Sunday, January 26, 2014

Basic stock investing - Valuation

Last week we discussed how to value a business and how business ownership differs from fixed income instruments such as GICs, savings accounts and investing in debt in general. We concluded that you own a business or a share of a business in order to own the profits on the business’ assets. The value of the business can be determined in terms of a basic price earnings ratio e.g. a P/E = 10 or the inverse which is called earnings yield (net earnings divided by business price). You can also determine the value of a business by calculating the net present value of its projected (net) earnings typically going out 25 years and using a minimum required return on investment or discount rate which often is set at 10%. Earlier posts on Microsoft and Intel provide examples of how to calculate a company’s intrinsic value. BTW I don’t guarantee the correctness of these calculations; I just try to give you a taste of how to estimate intrinsic value.

Using an APOD spreadsheet, you can similarly put a value on a rental property. These valuation methods are strictly based on the income from the assets not about how the MARKET values those assets. This is the big issue where so many investors get confused. Comparing a rental property’s actual value with market value should show you how to buy not only real estate but any form of investments – including stocks. You see, net income for a piece of real estate comes from two sources – appreciation and net operating income (NOI).  Net operating income is the money that remains after all operating expenses such as property tax; utilities; management fees and maintenance have been paid. Just like earnings yield in stocks, we’re dividing NOI by the purchase price or property value to calculate the ‘capitalization rate’ or cap rate for short.
Typically in Calgary, Alberta the cap rate for single rental properties such as a town house or apartment is around 3-4%.  In areas of lower population growth and thus often lower rates of appreciation, the cap rate is typically higher. During the 2008-2010 period in the U.S. you could find properties with cap rates in the 8 to 10% range. It really depends a lot on the location of a property, the local economy and demographics. I am talking about long term average cap rates, because cap rates just like earning yields fluctuate and sometimes can be quite volatile. Once you determine a rental property’s net operating income you divide it by the cap rate to get an idea of its business value.
For example: a rental property in Calgary, where the cap rate typically hovers around 3.5%, has an estimated NOI of $10,000 per year. Then that property’s value should be $10,000 divided by 3.5% = $286,000. Alternatively, you could calculate the projected NOI over the next 25 years to come up with the intrinsic value of a rental property similar as I did for stocks using an investor’s required rate of return on investment (ROI) as discount rate.
Now that you know how much your rental business (property) is worth based on its income you may want to acquire it (for the right price). To buy or sell a piece of real estate you have only one place to go: the local real estate market. Just like in the stock market, pricing in the local real estate market follows often the Don McLean song: ‘The more you pay, the more it is worth.’ The market valuation of any investment depends on the current mood of the market and a combination of fundamentals, personal perceptions, the current economy, hysteria or schizophrenia and whatever else – some markets even respond to sun spot patterns if you believe Harry Dent. It tells you what you can get for a property if sold ‘right now’. It is a bit like you sometimes hear on Dragon’s Den: “Do the deal now or I walk! 1, 2… 3… Gone, I am out”. The current market price is only important if you have to sell or buy RIGHT NOW. Do you have to buy a property at market price well above the business’ intrinsic value?  No! The patient investor can wait until he or she feels the price is right. What is the right price? It is the price which provides you the return on investment that you demand!  If 10% return is your required minimum then that is what you base the intrinsic value on!  So don’t buy at market prices above intrinsic value because your return will be less! That is exactly how guys like Warren Buffett invest they only buy at or below their estimated intrinsic value.
The same for selling an investment. The higher the market price is above intrinsic value, the lower your return on investment will be if from then on forward if you don’t sell and hold on. Of course the higher the market price the higher the risk is ending up with less money when holding on! Thus if the market price would only equal the intrinsic value using a discount rate of 2% that is probably when you want to sell. The market price is then too good to be true and it is time to cash in on the appreciation of the property.
During times of market undervaluation, only those who do not have the financial strength to hold on to a property have no choice but to sell at the price a market offers you. Avoid getting in that position. The only other reason to sell below intrinsic value is when you see another investment with a better return and, hopefully, with similar or less risk. That brings us to the topic of risk which is not only a post by itself but probably justifies reading many books.

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