How to value any investment
Updated: Jul 19, 2018
In our lives we make many investment decisions and we are often almost forced to choose among investment alternatives: 401-k retirement plans, new business ventures, real estate investments ... We often think of separate investments having specific and distinct dynamics requiring the help of specialized advisors. Truth is, we can evaluate apparently different opportunities in similar and simple ways once we focus on the few parameters that really matters.
Investment valuation is made essentially of two main steps or concepts, they are very simple and they are the same whether we are professional investors or young savers thinking about investing in the house we want to be our home for the next twenty years.
In general, we do not have to fall for the trap of “pricing” an investment by using formulae based on “comparables”: x % of revenues of similar businesses, the average price per square foot of houses in the area etc. We usually price something not giving us any cash flows in time: currencies, precious metals, cars for personal use and so on. Depending on the case, we may not even know what "pricing" exactly means or how to do it.
Investing is about return in time; we have to evaluate the return we get from the investment or, similarly, figure out how much we are willing to pay in order to obtain our required return in time. We should be able to do the first rough calculation by hand through a couple of numbers on a sheet of paper. If we need tools like Excel even for a first rough answer, probably we do not have a clear understanding of the investment and it should encourage us to study better its dynamics.
Let’s go through the two steps.
The only thing generating value out of the investment is the money we receive or save through that investment; that is the first step, determine the cash flows in time. The second and last step of investment valuation is the comparison of those cash flows in time with a required return we want (or need). The second step is really just about comparison; terms like discounting, actualization and present value of cash flows are just comparisons in time and summations: discounting a cash flow of $100 occurring in 1 year at a 10% rate means that we are basically comparing the $100 cash flow with a required 10% return in one year and in order to get it we are willing to pay today its actualized value of about $91 = $100 / (1+10%)^(1 year). Complex cash flow modeling is often more useful for cash management purposes rather than actual valuation.
We are all irrational when it comes to investments and savings; we accept lower returns not correlated with lower risk just on the base of our familiarity with the type of investment. That is also why it is tough to really have a reference required return when different investments are not always perfect substitutes for everyone. For our discussion we can consider as required return for long-term investments the historical after-expenses return of the financial market, about 5% per year. With that reference, we can now go through a couple of examples like buying a house or a private business, even though the same applies to the valuation of corporations, startups and even financial derivatives as long as we figure out their cash flows.
Let’s assume we can purchase a house for about $300k, receiving (or saving) about $15k in after-tax rent per year; in that case we would basically obtain the 5% return mentioned above. In order to evaluate the investment opportunity, we need to determine whether that is a good return or not to us. Maybe, in this case we would not be getting an exceptional deal since the extra risk and lack of liquidity and diversification of investing in a house would require a higher return compared to the average market return. However, probably many of us did purchase a house at about that return in the last decade once we consider possible restructuring costs, commissions and fees.
Let’s now consider investing in private businesses like restaurants, hardware shops etc… Each one of us can try to figure out the yearly after-tax cash flow of a small business we happen to know and understand. Probably at the moment, depending in some way on where we live, we would be able to buy out that small business for about 20 – 25 times the cash flow; we would basically get, again, about 5% return on the investment each year. That is maybe true for western countries at the moment and again, we would want anyway a little more from a risk management point of view.
Often we find ourselves stuck with apparently few investment opportunities just on the base of our familiarity with those opportunities. Often we also obtain return-on-investments barely acceptable once compared with alternative opportunities.
The brief discussion above is a way to gain an initial macro view of the investment. It is essentially about what we are getting vs what we are paying and want. Going directly through the details and the specific story of an investment opportunity may take us off-track without notice. Going with the flow and pricing (not valuing) our investment, just on the base of only apparently similar transactions, could make us lose sight of the return we are getting on our money.
This post is not, in any way, an investment advice