Category: Great Foundations

How much should you pay for your new home?

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Intrinsic Value – Part 2

Determining the intrinsic value of a potential home purchase is not overly different from determining the intrinsic value of an investment property.

When it comes to a home purchase the ‘expected net annual earnings’ are replaced by the ‘annual net rental savings’ you achieve by purchasing the home rather than renting it.

Even with a home purchase there must still be a ‘Required Rate of Return’ as there are still costs and risks associated with home ownership and you must be compensated for this. Risks include financing and opportunity costs, structural risk, market risk and government.

So let’s analyse. A house comes onto the market and you feel it would make a nice home.  Three bedrooms, two bathrooms and a decent sized backyard for your children.

You are currently renting a similar property, of similar age, similar condition, in a similar location for $450 per week. You expect that this new property might be rented for a similar amount. However, as a homeowner you will be paying some larger annual expenses you would not be paying as a renter. These expenses include council rates, water rates and insurance. Let us assume $3,000pa total for all. 

You know that the current standard home loan interest rate is 4%, so you apply this as the required rate of return.

What is the intrinsic value of your potential new home?

Let’s start by revisiting our Intrinsic Value formula.

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

Adjust the formula for a new home purchase calculation, as discussed previously.

Intrinsic Value of new home = Expected annual rental savings less major ongoing homeowner expenses / Current standard home loan rate

= (($450*52))-$3,000) / 4%

= $20,400 / 4%

= $510,000

The intrinsic value of the property is approximately $510,000 and this is the maximum you should pay, including all associated purchase costs.

Should borrowing costs fall, so too do the risks associated with asset ownership. Should borrowing costs rise, so too does the risk of property ownership. The discount rate applied should be adjusted to compensate you for the risks assumed. By simply applying the current standard home loan rate, your required rate of return will adjust automatically with market conditions.  

Understand that you are taking on more risk buying an investment property than you are when buying a home.  Afterall, you don’t need to find tenants to rent your home. So be sure to apply a higher discount rate to calculate the intrinsic value of a potential investment property. Whilst this does mean that the same property could have two intrinsic values, this is fine.  Paying a little more to secure the home of your dreams is not necessarily a bad financial decision. Just be sure to get a discount on the investment property. 

When all is said and done, if a seller is demanding more for your dream home than the intrinsic value, you are probably better off financially by continuing to rent and waiting for a pullback in general property prices. 

Finally, when it comes to a home purchase it is likely to be one of the largest and most important financial decisions you ever make. Please be sure to thoroughly examine the property before signing up to buy it.

We will be back to examine intrinsic value soon, this time with respect to share purchases.

GOLDSMITH

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Risk-Free Return

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The third foundation block, paramount in your financial awakening is an understanding of the Risk-Free Return. I say paramount, as before you make any investment decision you should know exactly what return you can make, taking zero (or near to zero) investment risk.

Why take on additional risks, when you can reach your destination safely?

When it comes to risk-free returns there are different types, depending on who you are and the country in which your reside. 

In the case of an Australian Citizen, I consider that there are 5 types of risk-free returns… plus… 1 risk-free asset worth an introductory mention.

The first of the risk-free returns is the $US 10 year treasury bond – considered the risk-free investment of choice for bankers and fund managers the world over for 3 generations – currently paying interest of 1.47%pa.

The second, for an Australian, would be an Australian Government Bond – currently paying 0.93%pa.

The third would be a term deposit with a Big 4 Australian Banking institution – currently 1.5%pa

Presently, funds held on account with any Australian financial institution are backed by the Government Guarantee up to $250,000 per entity, per institution.  As such a term deposit with a small Credit Union, has about as much risk of default as an Australian Government Bond. So forth, other term deposits. Currently 1.75%pa.

The fifth risk-free return – is the most important risk-free return of them all. It is generally a tax-free return and its nature is ‘debt reduction’. These ‘debt reduction’ measures might include, assuming no early payout penalties:

  1. Early repayment of a home loan – will currently save you circa 3% pa.
  2. Early repayment of an investment loan – should save you 3-4%pa.
  3. Early repayment of a credit card – save 20% pa.
  4. Holding cash in a 100% loan offset account – save 3-4% pa.

Before you make any investment decision you must at least give consideration to these 5 risk-free return opportunities, as described above and particularly the last. However, please be sure to ask about any early payout penalties on loans and other finance you might been looking to repay.

Over the coming weeks I will provide you with examples on how to apply the risk free-return concept to your financial decision making processes.

Now I mentioned that there was also a single ‘risk-free asset’. Care to take a guess what this might be?

Occasionally it is referred to as a ‘barbaric relic of a bygone era’.

The bankers and the ultra-rich have been telling you it is worthless for 120 years. ‘Just a commodity’ they say. Yet over the past 20 years alone, this risk-free asset has grown in value by approximately 450%. 

In case you haven’t guessed already – this risk-free asset is… GOLD. Yes, GOLD is a ‘risk-free’asset.

It is important to be clear here. GOLD is not risk-free because it provides you with guaranteed income or annual capital growth. Physically held GOLD is risk-free, because it is not a liability of any other party. Meaning there is no risk of default.

Don’t just take my word for it though. On 31 March 2019, GOLD was reclassified as a ‘Tier 1’ asset under the Basel III International Regulatory Accord. Meaning that for the purpose of International Banking Standards, GOLD is now always considered a ‘ZERO risk asset’.

We will be discussing GOLD in much more detail here at the Financial Awakening, over the months and years to come. And with great personal pride and pleasure.

GOLDSMITH

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Intrinsic Value

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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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The Golden Rule

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There are many financial self-help books which claim to hold the secrets to unimaginable wealth and financial success. They promise that you, no matter who you are, you are just 5 steps away from being the world’s next billionaire.

Well dare I say that not everyone is destined to be a billionaire. However, there is a common theme that runs through these books – this theme I call ‘The Golden Rule.’

Not to be confused with the Golden Rule of the Bible – ‘Do unto others as you would have others do unto you’, this Golden Rule guarantees financial success for all who do obey. 

Mums and Dads, businesses small and large, clubs, co-ops and even governments should all strive to learn the Golden Rule.

The ultra-rich of the world already know the Golden Rule.

And now you do too.

The Golden Rule is –

‘Spend less than you earn!’

Or to be demonstrated mathematically –

EARN > SPEND

This is it!

About all it takes to be wealthy… and perhaps even happy.

‘Spend less than you earn’ or ‘earn more than you spend.’ Whichever way you prefer to say it, success is most definitely guaranteed.

For a household, the rule should mean running a budget with a savings plan… and sticking to it. 

For a business it means running a profit.

For a government it means running a budget surplus.

Adherence to the Golden Rule is wonderful – your wealth will grow and from this new wealth, more wealth will grow. 

The Golden Rule declined

Failing to adhere to the Golden Rule is fraught with danger. 

Spending more than you earn depletes your savings, may force the sale of your assets and may force you into debt. For a time this may be manageable. Understand however, spending more than you earn now, means you are taking an advance on your future earnings.  

In the case of an individual, this advance required you to forgo the use of your future earnings in exchange for a perceived benefit now.

In the case of a business, you will forego future profits to bring forward a benefit.

In the case of a government – they are taking an advance on the future taxes which will be paid by you, by your children and maybe even your grandchildren.

Economics

When it comes to government spending, there is an economic theory which suggests that the more a government spends, the more prosperous that nation will be. The premise being that by spending more than it earns (deficit spending), the country will foster economic growth. This theory is known as Keynesian Economics.

Back in my university days I questioned the validity of this theory, much to the distress of the faculty and staff.  To this day I have seen no practical evidence to support this Keynesian Economic theory. There has certainly been no shortage of national borrowing in the past 20 years and over this period there has been little in the way of real GDP growth. So I stand by what I said back in the late 90’s – ‘a country can never borrow its way into prosperity.’

A Golden Choice

Stick to the Golden Rule – it will not let you down. Strive to increase your wages, salary or business income and be constantly questioning your purchases.

Avoid credit cards and other personal debt. Living within your means now, should improve lifestyle over time.

Don’t be mistaken though, the Golden Rule in no way implies that all debt is bad. Some debt can actually be good. To understand which debt is good however, you must understand Intrinsic Value, our next foundation principle.

GOLDSMITH

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