What The Wonders And Horrors Of Compounding

Google Price Target: $16,578.90 Some of you will immediately recognize this headline is a joke. I’m not going to say anything interesting about Google.To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to – brace yourself – precisely 2,011,011. 3% annual gain and a 6% annual gain may look relatively small. If, during the 20th century, the Dow had achieved a gain of 6% compounded annually rather than a gain of 5.3% compounded annually, on the eve of Y2K, the index would have been sitting at 22,302. That’s right, if the Dow had achieved a gain of 6% compounded annually during the 20th century, the index would have broken the 10,000 mark while the Berlin Wall was still standing. Over a century, that extra 0.7% really adds up. I have a price target of $16,578. First, we need to see what it would take for Google’s share price to reach $16,578.Last I checked, each share of Google had a book value of $31. You’re going to get a 12% return on equity, but there will be no limit to your growth. With something like $9 billion in equity to start with, a 12% return on equity, and the reinvestment of all earnings in the business, Google would get awfully big. Don’t believe me? I know a 12% return on equity looks ridiculously low, but watch what happens. Of course, the big question is: do I mean market cap or revenue? I mean profits! At a P/E of 15, Google would have a market cap of $4. That same Google share that was quoted on Friday at $378.18 would be worth $16,578. Google’s EPS would be $1,105.One, in 2056, it’s more likely Britney Spears and Kevin Federline will be celebrating 50+ years of marital bliss together than it is that Larry Page and Sergey Brin will be celebrating 50+ years of 100% retained earnings at Google. You see, if on Monday, you were to shell out the $378.18 for a share of Google, when the stock reached $16,578.90 in 2056, you’d be able to brag to Britney and K-Fed about your annual compound gain of…drum roll please…7. Google would have a $4.68 trillion empire, and you’d have an annual return of 7.85% – how can that be? Time turns molehills into mountains and mountains into molehills. What would your return be if you bought Google at book value? 13. I mean, if you had the prescience to buy a $4.68 trillion behemoth when it was just a $10 billion company (remember, you’re paying book this time) all you’d get for your trouble is 13. 87 a share, 85% of your purchase price would be backed by cold, hard cash and you’d be buying a stock with a P/E of 6. So, why would buying a stock trading at a P/E of 6.3 and growing earnings per share at 11.4% a year for fifty years only yield a 13.32% return? Where are the insane gains? Return on equity is the puppet master here. They’re doing something strange; they’re converging. Everything is getting closer and closer to 12%. Why? Because that’s your destiny. If you buy a business that earns 12% a year and you hold it long enough, guess where your returns are headed? Here’s one last excerpt from Buffett’s letter. He’s writing about all businesses, but a long-term holding in a single business works in much the same way: “True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. Google may very well earn a return on equity much greater than 12% for the next fifty years. It has already earned “extraordinary profits”.