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payout. The investing frameworks within which the two groups operate–even if they have the sameIRR hurdle–lead to vastly different underwriting processes. Take as a simple example a business called ABC Co., which sells for $100 a share and produces $10 inannual earnings (let’s ignore any potential growth or decline in those earnings.) An investor with a 20%IRR hurdle would conclude he could not pay more than $50 a share for this business ($10 / 20% =$50). In other words, the investor looks to achieve his IRR target by relying on what the asset itself
. A trader, however, may look at ABC Co.–while also having
20% IRR hurdle–and justify purchasing the shares. The typical trader argument would be that this business is worth more than the10x earnings it sells for–
to someone else
. This valuation would typically be justified by either using peermultiples, private transaction comps, value to a strategic acquirer, or simply a multiple re-rating by themarket when it “smartens up.” In other words, the trader looks to achieve his IRR target by relying on what the asset
. Though there is nothing inherently wrong with trading, such a strategy risks lowering the underwriting standards of a capital allocator. This temptation to lower valuation standards becomes especially acute when there is a dearth of great investment ideas. That is because even during times when asset pricesare high, a relative value approach can always be used to justify still higher prices. On the other hand,an investor with an objective value approach–a sole focus on the total cash that an asset can produce– has only one way to justify a valuation that meets his IRR hurdle. Consequently, during frothy markets,a trader is susceptible to finding rationalizations for activity, while an investor is likely to be forced tohold cash. Trading, as opposed to investing, also comes with greater risk of ignorance. Since a trader expects toeventually flip the asset on to another buyer, he will rarely ask the same questions as the investor whoacknowledges he may hold the asset forever. The essential question in a trader’s repertoire is, “What will my return be when I sell it for X multiple?” The investor instead asks, “What will my return be if Ihold the asset till the end of its life?” That fundamentally different question leads to a drastically different research approach. The due diligence hurdle for an investor is higher, which leads to greaterconviction and a more concentrated portfolio than that of a trader. Additionally, trading decreases the odds of finding an investment in which one has an edge. A traderopens the floodgates of information overflow–using a relative value approach, every asset for saleseems like an opportunity. An investor, however, substantially narrows the pipeline of opportunitiesthat warrant his attention–using an objective value approach, he knows there are few assets whoselifetime cash flows he can confidently predict. When an investor looks at an asset, he pictures the size of the cash pile it could generate throughout itslife. When a trader looks at an asset, he pictures the size of the bid it could receive at a future auction.