Saturday, July 28, 2012

What is the investment’s value?

On Wednesday July 19, 2012, Apple was worth $ 567 billion. This Thursday it was worth nearly  $ 40 billion less or $ 530 billion. So, what is it really worth?

That question is difficult to answer, but it is hard to justify that a company loses $40 billion of its value in less than a week. Not that Apple lost money. To the contrary it earned $35 billion dollar in the last quarter or nearly 18% more than in the same quarter a year ago.  Its profit margin went up to 42.8% from 41.7%! To top it off, Apple announced its first ever quarterly dividend of $2.65 per share something hardly anyone bothered to mention!  Is it a growth company trading at a super high unsustainably high P/E? Hardly, with $41 per share in annual net earnings it traded at 15x earnings and at its current price it is trading at a P/E of 14
No, the reason for its fall was a drop in sales revenue!  Not a real drop, it only sold fewer products than ‘The Street’, whomever that may be, expected!  And really, the sales were less than expected because many buyers are waiting for the release of new product, in particular iPhone vs 5 in the next quarter.  Wow, so much bad news J No wonder the world is coming to an end. 

In 2007, a nice condo in Whistler, BC was sold for close to $ 1 million and last summer it sold for $725K. What is it really worth? 
What happened?  Did we enter a new ice-age?  Did the place get flooded? Did it burn down? Nothing of the sort! We went through the U.S. real estate collapse and through the U.S. financial crisis and today we're going through the European crises.  Nothing changed with the property – in fact, they just added a beautiful, state of the art gas-stove and complimentary range-hood. 
In terms of assets both Apple and the Whistler property have increased in value.

However, potential buyers have disappeared nobody has the guts or the money to buy Apple nor the Whistler condo. Both have retained their functionality (earning money and providing a nice lifestyle) but nearly like flipping a switch you can now buy these assets for a lot less than just a short time earlier.
If the buyers disappear or if nobody wants to sell then prices are affected. I am not talking about the value of the asset but about whether it is available for sale or whether there is a buyer. Supply and demand.  Is the Whistler Property truly worth $275,000 less than a few years earlier?  No, but in the recent past there was one owner out of many, who was in financial trouble and needed cash badly enough that he/she was willing to sell it for any price while there were only a few buyers who were willing to take the property off the buyer’s hands and only if they got an exceptional good deal.  There were hundreds if not many more owners who were not willing to sell for that price. But we often seem to think that it is only the last sale that sets the value of an asset.  Ludicrous!  I have no other word for it – just ludicrous.
We have in real estate a number of ways of appraising the value of a property. In fact there are three distinct methods:
  1. based on the sale price of several other properties of comparable quality in the same area.
  2. based on the replacement or building costs of the property.
  3. based on the income (or better) the net operating profits it generates.
Guess what, each method results often in different values. So which one is the real value?
The market is exactly that – a place of trading. We buy and sell assets in the market and a price is negotiated based on the motivations of buyer and seller. If you ever went to a flea market and traded you know how one buys in a market. It depends on how badly you want a certain gadget and how badly the seller wants to get rid of it.  Often, you can buy a similar gadget in a normal retail store nearby, but you would have to pay a lot more. So, is the price you paid for your gadget in the flea market the real value or is ithe price you have to pay in the store its real value?
Alternatively, we could estimate how much it costs to make such a gadget and set that as its value. So then the price is dependent on the costs of labour, the raw materials that go into making the gadget, taxes, patent  or license fees or the product development costs, etc. But if nobody wants the gadget, is then its sale price based on production costs reflective of its true value?
We could look at value based on how much income an investment generates, but is that income, net operating income? Or is it net or free cash flow or is it that part of an investment’s free cash flow that is paid out as dividends?  Many sophisticated investors use the amount of free cash flow that an operation throws off over its expected life discounted over time (i,e, net present value of a cash flow stream). But, who determines the real life span of an investment and who determines what discount rate is appropriate?
Wherever we turn, there is always a judgement call required of the investor and there never is a real objective value. So value is volatile and the only way we can set it is by determining how an investment fits in our overall portfolio and the goals we have set for that portfolio in order to realize our dreams in life, our personal Belize as REIN calls it.  There is no objective value for an investment; value depends on the owner of the asset.

Say, I've got a condo that cash flows every month (after all expenses other than financing) $1100. In Calgary, a typical rental property has a cap rate of 3 to 4%. If we set a cap rate at 6%, then this property is worth 12 x $1100  annual NOI = $13,200/cap rate = $13,200/0.06 = $220,000.  The last time one of those units was on the market it sold for $180,000 so would you sell it for that price?  Would you sell it for $220,000?  Heck no, were would I find another property that cash flows 6% in Calgary?  For me, the property is worth $13,200/0.035 (the average cash flow) $440,000 but at that asking price I won't likely find a buyer. So I keep it.

The same with stocks, many Dow stocks trade at barely 10x earnings, the dividend yields are 3 to 4%. The market pays not enough to sell it and replace it with another investment of the same potential.  If I put the same money in a 'risk free one year GIC' I would get a 1% interest rate. Even if the stock appreciates 2 or 3% per year, I would have a hard time to find another investment of this quality for the same price. So, I won't sell. How much is it worth to me? $1 invested in a GIC pays me $0.01 per year. That same dollar invested in the Dow makes me 3.5+2.5= 6% or 0.06 cts per dollar. If the stocks perform taccording o their historic average performance of 14% over the long term, I'll make even more. Long term, what is the risk?  As long as I don't sell in a panic at the bottom of a bear market there is virtually no risk. So how much is it worth to me?  I won't sell until I get at least double; yet in today's market there are no buyers willing to pay that price! Thus I'll hold on.

Focus on asset acquisition not on building ‘net worth’. Focus on assets that generate potential cash flow (because even the best property or the best asset can be poorly managed) and focus on the questionwhether the asset will bring you closer to achieving your aspirations in life. Wealth is not about how much money you have, but about how many assets you own that help realize the life you want.

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