Sunday, March 10, 2013

What is the INTRINSIC or TRUE VALUE of an investment asset? Part I

By now most of us should know about the psychotic way the stock and real estate markets valuate businesses and properties. There is rhyme nor reason in these markets just a big bundle of emotions. So how can one know what the proper price to pay is – i.e. taking the emotion out of investing? What is the INTRINSIC or TRUE VALUE of an investment asset?

Let’s start with the basics: when we invest we’re buying an asset that provides us a return on our investment (ROI). Basically one would be tempted to say that the higher the ROI the better. That is not necessarily true because often with a higher ROI investment risk increases. For now, let’s not talk about risk because then our discussion will never end. Instead let’s focus on ROI generating assets.
Investing like most complex things can be summarized in a very simple principle:
 
The big difference between real estate and stock market investing is how the investment return is handled. In real estate the return is used by the investor to pay for financing and the remainder is net- or free cash flow.  When dealing with stocks, the returns are used by the corporate management to pay for financing, re-investment and the remainder is net- or free cash flow that can be used for stock buy-backs and/or dividends for the investor.  This is shown in the next two figures.


                Now ask yourself, what is the real value of the real estate and common share investments? Intuitively one would say for real estate it would be the costs of land and building and for the stock market it would be the costs of the production facilities which may include (if not leased) that of the real estate that the publicly traded company owns. Another way to value these investments is based on how well the assets are being managed, i.e. the investment’s Net Operating Income (NOI or EBIT).  If you project EBIT and NOI over the life of the investment then you could calculate today’s value of the summed incomes using a discount rate such as inflation or the interest rate you make on the money if invested in a ‘low risk’ GIC or government bond.   The result of this calculation is called the Net Present Value of an investment or Intrinsic Value

Intrinsic value refers to the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value (Wikipedia).

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