This is called the future value formula, it helps you calculate what something will be worth in the future.

• Future Value (FV) = value in future

• Present Value (PV) = value today

• r = growth rate (or interest rate)

• N = number of years (or competitive advantage period)

Let’s test this formula out with something we all understand – interest earned on a bank account.

If you have $100 in the bank and you earn 5% interest per year, how much will you have in one year’s time?

We can also rearrange this formula to solve for the growth rate:

If we simplify the equation by looking at things over 1-year (N=1), the equation becomes:

Investment styles

You’ve heard of growth and value investing. You may have been led to believe that they were opposites. They’re not. All styles of investing are about increasing the growth rate because that is what makes future value larger. Each style goes about it differently.

Value investing

A value investor is someone who wants to buy a stock today at a price lower than what he estimates it is worth. In other words, he has an idea of what the future value could be and is trying to buy stock today at a lower present value.

If we look at our growth equation for one year, you will notice that if future value is a fixed number, then the only way to increase the growth rate is to reduce the present value. The smaller the present value, the larger the growth rate will be.

A good investment to a value investor is to buy stock today (present value) at a discount to what he thinks it worth. This helps to boost the growth rate of the stock.

Value investors typically would like to see the price of the stock rise to intrinsic value over 1 to 3 years. Some might be willing to wait longer, but I cannot imagine a value investor holding on for 10 years. At some point, they have to consider that they may have gotten it wrong.

Growth investing

A growth investor is someone who wants a high growth rate and she doesn’t mind paying a higher present value today, as long as the growth rate is really high.

If we look at the equation, the future value is likely to be a high number and the present value is known. Growth investors justify their investment by saying if the future value is very high, they can pay a higher price today because it will still result in a good growth rate.

A good investment to a growth investor is to buy a stock at a fair price today, but their estimate of the future value must be much higher. Per the formula, you have a future value much higher than the present value - that maximises the growth rate.

One caveat, there is a law of diminishing returns, which means that companies cannot grow at high rates forever. Size will become its own anchor and growth will slow down. Think of Google 20 years ago – it was a growth machine, but has slowed. The same happened to Apple and Meta.

Value vs growth perspective

When you think about investing in this way, it’s hard to say that value investing and growth investing are opposites. They look like the same thing being done in different ways. Value investors worry about present value while growth investors worry about future value. 

In fact, if you look backward at an investment, it is hard to distinguish value from growth. Imagine that you purchased a growth stock and it did really well. You could look back and say you purchased it at discount to its intrinsic value - which is value investing. It’s all about perspective.

Extraordinary Investing

Extraordinary investing is about owning companies that are profitable and which generate high returns on capital for long periods of time. These companies are already successful.

With Extraordinary Investing the focus is on achieving a high future value. If we look at the first equation, the future value is dependent on the growth part of the equation (1+r)^N. If N=1 then present value and future value are linearly related to each other. This means that the future value is a factor larger than the present value. In our interest rate example, the future value was 1.05 times larger than the present value.

But if N is a large number, the equation becomes a higher order exponential equation. Then present value and future value are exponentially related to each other.

If you want to make the linear relationship exponential, you have to increase the number of years that growth is experienced. In other words, you have to increase the factor N.

The problem is that economics tells us that if something is highly profitable, competition will enter the market which forces growth rates down. This is called Mean Reversion – the tendency for high rates to drop toward the mean (or low rates to increase toward the mean).

It is hard to buck this trend, but it is possible for a small group of companies that have special advantages.

If the structure of an industry confers an advantage on a company, it can maintain higher rates of growth and fend off competition over long periods of time. In other words, you can make the growth equation exponential (i.e. N = high number).

VISA

Let’s consider the example of Visa, the biggest credit card company in the world. The more people that have a Visa credit card, the more inclined stores (merchants) are to accept the card – because they want to make it easy for their customers to pay.

The more merchants that accept the card, the more inclined people are to get the card because they can purchase easily everywhere. This is a virtuous circle. The larger Visa’s payment network becomes, the more valuable it is to customers and merchants. As the network gets bigger, both parties get locked it to using it.

If a new credit card company starts, the structure of the industry makes it hard to get customers. After all, who wants a credit card that isn’t accepted everywhere? And if the customers don’t want it, then the merchants don’t need it. Furthermore, since the new credit company does a lower volume of business, its costs are spread over less customers, making it less profitable and less able to compete.

So the structure of the industry has locked-in the customers and merchants and made it very expensive for newcomers to enter the industry and compete. That combination plus tailwinds from the world moving away from cash make Visa an Extraordinary company. 

Extraordinary companies can grow exponentially

Extraordinary companies have long competitive advantage periods (i.e. N = high number) over which they can grow. The second part of Extraordinary companies is to maximise their growth rate (r). You do this by looking for:

1. Well run companies

2. Industries with growth potential

3. Reasonably priced stocks

If you maximise growth (r) and competitive advantage period (N). The factor relating present value to future value is a higher order exponential factor.

Higher order exponents are the most powerful multiplicative force in investing. That is why extraordinary companies can deliver extraordinary returns. It’s simple mathematics.

That is why I prefer to own Extraordinary Companies. It is not merely emotionally driven enthusiasm for a particular type of company. It’s the math of investing.

Conclusion

The question that comes to mind - is one style of investing is better than another?

My answer is both yes and no.

No. One style is not better than the other because there are many ways to look at the problem. Having different styles at work in the market is what increases market efficiency and helps to value companies fairly over time. If we all followed the same style, it would result in overvaluation of certain stocks, which would drop their return profile. (Using the equation that means making the present value higher than the future value, so the growth rate becomes negative.)

Yes. One style can be better for you. To be successful as an investor, you have to develop a style that suits your disposition. For instance, I don’t think I fit neatly into the established categories of value and growth. So I figured out what suits my psychological make-up and beliefs and called it Investing in Extraordinary Companies.

From a mathematical point of view, I think Extraordinary Investing makes sense BUT it also comes with challenges. For instance, it takes time to create value. Mostly people don’t like the idea of getting rich slowly. It also reduces the investable universe down from 65 000 stocks to a few hundred. And amongst those, you need to find specific characteristics at a good price.

But these challenges don’t deter me because the investment process aligns with my beliefs. In other words, I am not fighting my psyche every time I make an investment.

I think that is perhaps the most important thing to be a successful investor. Align your investment style with your psyche. You can make great returns with any style if you understand value creation in your style and stick to your knitting.

That doesn’t mean you cannot evolve as an investor. You might start in one way and move toward a different way as you learn – that’s okay. That’s evolution, not inconsistency.

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