sales were on this home. I went all the way back to the very first sale, from the developer, when this home was built. What I discovered is since the year 2000, which is when the home was built, the home has doubled in price. Again, on paper it’s kind of a sticker shock and you think “Holy crap man, we could have doubled our money if we had gotten in earlier, right? We missed out.” Or you might think to yourself, “Well, geez, this house is very expensive. Maybe we shouldn’t buy it.” Ah, but if you run the math – and I’m going to run that math for you – what we figured out is it was like a 3% annualized return had we bought the home in the year 2000, and still held it today, in 2022. How we ran that math is simply using the rule of 72, which I’ve spoken about a lot on this show. You take 72 on a calculator, or old school hand math, and you divide by the annualized return that you’re either anticipating getting in an investment, or that you did get in an investment. What it tells you, when you equal it out, is how many years it takes to double your money.
So in this case with the home, we took 72 divided by 3.2, so it’s actually a 3.2% annualized return, equals 22 years; that’s how old the home is. The question that I would ask you or anyone else is, well, is the home a good investment if historically, it appreciates at 3%? I don’t know, it might be right for you, or it might not be.
This is where I’ve made the case in previous episodes about rent versus owned and what makes more sense. But the fact is not a lot of investors and not a lot of industry professionals are talking about this stuff. I very seldomly hear about the rule of 72, very seldomly hear about velocity of capital, I very seldomly hear about the time value of your money as an investor. That’s why I’m making an episode today out of it. It’s one of those epiphanies I had that I thought, “Ah, that’s relevant information that everybody should know.” Thank you for being a Best Ever listener. The benefit to you is I’m taking the complex and the sophisticated, digesting it, breaking it down, making it as simple as I can, and I’m sharing it with you right here at Best Ever. Thank you for listening to episodes like these.
Let me share one more story with you guys. I love this one. There’s a book, it’s called The Men Who Would Be King. I think that’s the name of it. It’s basically the story of DreamWorks production studio, whatever you want to call it, and how that came to be. You’ve got these investors – you’ve got Steven Spielberg, you’ve got Jeffrey Katzenberg, you’ve got David Geffen, and they came together to create DreamWorks; this was sometime around 1993 or 1994 or something like that. Each of them put in about $33 million of their own capital into this venture to launch what would become DreamWorks. They quickly realized after putting about 100 million into the business that it was going to take far more capital to actually launch this business the way that they intended to do it. So instead of putting more of their own capital, they raised capital from investors, somewhere to the tune of about $1 to $2 billion more than what they anticipated, so that’s a pretty big miss there on the projections.
Break: [00:07:43] – [00:09:39]
Travis Watts: One of the primary investors, one of the largest investors that they attracted was Paul Allen; he was one of the co-founders at Microsoft. Paul Allen put about $700 million of his own capital into this venture. Guess how much Paul Allen made on his investment? Well, he took that 700 million and turned it into about 1.2 billion. Again, on paper, you look at that and you go, “Wow, fantastic return. That’s amazing.” But is it? It turns out, Paul Allen and the other investors involved in the venture were actually very disappointed in the returns that they got from this business venture. Why? The time value of money. Consider this – for you and I, let’s break these numbers down into maybe more realistic numbers. If you or I put $70,000 into an investment and we ended up with $120,000, so I’m just X-ing some zeros out of the equation… Is that a good return or not? I would argue that it’s only a good return if that investment matures in a relatively short timeframe, and this is why. Back to the rule of 72; let’s say our overall return was about 15%, annualized. So you take 72, divided by 15, your annualized return, equals about 4.8 years. That means that we would have put our money in and about five years later we would have realized a similar type of game. But here’s the deal – in the case of DreamWorks, it actually took about 12 years to realize that same kind of game. So you take 72, divided by six, or 6% annualized return, and that’s about 12 years to double your money. But here’s the kicker – they didn’t double their money. They took 700 million and turn it into 1.2 billion; that’s not double. That would be 1.4 billion if they were to double their money. It was actually a sub 6% annualized return.
You might imagine the disappointment among them as you put that much capital to work at that kind of return. I’m sure that was a tough pill to swallow.
The main takeaway here is if you guys are looking at investments that you’re potentially going to partner in, you’re looking at things like equity multiple, and you see that maybe a syndication deal says we have a 2X multiple; what that implies is basically that you’re going to potentially double your money over – what period of time? That’s the question to ask. A 2X multiple may be fantastic on a three-year business plan, or even a five-year business plan; but if it’s a 2X multiple over 10, 15, 20 years, is it a good investment, even though you doubled your money?
That’s the takeaway for you guys today. That was my little spark of inspiration for this episode. I hope you found it useful. If you guys find value in these episodes, I truly appreciate the likes, the subscribes, the comments. Reach out anytime if I can be a resource. Thank you so much for being part of the Best Ever community and we’ll see you on the next episode of The Actively Passive Investing Show.
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