What do you prefer? Cigar Butts or Great Compounders?

Ok, let's look at 2 potential investments I found recently. I know you may not be familiar with some of the terms below but if you are really keen to learn about investing, have a go at this. You will learn more if you try this exercise first.

Company A:
- Share price $10. (Not bad, almost single digit PE)
- Earns $1 per share in year 1
- Book value per share of $20, (ie only 0.5 times book value! cheap!)
- Pays out 100% of its earnings as a dividend every year, so dividend per share is $1 and the dividend yield is 10%! (Yum!)
- ROE is 5%

Company B:
- Share Price $22 (wah! 22x PE!)
- Earns $1 per share in year 1 (same)
- Book value per share $4 (yikes! 5.5x book value!)
- Does not pay any dividends. Earnings are reinvested in the business.
- ROE is 25% (much higher than A, meaning it can make more money for every $ of capital)

Which company would you buy and hold for 10 years? The one that pays you a 10% yield every year for the next 10 years? Or the one that grows much faster but will not pay you any dividends?

Why?

Even if you don't have a clue what I am talking about, just make a guess with a reasonable reason?

When you are ready, scroll down...

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Have you done the exercise?

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Really?

OK!

What I was trying to get at is to highlight the power of compounding when the company you invest in is able to continually reinvest at high rates of return (ie the ROE).

Company A is the typical cigar butt type of company that is ex-growth. Using the numbers I illustrated, even if you have PE expansion in year 10 to 15x (I am being extremely generous here),it will only result in a return of about 2.5x your original investment.
 

On the other hand, if you can find a company that continually compounds its invested capital, your return could be 7-10X your original investment, even if I assume PE contraction in year 10 to 17X.
 

Some other points to note:

1. Valuation shortcuts like PE, PB and dividend yield can sometimes give you very misleading results.

2. It does not mean you cannot invest in Company A. But because it has such low ROE, time is no longer on your side. If you find a cigar butt type company, that undervaluation needs to be discovered by the market very quickly. The longer it drags, the more value is being destroyed. On the other hand, Company B will benefit from a long runway.
 

Obviously this is an ultra simplified example, but there are actually many companies with those types of numbers!

Are you ready to find the next Great Compounder?