Mr Moneybanks lives in the UK working as a financial modeller. He is also a qualified accountant and writes on MultimillionaireRoad.com where he shares his thoughts on growing wealth. Check out Multimillionaireroad.com to join him on the road to riches
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When it comes to investing the key is quite simple. You want to figure out the intrinsic value of the investment opportunity and then ensure that you pay less than the intrinsic opportunity. As the great investor Warren Buffett neatly summarises: Price is what you pay. Value is what you get.
My current job is in financial modelling. We help businesses to predict what their future profits and cash will be. Often times our clients want models that tell them the value of their business in order that they can get a fair price when they sell; or we tell them the value of a potential acquisition in order that they pay under the intrinsic value in order to get a bargain.
I’ve been investing in the stock market since I was 11 – albeit, helping my grandpa to choose and to track stocks. My interest in business grew from there. I started to read about Benjamin Graham, The Intelligent Investor, Phillip Fisher and Warren Buffett.
Post University (studying Economics) I decided that I needed a better understanding on Financial Statements and trained to become an accountant. Financial modelling wouldn’t be possible without a strong understanding of company financial statements – and I encourage everyone to take the time to learn basic accounting if they want to become a better investor.
I use three key methods for determining investment value. These are the payback method, the average rate of return (ARR) method and finally, the net present value methodology.
The payback method is the simplest starting point when appraising any business as a potential investment. The methodology asks: how long will it take me to get my money back? A valuable company will pay back the initial investment quicker than a less valuable company.
The calculation is quite simple. A company pays dividends to investments in return for the initial investment. The payback method assesses how long it will take for the investor to receive enough dividends in order to cover the initial investment.
For example, if you invested £100 in a company that pays a 5% dividend (i.e. £5 per year) then the payback method would suggest that you will receive your initial investment back in 20 years time. However, you need to account for growth in the dividend over the years. In this example, if the dividends grew by 5% each year then you would actually recover the £100 initial investment in just over 14 years.
Another way to assess an investment is to calculate the average rate of return (ARR) that the investment will earn over a period of time.
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
Initial investment | – 500.00 | ||||
Net cash return | 150.00 | 200.00 | 250.00 | 300.00 | |
Net return | 400.00 | ||||
Years of investment | 4 | ||||
Net return as a percentage of initial investment | 80% | ||||
Average return over the 4 years | 20% |
As demonstrated in the diagram above the calculation is fairly straight forward. Calculate the overall net return of the investment. Sum the total cash returns from each of the four years minus the cost of the initial investment. In this case it is 150 + 200 + 250 + 300 – 500 = 400.
The average rate of return is then calculated as the net return of 400 divided by the initial investment of 500 divided by the number of years of investments i.e. 400/500/4 = 20% average return per year.
The ARR enables an investor to compare alternative investments. The investment choice is the one with the highest ARR.
Finally, my favorite investment appraisal technique – the net present value methodology. The payback rate and the ARR are techniques that indicate that the investment may be worth investigating further. Using the net present value determines once and for all as to whether I’ll make the investment.
Discount rate: | 10% | ||||
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
Initial investment | -500.00 | ||||
Net cash return | 150.00 | 200.00 | 250.00 | 300.00 | |
Discount factor | 1.00 | 0.90 | 0.81 | 0.73 | 0.66 |
Discounted returns | -500.00 | 135.00 | 162.00 | 182.25 | 196.83 |
Net present value | 176.08 |
The benefit of the net present value methodology is that the technique takes time into consideration via the use of a discount factor. £100 in four years time is not the same as receiving £100 today. For one thing, you could put the £100 today into a high interest savings account so that it would be worth even more than £100 in four years time. Additionally, over time the value of money is eroded by inflation such that £100 in four years time is simply not worth as much as £100 today.
The discount rate reduces the net cash returns to today’s equivalent value. The net present value is simply the sum of all of these discounted cash flows. If the net present value is positive then the investment is worth considering. Once again, the net present value methodology allows you to compare different investments. Invest in the one with the highest net present value.