Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

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Friday, 25 January 2013

3 of the ways in which to value an asset

What is an asset worth?

How do you know how much to pay for an asset, such as a car, a house or a parcel of shares? Whether consciously or not what we weigh up is how much value the asset will give us while we own it and how much we can sell it for at the end of its usage period.

In the case of a car we know that we will ultimately sell it for much less than we pay for it and it won’t pay us any income (quite the opposite!), but while we use it we are extracting value from it so we know that we can pay a little more in the first instance.

When it comes to investments, we need to be more dispassionate, but the principle is the same: we need to consider the value we get during ownership and the ultimate sales price.

But how to measure these factors? Today I’ll look at just three of the many ways of valuing an asset:

1 - Book value

When valuing a company the simplest way to measure what it is worth is to look at its balance sheet total or its net assets. That is, the sum of all of its assets such as its stock, cash and its plant and equipment less the value of all its liabilities such as its loans and what it owes to its creditors.

Then, you can compare this figure to the total value of all of the shares on issue. If the shares are selling for the less than the value of the net assets then you might have found a bargain.

How many people do you know who use this approach today? Zero. It’s totally out of vogue.

In The Intelligent Investor, Benjamin Graham talks of finding companies which are trading at two thirds of net current asset value (excluding long term assets) – he called these net-nets -  and buying shares in them as it gives the investor a margin of safety.

In other words, even if the company is liquidated, the shareholders should still do OK - it is a ‘sure thing’. And the method showed some merit too. Trouble is, it could take many years for a company to be liquidated. There are better indicators of what a company is worth, such as its future profit-generating ability.

But if only people still took some notice of market capitalisation versus book value then they could have saved themselves a lot of pain during the tech stock bubble. Buyers were only looking at movements in share prices but were not considering the value of the companies they bought shares in, and the inevitable conclusion was a crash.

In the property world, it is possible to consider an equivalent to book value. Sometimes investors might look at replacement cost. What might it cost me to build an equivalent property on an equivalent block of land?

2 - Multiplier of yield

An investor in a bond or a term deposit will look at the yield of the instrument. In the present environment interest rates are low, so a term deposit which pays 5% interest is far more attractive than it would be when interest rates are higher than they are now.

Bond yields tend to reflect prevailing interest rates and the perceived default risk. Some government bonds have been paying extremely low yields in recent years and occasionally even negative yields!

US government bonds have been paying very low yields due to the Fed Funds rate in the US being effectively at zero. But governments don’t buy US bonds so much for the income as much as they do because they see the US government as a safe place to put their money – the US is seen as very likely to repay their loan.

In stark contrast company junk bonds or government bonds in countries such as Greece have at times paid very high yields indeed. The income may be high but of course there is a risk that you don’t get your money back.

This is why purely looking at yield is one of the worst possible methods of measuring the quality of an investment.

Yield can be a useful way to value commercial property. If you determine that you want to attain a yield of 10% and you find an industrial unit which is being rented for $10,000 per annum, the investor can calculate the maximum he or she should pay for the investment (I’ve made the maths nice and easy for you...!).

3 - Discounted cash flow

To my mind the most rational way to value an asset such as a company or property is to calculate the present value of all of its future cash flows. This is a bread-and-butter calculation for a bean-counter such as me, but many struggle with the concept.

Suppose I offered you an investment whereby you gave me $1,000 today and in years 1, 2 and 3 I paid you $100 before paying you your $1,000 back in year 4, would this be a good investment for you?

It might be, but really it depends on the risk you associate with me paying you back, doesn’t it (why don’t I ever consider this when ‘lending’ money to mates – seriously, I’ll never learn)?

Also your $1,000 in the future will be worth less than it is today due to inflation, so we need to use a risk factor to discount the future cashflows back to today’s value. Let’s say you consider me to be a little bit risky, but not too bad, and thus you use a discount factor or risk factor of 10%:

Cash flow ($)
Discount factor at 10%
Present value of cashflow ($)

If we sum up the present value of those cash flows at a risk factor or discount factor of 10% they come to $(68). Negative 68 bucks! Lending me money is a bad investment for you. But if you considered me a lower risk or I offered you cash flows each year of, say, $300 each year, it might a good investment.

This is how we value a company, at the present value of all of its future cash flows. Of course we can never know the value of all of a company’s future cash flows so a whole range of assumptions must be made include at what rate the company can grow its profits and for how long into the future. The idea is to come to a figure which is approximately right rather than one which is precisely wrong.

It is a far more complete methodology than simply looking at a Price-Earnings ratio which can be massively distorted by an abnormal net profit or “exceptional” accounting entry, although looking at an average of 10 years’ worth of profit can be a handy guideline.

Present value of residential property

Although we never stop to think of it in such a way this is how we value residential property.

But with a residential property prices tend to be high and net yields after expenses (cashflows) low. Why? Because most people (just as with a car) place a value – a highly emotional value – on residential property ownership - and we usually borrow funds to purchase real estate. People in Australia want to own prime location land and property which pushes up prices ahead of yields.

This is why when people try to measure residential property based upon imputed rents they so often look grossly overvalued.

There is also seen to be value in residential property as an investment. Not a year or two ago the smarty-pants bearish commentators on Australian housing were praising the benefits of the German housing system where most people opt to rent rather than buy, and thus prices are more "rational" and lower. If only we followed the German system, they said, we’d all be sorted! Woo-hoo.

But guess what happened when the Eurozone got in a panic? That’s right, a flight to the perceived safety of residential real estate and German property prices are booming (did someone say “bubble”?).

As net yields are low in our effective present value calculation, we are therefore placing a huge reliance on what the property will be worth at the end of the ownership period.

So when I hear people say “buy off-plan properties in Cairns because of the depreciation benefits! Buy in rural South Australia because  yields are higher!” I cover my ears and say "la la la". Why? Because I don’t have a Scooby Doo* what the demand for property in Cairns or in regional Australia will be in 30 years’ time.

Yes, property in inner- and middle ring Sydney might only secure me a gross 5% or 6% yield. And because investors generally use leverage to buy property, income does not flow for some years into the investment decision. 

But with the population of Sydney growing by more than a third of the population of Cairns every single year I do know what the demand is doing. In property investment we need that final sales value figure to outperform inflation to compensate for the low net yield - and where demand continues to grow, so it generally does.