I am often asked how to estimate the fair price to pay for a property, stock, a business, etc. What we really need to know first is how we determine the value. Once we have a value estimate of some sort, we can compare it to the market or asking price to determine if it is relatively undervalued or overvalued. Alternatively we can use our estimate of value to determine the level at which we place a bid.
Value estimates generally come in three forms. All three stem from a similar concept that looks at the asset’s future earning potential or cash distributions. The simplest is a relative approach, where we simply compare a ratio of price to earnings or price to the book value of assets. This approach works well for an actively traded asset where there is lots of easily accessible public information such as stocks and housing in many developed countries. The main drawback is that even if an asset is relatively undervalued when compared to its peers based on a P/E ratio when the entire asset class is in a bubble period, the real underlying fundamental value may still be quite less than the current market price (you are still over-paying).
A dividend discounting model of some sort is usually the best approach to value a holding where you will be a minority shareholder, for example a stock that pays a dividend. While income properties use a slightly different model the concept is the same. You look at the future dividends, assuming you can determine that they are likely to be stable, and discount the stream back to obtain a net present value. The simplest form of this assumes constant growth rate of dividends. Thus you simple divide next year’s expected dividend (which is this year’s dividend multiplied by 1 plus the historical growth rate) by your required return minus the growth rate. Your required rate of return is best estimated by using what you could expect to average in the long term by rolling over 12 month fixed deposits. While they are low right now, I would expect over the coming 15 years to be able to average a nominal return of at least 4-5 percent, likely a little more. I know this may be hard to believe as we continue to live in a near zero interest rate world, but many Fed members are already publicly mentioning raising rates in the not too distant future.
A more complicated method, in which you gain control of an entity and thus can control what happens to cash flows (if they get re-invested or distributed) is to discount the future free cash flows. Free cash flows are a much better proxy than dividends, especially during periods where many firms are not paying dividends or making accounting profit, but are cash flow positive. The math is a bit heavy but if you are contemplating a serious business acquisition it is not too expensive to hire someone to do this analysis for you.
Regardless of which route you take to arrive at an estimated value, usually with an ongoing concern in the long run returns are mean reverting (this is actually a very big assumption, remember that many companies fail). Thus if you buy an asset after a period of low returns when you determine it to be trading at a discount to its fundamental value, you will likely experience above average returns as it swings to the other side of the pendulum and trades at prices above its intrinsic value. Obviously the time to sell is when the asset is trading above its intrinsic value. In practice most people invest in what they simply believe to be good companies at a time when they feel the economy is safe and they pay little attention to value. Unfortunately when the economy feels safe is usually when stocks or properties are trading at premiums, whereas when the economy is in the gutters the value buys are plentiful. Doing even a simple relative valuation analysis can prevent serious timing errors and greatly increase the success of your overall investing experience.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at firstname.lastname@example.org. Faramond UK is regulated by the FCA and provides advice on pensions and taxation.