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Valuing an Asset
Is valuing an asset easy or hard? It is both. Everyone one of us can easily understand how hard it can be to value business and property assets.
The fact is that property and stock market assets, when fairly valued, produce much better returns than banks deposits over time. To benefit from those superior returns most of us must understand why assets are hard to value. In accepting that, we become more open to diversifying, which allows us all to save and invest in the stock markets, and to obtain the higher returns that have been available in the past. It is likely to be the same in the future.
In Ireland, few save/invest through the stock markets no doubt feeling that they are either too risky or to hard to understand. Let me show you why both assumptions are wrong.
Valuing an Asset
You own a newsagent and are making a profit after tax of €50,000 per annum. You wish to retire in five years and transactions in your area lead you to believe that you will probably be able to sell the shop for €500,000 at the end of year five. The question is: how much is the shop worth today?
We will assume interest rates are 4% today and likely to stay that way for the next five years (to make our valuation efforts easier). Hence, we will receive €50,000 each year for five years and a lump-sum of €500,000 at the end of year five. That's €750,000 in total. The value of that €750,000 to us over the five years is not the same as if we had it today. Why not?
Because if we had the €750,000 today we could put it on deposit at the bank and earn a risk-free interest rate of 4%. If we did that our €750,000 today would be worth €919,824 with compound interest in five years time.
So to determine what value we might place on the cash flows today that we are to receive over the next five years - which in total will equal €750,000 - we need to discount those cash flows at 4% per annum - compounding in reverse. The first table highlights the answer. If interest rates are 4% then the cash flows (or business), in today's value, are worth €633,555 to you because at an interest rate of 4% that €633,555 will compound to €750,000 in five years.
If interest rates are higher today then that has a bearing on the value you will attribute to those same cash flows. After all, if you had the cash today and could deposit them with the bank to earn a risk-free 6%, for example, then clearly you would need less today to compound up to the €750,000 that you will receive over the next five years.
So higher interest rates today will mean that you value the business at a lower price today than if interest rates were lower. In the second table, the value of the cash flows to you today if interest rates are 6% is a lower €584,247.
As a recap then, at an interest rate of 4% the €750,000 of cash flows you are due to receive over the next five years are worth €633,555 today. Similarly, if interest rates today are 6% then those same cash flows are worth a lower €584,247 to you today.
What can we conclude? We can conclude that higher interest rates lower the value of assets - be that property or stock market assets. Conversely, lower interest rates raise the value of assets.
Adding a Risk Premium
In reality, however, we could not have been sure that we would actually receive those cash flows from the shop. A new competitor could open up locally and reduce our sales. We might encounter product supply difficulties, again reducing our sales. Our products might become more available over the internet putting pressure on our prices. A myriad of risks could mean that the actual cash flows we receive are lower than what we anticipate. These are risk factors.
In valuing the business and its cash flows above we used a risk-free rate. In reality, however, there are risks and we need to add a risk premium to the risk-free rate. This increases the interest or discount rate we use, and we know that the higher the interest rate (or discount rate) the lower the value we should place on the business.
For this reason, if interest rates are 6% and we wish to take account of the unknown risks facing our business, then instead of valuing it at €584,287 today we might place a lower value on it to take account of the risks. How much lower?
Therein lies the rub of it. Each business is different and faces different risks. Some businesses are strong with brands to protect them or are operating as a monopoly and are very low risk and their cash flows more predictable. Others are very high risk with unpredictable cash flows. But to the lay person unaccustomed to valuing assets this makes the task difficult.
Business overall, however, makes a better return than bank deposits. If this was not the case then why would any businessman invest monies in his business if all he could get was the same return as the bank deposit rate. In reality, stock markets in the developed world have delivered returns some 4% above the risk-free rate over the past 100 years.
Herein lies the reason why a programme of saving and investing in risk assets - like property and the stock market - has produced higher returns than bank deposits than in the past. Quite simply, due to the risk, they are priced to deliver higher returns. In the market place, instead of paying even €584,247 for the shop you might pay €300,000 setting yourself up to generate returns much higher than bank deposits. While it doesn't work out in every stock you buy, it will work out if you are diversified across many stocks.
A Global Equity or Property Fund Covers a Lot of Risk
Few of us are experts at knowing the right value for any individual business. So we diversify. For novice investors you can start out with a global equity fund or a global property fund. Not only is a global equity fund diversified by business, but also by sectors and geographic regions. And by buying these types of funds on the stock market rather than through insurance brokers or IFAs you can eliminate most of the costs.
Of course, that doesn't ensure that you buy good value. But for the person who can invest or save via the markets overtime then you get great value on some occasions and poor value on other occasions. Over time you'll get the average values, which should ensure you get the average long-term returns of some 4% over bank deposit interest rates.
The lump-sum investor has the trickier task. But by keeping an eye on the dividend yield of the fund you can avoid buying such a fund when the value is plainly not there.
Volatility in Markets is Not the Enemy
In the context of risk as I have outlined above, volatility does not actually feature. That's because volatility is not the same as risk. Understand that and you will take downturns in markets as an opportunity to hunt out a good diversified fund offering decent value.
This is Where We Come In
The Gillenmarkets website has the tools that allow you to save/invest in the markets over time. We provide analysis of suitable funds and stocks. We identify the risks for you and provide guidance throughout the year. The key is that we are not sellers of stocks or funds. You pay an annual subscription for access to our weekly investment bulletin and the list of stocks and funds we recommend. An annual subscription to our website costs €199. GillenMarkets is a Global Investment website providing tools of professional investors to anyone interested in how to safely get a return on their money, reduce costs, guiding them on strategy, asset allocation and identifying real value.
We also provide training for those who wish to kick start or speed up their knowledge of investing. Our 1-day training seminars have been going since 2005, and our next seminar is on in May - email to email@example.com if you wish to register or to get details of the day and costs.
If you are curious, but not sure, then you can avail of our 14-day free trial to the website, which gives you access to the whole website for two weeks, and to two weekly bulletins from myself - published on a Saturday. You will have to enter your contact and credit or debit card details to avail of the free offer, but you can opt out before the free trial is up, and before anything is charged.
These Free Newsletters are part of our marketing. We hope you enjoy them, but we also hope that at some stage you'll consider joining our growing list of subscribers.
Until the next Free Newsletter...which will touch on some of the reasons why markets are so volatile. Understanding volatility provides you with the confidence to invest through the many volatile bouts that markets suffer