For me, value investing is the only logical approach to investing. I recently wrote about how the price you pay for an asset will determine its rate of return, using a condo as a simple example. It really is as simple as that: you need to determine the rate of return you are seeking and then calculate the appropriate price to pay for the cash the asset will generate into the future. Value Investors will talk a lot about discount cash flow analysis. I’ll show you a simple way to look at discount cash flow and how it connects to the price of an asset and the rate of return you are seeking. If you’re still feeling slightly confused, don’t worry, let me show you what I mean by using the ad revenues of this website to determine what price you would need to pay to purchase this asset’s cash stream.
Going on Google AdSense data from October 2014 to February 2015, Kapitalust has generated on average $0.14 a day in ad revenue.
Now, to keep things simple, let’s ignore expenses (such as hosting costs) and use only the cash that is generated from the ads. To further simplify, let’s use this $0.14/day average and imagine that this is what this site will generate for the next 3 years.
Why 3 years? I just wrote about how I saved 50% (you could even say $36,000) by haggling with BlueHost for a heavily discounted 3 year hosting rate. Kapitalust will go on for at least 3 more years.
These are the facts we’re working with:
- The asset generates $0.14/day
- The asset will generate a total of $153 at the end of 3 years ($0.14 x 3 years)
- We will assume inflation to be 2% over 3 years
- After 3 years, you will close up shop and no longer collect any cash from this asset.
- For simplicity, we will ignore expenses, taxes, and focus only on the cash generated.
- For further simplicity, we will think of the $153 as the future value of a single sum.
Now, since we know that Kapitalust will generate $51 this year, $51 in 2016, and $51 in 2017, we need to discount $153 (the future value of the cash generated by this asset) back to the present.
We use the formula where PV is Present Value, FV is Future Value, i is the discount rate, and n is the number of years.
PV = 153/(1+0.02)^3 = $144
Therefore, the Present Value of the cash Kapitalust will generate for the next 3 years is $144 assuming 2% inflation over 3 years.
Let’s say you are interested in buying Kapitalust and the 3 years of cash it generates. If you pay $144, well that was a terrible investment because you got a 2% nominal and 0% real return on investment.
However, if you were seeking a 10% return on your investment, what would you have to pay?
Using the same formula, you would have to use a discount rate of 12% (2% for inflation and 10% for the returns sought):
PV = 153/(1+0.12)^3 = $108.90
This means, if you demand a 10% return on your investment, you cannot pay a penny more than $108.90 for Kapitalust.
If you bought Kapitalust for $108.90 and the site earned you $0.14 per day for 3 years, you would have gotten yourself a 10% return on investment. 10% real return is nothing to sneeze at in investment terms.
It’s as simple as that. Well, the general concept is as simple as that. This is value investing at its core. You never overpay for an asset, unless you are seeking mediocre or sub-optimal investment returns.
Now, we’re off to the Oregon coast for a little winter vacation. Surfing, reading, and relaxation. Sounds like paradise.