A Framework for Investments
When evaluating any sort of cash flow-generating asset or venture, we can use a simple framework to quickly determine its value and if it financially makes sense to invest. Or at the very least, model out more thoroughly.
A confluence of three components needs to align for these investments to be great: Price, Cash Flow, and Financing.
Price
Let’s use equities or more specifically stock picking as an example. Despite the common refrain that what matters most is the quality of the company, what really matters is what price you buy it at.
I’m not saying the quality isn’t important, but it’s just not the true metric for generating a return.
Placing the statement in the appropriate context, it’s what price you buy it at relative to what a future person is willing to pay for it.
Unless you’re a hedge fund or some other institutional investor, it doesn’t matter if the fair value of a company is higher than its current stock price if no one is willing to buy it from you at that price.
It generally requires the vast resources of the aforementioned entities to stay in the game long enough for efficient markets to kick in.
Remember the key adage: the market can stay irrational longer than you can stay solvent.
I’ll admit that knowing what others are willing to pay, especially at some future point, is much easier said than done, which is why for the purposes of this framework we can rely on historical patterns and assume mean reversion will apply.
One valuation measure is the price to earnings or PE ratio, which looks at a company's stock price against the latest reported earnings (usually trailing twelve months).
Here the data goes back to before the 1900s and up to July 8th, 2022.
A metric in a similar vein is the Shiller PE ratio which looks at the average inflation-adjusted earnings from the previous 10 years.
Remember PE ratios are often unique to that specific stock or industry, so use the correct metric to evaluate companies accurately.
Here’s one popularized by Warren Buffet, which takes the total value of all publically traded US stocks over the US GDP.
Looking at these metrics helps provide context to short-term localized moves. Despite stocks falling significantly in 2022, by historical measures, there’s a good argument to be made that US equities are still overvalued.
Though these measures don’t tell us when to buy something, they provide a way to determine if something is “cheap” to increase the odds of being able to sell at a higher price at some future point.
Cash Flow
A fundamental reason someone is willing to buy something is the rate of return that asset will generate in the future.
This is somewhat difficult to predict for many stocks especially those that aren’t profitable yet or younger ones that are still growing rapidly and don’t have a strong track record.
Dividends then are a great way of predictably determining the return assuming the stock price stays stable. Even then, there’s generally no guarantee that even a dividend will stay fixed but there exists a class of equities called dividend aristocrats which have increased their dividends consistently for at least the past 25 years.
Many companies that pay dividends tend to be very reluctant to cut dividends for fear of alienating existing investors and spooking potential ones.
On the flip side, future cash flow is much easier to determine for bonds paying a fixed interest rate to the holder or in real estate where rents tend to be quite sticky.
These face value returns can be deceptive without due diligence. The cryptocurrency Luna is a recent high-profile example where 20% interest was offered before it eventually collapsed.
Just because something is offering a certain interest or promising a certain return, doesn't mean it’ll be guaranteed. In fact, the more better something sounds, the more we should be wary of it.
However, there is one place we can go for virtually guaranteed returns. Anything backed by the federal government can generally be trusted with a high degree of certainty, such as FDIC bank accounts and Treasury bonds.
In this case, if the federal government is unable to meet these obligations, we’ll have much bigger problems than just missing the owed interest.
Financing
Financing is not necessary but often makes the most sense for very large purchases such as real estate, cars, or business loans.
When we do take financing, we want to properly evaluate the terms, interest rate, and length.
Similar to the aforementioned metrics used to evaluate the “priciness” of US equities, we can take a look at historical borrow rates for products like mortgages.
Take 30-year mortgage rates. Given the current environment, it’s no surprise to see that rates have achieved a decade high.
It is important to place the data in the proper historical context and we see that zooming all the way out, rates could still be considered relatively reasonable.
In this case, which chart to use is more about what kind of regime we believe we’re in a now. One where inflation is here to stay and will force the steadily rising rates or one where we’ll mean revert to the low rates we’ve come to expect over the last decade.
Regardless, the data suggests that purchasing housing right now would be quite expensive to finance compared to recent historical norms.
By taking these three components: price, cashflow, and financing, we can relatively quickly determine how valuable an investment or business venture may be and position ourselves to take advantage of great opportunities.
