I live in Vancouver. A perfectly true stereotype of people in Vancouver is that they are obsessed with real estate as an investment. People in Vancouver love to talk about how real estate is the best investment since sliced bread. Real estate can be a good investment, but it depends entirely on the price you pay. As a famous investor once mused: “at what price and on what terms?” What determines the returns you receive on an asset? The returns you receive on any asset depends entirely on the price you pay. Let me show you by using a rental condo as an example.
Let’s imagine that you can generate a net profit of $10,000 per year from a rental condo. That is, after you’ve paid taxes, insurance, strata fees, and maintenance costs, you can pocket $10,000 per year in pure profit.
The return you will receive from your rental condo will depend entirely on the price you pay for the asset. Take a look:
- $100,000 = 10% Return
- $200,000 = 5% Return
- $300,000 = 3.33% Return
- $400,000 = 2.5% Return
- $500,000 = 2% Return
- $600,000 = 1.67% Return
- $700,000 = 1.4% Return
- $800,000 = 1.25% Return
- $900,000 = 1.11% Return
- $1 Million = 1% Return
Now, it doesn’t take much to realize that this rental condo is a steal at $100,000 and a disaster at $1 million. The return you will receive on your investment will depend entirely on the price you pay for the stream of profits your asset will generate.
You can extrapolate this to any asset.
A stock, for example, is a piece of ownership in a business. The price you pay for that ownership of a business through the purchase of a stock will determine the returns you receive. It’s true.
A stock isn’t some piece of paper that fluctuates in value every second of the day. Well, it is. But it legally represents a fractional ownership of a business, and that fractional ownership entitles you to a share of the profits that business generates.
Hypothetically, if McDonalds only had 1 stock and you owned it, you would be the sole owner of McDonalds and would be entitled to all the profits McDonalds generates.
In 2013, McDonalds had net profit of $5.58 billion. I’m over-simplfying here, but as the sole owner of McDonalds, you could have pocketed that $5.58 billion and gone off and spent it in any which way you so desired. Perhaps you would have spent it buying $5.58 billion worth of rental condos?
Of course, this is not the case in reality. Rather than 1 stock, as of 2013, McDonalds had 990,400,000 outstanding shares of stock. That means the net profit was divided by the total number of outstanding shares. If you owned only 1 share, you were entitled to 1/990,400,000th of the profits – this worked out to $5.55. The more shares you owned, a bigger slice of the business you owned, and a bigger slice of the profits you got.
Your job as the investor, is to determine whether the cash stream that an asset is going to generate for you is worth the current entry price of ownership. The price you pay will entirely determine the returns you receive. If you overpay, you will get dismal returns. If you can get a great deal, you will get fantastic returns. Always ask yourself “at what price and on what terms?”