Debt Free

The only question you need to ask yourself when considering a potential investment is “Will it make me any money, and if so, how much, and how risky will it be to generate that return?” Yes, it’s kind of big, complicated question, but if you can’t answer it, you should just buy shares in a good no or low load mutual fund and call it a day. Even then you should have some inkling as to weather you’ll generate enough to retire, buy that Prevost you’ve always wanted, and drive around Arizona.

For most people, just buying into a few solid mutual funds, or getting whatever your 401(k) offers is probably the best strategy anyway. Picking stocks takes creativity, insight and most importantly, plenty of research. Most people simply aren’t able to do the copious research required to pick winning stocks. To retire well, you’ll need to choose investments that generate consistent returns, and even the pros who can do so are wrong on many occasions. The key is to be right more often than you’re wrong, and by a greater margin.

Here are 3 different purely financial analysis techniques you can use to look at potential investments. Some of these are better suited to one time capital investments than investments such as stocks, where the future is hard to predict. In addition, the quality of information you use to make the calculations will obviously impact the accuracy of your results. In a game that lives and dies by a few percentage points, it doesn’t take much of a swing either way to make or break your portfolio. The 3 analysis techniques are: Net Present Value, Payback Period and Average Rate of Return. Oh, you can also use the “Stick my wet finger in the breeze” technique, which has, in fact, been practiced by many successful investors, but more often than not leads to financial disaster.

Which you choose is determined by your individual requirements. The one common problem faced by all purely financial analysis techniques is that they ignore non-financial factors such as the quality of the management team and their past performance, future plans of the company, what a company’s competitors may be doing, regulatory issues, the legal environment, the general market situation the company faces, opportunity cost, and so on. For this reason, purely financial analysis should never be the sole criteria for evaluating an equity investment. These other factors may have as much or more of an impact on the investment’s future.

Investment Analysis Technique 1 – Net Present Value
If you took any finance classes in college, you probably remember this one. It uses the time value of money, and is in fact useful any time you have to determine the value of a series of payments over time, such as when calculating the true value of an annuity or the cost of a loan. Here’s the formula for it:

Got that?? Well, basically it states that the sum of a future payment or payment stream, with the appropriate discount rate applied, equals the sum all the discounted payments received over time. t = time of the cash flow, Co is how much cash you start with, Ct is how much cash you have at time t, and r is the discount rate. Obviously the discount rate will drastically affect the project. If it’s a certainty the calculation will be accurate, if it’s an educated guess, well, maybe not so accurate. It’s really much easier to use a financial calculator or Excel, which is why such devices and software was invented. The advantage is that you can use this technique to easily see the effects of interest rates and profitability on the investment.

Investment Analysis Technique 2 – Payback Period
This technique takes a look at how long it will take to recoup your initial investment. It works well when you have little time for an investment to bear fruit and you need to know if it will pay off in the allotted time frame, and indicates when the investment will begin generating positive cash flow.

The downside to the payback period technique is virtually everything else, but critically it ignores the time value of money, something you can ill afford to do on a long term basis. It also fails to account for profitability after the initial investment has been recouped, so it’s not great for projecting long term results. It’s better for firms looking to analyze a capital investment, though. Its greatest advantage is that it’s very easy to use, which is also why it fails on so many other levels. You simply look at how long the return from the investment takes to equal the initial cost of the investment. Bingo!

Investment Analysis Technique 3 – Average Annual Rate of Return
This is similar to the payback period technique in that it looks at the stream of revenue generated by an investment and the initial cost of the investment. To determine the average annual rate of return generated by an investment, you take the net total cash flow that it generates over a specified time period, divide it by the time period, and divide the result over the amount of the initial investment. To include the time value of money, you want to use the compounded rate of return.

If you bought a rental property for $300,000, put 10% down, and rented it for $2,500 / month, your rental income total for the 5 years would be $150,000. To check your average rate of return over a 5 year period, you need to look at your costs over the period. If you got a 6% mortgage for the $270,000 balance, your P& I would be $1,350. If you pay an additional $500 for taxes and insurance, your costs for the 5 year period, including your $30,000 down payment, would be $147,000.  Income for the same period would be the aforementioned $150,000. Your total simple return for the 5 year period would be 2%. Ouch! Taking into account the time value of money for the 5 years, your compounded return would be only .4%, dismal by any standards. NOTE: This example ignores such factors as closing costs and possible rent increases over the 5 year period.

Now a .4% compounded return is nothing to write home about, you could do way better in the stock market or even at Uncle Larry’s dice game, and that doesn’t even take into account any expenses you may have for repair or renovation. But it also doesn’t take into account any appreciation or depreciation on your property, and here’s where real estate investors count on the power of leverage to make their investments pay off. (Considering today’s market in some areas, counting on appreciation may seem foolish, but over the long term the property will appreciate).

Stocks may generate far higher returns and some pay nice dividends, which can be reinvested or used as an income stream for living expenses. With equity investments however, the amount you invest is the amount you invest, and that’s all there is to it. With real estate, you have the principle of leverage that can multiply your results substantially. The rental income provides you with a .4% compounded return, but if the property appreciates at the annual average of 6.3% over the 5 years, you will make out much better, because that 6.3% affects the entire $300,000, not just your $30,000 initial investment.

If the 6.3% holds, your property will be worth $407,181 at the end of the five year period, giving you an unrealized gain of $107,181. If you add this into the equation, it changes substantially. Now your compounded return for the 5 years is a much more favorable 11.8%, and with time will be even more impressive.

Have a great, debt free weekend.