Great Foundations

Intrinsic Value


If I were to ask you ‘how much a house was worth?’ – would you know? Or how much a share is worth? A business? A bond? Or an annuity?

Chances are, you don’t know.  Don’t feel bad though – there would be many financial professionals who don’t know either, if this is not their field of expertise.

When it comes to a property valuation, many investors and home makers may be guided by a real estate agent. They might also look at recent sales in the area.  The problem with this method is that they are relying on the opinions of others.

In the case of shares, investors and traders may simply assume that the current market price is the true value. In fact, the ‘Efficient Market Hypothesis’ proposes just this.  That all news and information concerning a stock is reflected in the share price and as such the share will always trade at its true value. If this was true then there would be little or no opportunity for a buyer or seller to profit from market inefficiency.

In the case of a business asset, your accountant might tell you that the business is worth a multiple of EBIT or EBITDA, in accordance with a predetermined industry standard. Again you are relying on the subjective opinions of others to determine the value.

Finally – some might adopt the old adage, an asset is only worth what someone else is willing to pay for it. Once again – relying on the subjective opinions of others, with little to no regard to their personal motivations.


So how much is an asset really worth?


For the individual and putting all emotional attachment aside, an asset’s worth is determined by two factors:

  1. The future net cash flow created by the asset.
  2. The investor’s required rate of return.

Or put more technically – an asset is worth the ‘sum of all its discounted future cash flows’. Otherwise known as its Net Present Value’ or the ‘Intrinsic Value.’

Financial analysis such as cash flow discounting is very much a specialised field.  The basics however are not beyond the average person. The purpose here is to lay the foundation for your Financial Awakening, not to frighten you with a myriad of mathematical equations. 

So I will now give you one simple formula to learn and remember. This formula will arm you in your investment decision making and may even start you down the path of complex asset valuation modelling.  This formula is:

Intrinsic Value = Expected net annual earnings / Required Rate of Return

Expected net annual earnings is the total average annual income expected to be received less expected regularly occurring expenditure; excluding interest and other finance costs.

The Required Rate of Return also referred to as the ‘discount rate’, is a personalised rate which ensures that you will be adequately compensated for taking up the risks associated with asset ownership. 

Let’s look at one quick example, close to the hearts of many.

The Investment Property

If a potential investment property can be let out for a net annual rental return of $25,000 – this annual cash flow has a value.  If I require a 5% per annum return from any real estate investment I make, using the Intrinsic Value formula I can quickly calculate the maximum price I should pay.  

Intrinsic Value = Expected net annual earnings / Required Rate of Return

= $25,000 / 5%

= $500,000

I have now calculated that the property has an intrinsic value of $500,000.  This is the maximum amount I want to pay for the property, understanding that I am targeting a return of 5%pa.

Let’s look at the same investment property, only this time we as potential investors require a rate of return of 7.5% pa.

Intrinsic Value = Expected net annual earnings / Required Rate of Return

= $25,000 / 7.5%

= $333,0333

This example clearly demonstrates that if we want to achieve a higher rate of return, we must pay less for that asset initially. Which brings to mind another adage –

A great investment is determined at the time of purchase, not the time of sale’.

At this point some of you might be thinking – what about the capital growth?  Shouldn’t the capital growth be taken into account when calculating the intrinsic value, not just the rental income?

Let’s consider this – why does an asset grow in value? 

Well we now know that an asset’s value is the ‘sum of its total discounted future cash flow’. So the capital growth of an asset must be simply the result of the growth of that expected future cash flow.  

This future increase may be the result of higher than expected demand for rental properties and thereby higher rents. It could also be the result of a property rezoning, which may change the overall income earning potential of the asset.

Alternatively – government and council policy changes, tax changes, property damage and demographic shifts could all in turn impact negatively upon the property’s cash flow and thereby cause a reduction in the value of the property.

So use this formula as your starting point in your decision making process, knowing that there could be good surprises, or unpleasant surprises in the future. The formula is a solid guide to what you should be paying for an investment asset, but it is only the beginning of the research you should be doing.

If you do come across a property which you feel has tremendous income growth potential, model the cashflow and re-calculate the Net Present Value. There are plenty of online guides and calculators to help you do this.

Finally don’t forget to give consideration to imposts such as stamp duty and land taxes, as these will make a difference to your investment returns.

In my next post on Intrinsic Value, we will take a look at home purchases. Buying a new home is a very emotional decision, but if we were to put emotion aside… how much should we really pay?

GOLDSMITH


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