By Professor Ricardo “Rick” Ulivi, Ph.D.
Often when people ask me what I do, I reply that one of my jobs is being a finance professor. To emphasize the point, I tell them that I teach how to buy low and sell high. On hearing this, many people chuckle and say they often buy high, and sell low! Oops, that’s not good. What do you need to do to get it right?
One of the keys to investing successfully is to understand valuation. This will help you determine if the price of something is below or above its true value, and therefore whether it’s a good or a bad deal. What determines value? Let’s review three examples: real estate, stock, and bonds.
How to value real estate
There are several measures of valuation, including the cap rate and gross sales multiplier. But let me focus on a simple rule: a good deal is if your rents cover your mortgage and property taxes, assuming you borrow 100% to buy it. Imagine, tenants help you pay all the mortgage and taxes, and in 30 years you will own the property free and clear. That was the case in 1998 thru 2000 but it’s not the case today!
What’s a bad deal? Let me illustrate it with an example. Suppose you want to buy an apartment building today with four units; the sales price is $1,000,000, and the annual rents are $70,000. The mortgage payments, assuming a loan at 6% (remember it’s 100% leveraged deal), would make your annual payments $72,000. The property taxes will add another $12,500, so your total payments are roughly $85,000. Your rents ($70,000) do not cover your payments, so this is NOT a good deal. The property is overvalued. You should walk away from this investment.
Using the gross rent multiplier as a valuation measure also confirms that this is a poor investment. You divide the asking price by annual rents which gives you 14.2–pretty high in historical terms. Years ago, you could buy using a 7 multiplier. A good deal would be buying this property for $500,000.
In today’s real estate market, it is very difficult, if not impossible to find good deals. So why are people buying? Either they are making some very rosy assumptions, or they will end up being guilty of having bought high and sold low.
How to value stocks
One of the most popular valuation indicators is called the price/earnings ratio, known as the PE ratio. In many ways it’s similar to the gross rent multiplier in real estate. That is, a stock price is determined as a multiplier of the earnings. For example, a stock selling at $20 with one dollar of earnings would have a PE of 20. Another stock with $2 of earnings, and a price of $20, would have a PE of 10. Another way of looking at this measure of valuation is to ask yourself: how much are you willing to pay for one dollar of earnings? If you are willing to pay $10, that’s your PE ratio. If you are willing to pay $20 for one dollar of earnings, you PE ratio is 20.
What’s the current valuation of the stock market? Let’s review some history. An index of stock prices, the S&P 500, has had its PE ratio fluctuate between a low of 5 and a high 40 times earnings, using Professor Shiller’s widely followed valuation methodology. The historical average is around 17 times; this indicates that a PE ratio below 17 is a good value, while one above 17 suggests you are paying too much for a stock. Presently, this PE is around 31, which strongly suggests that stock prices are overvalued. Yet, each day the stock market sets new records, and the PE ratio keeps going up. Too many investors, in my opinion, have lost their good sense of value.
At these prices, I believe anyone buying will regret it later. Prices are overvalued.
How to value bonds
When you buy a bond, you are basically lending money to someone who promises to return your principal sometime in the future. To compensate you for giving up the use of your money, the borrower will pay you an interest rate. This rate should also compensate you for inflation; that is, when the principal is returned to you, you want to have been able to conserve the purchasing power of your money.
So, are bonds today a good or bad deal? The ten year US Government bond is paying around 2.3%. Suppose you buy one of these bonds by lending the government $100,000. Each year, you will receive $2,300 of interest and ten years later, you will receive your original $100,000. The problem is that inflation is running around 2% presently, so you are basically being compensated for inflation but not for the use of your money. In other words, you are giving an interest free loan for ten years. Obviously, bonds are a bad investment today.
What investment looks good now?
I just tried to prove, in simple terms, that real estate, stocks and bonds are overvalued at this time, so investing in them makes no sense. If you want to buy low, and sell high, this is NOT the time. Staying in cash makes a lot of sense to me.
Some people argue that I am negative, or pessimistic. Nothing could be farther from the truth. It’s just that I love making money and hate losing it, and given today’s economic and financial situation, it’s far better to keep lots of money in cash. Now is a good time to practice patience, a lost art among young people! Things will turn around soon, values will be more realistic, and that will be the time to buy low, and later sell higher.
If you want to meet with me to review your situation, please call me at 714-771-6000