Ten investing truths

It's all about income

Make sure that the price you pay reflects the real value of your investment

How do you decide whether a current price represents the real value of an asset?

The answer is to assess the asset's value against its income. Wherever you invest - bonds, property, shares - it's the asset's current and future income that determines whether you'll get value for the price you pay.

That's how investment managers find the "intrinsic valuation" of an asset.

By estimating the present day value of the asset's future income streams - profits from a company, rents from a property and interest payments from a bond - an investment manager can arrive at a valuation that reflects the asset's current value. It's a type of analysis they call Discounted Cash Flow.

Investors lose out when price doesn't match earnings

Prior to the dot.com crash, companies like online sales phenomenon Amazon reached the dizzy heights of US$100 a share but failed to generate significant revenue.

Caught up in the frenzy of the dot.com boom, many investors gambled on the future earnings of Amazon. Ultimately they were disappointed, the earnings failed to materialise and the company's share price fell dramatically.

Now that the dot.com boom is past, today's Amazon is valued at around US$40 on the basis of real earnings growth - $US1.46 billion in just three months leading up to September 2004.

Australian property investors risk making the same mistake as the original Amazon 'gamblers'.

Over the past few years, the yield on residential property - the rental income a property generates compared to its price - has slipped to around 1%, a level at which property prices traditionally slide as investment funds flow to assets that offer a better return such as cash and shares.

Despite the drop in investment returns, investors stayed in the market and property prices remained high for most of 2003 and 2004. Finally, towards the end of 2004, property prices started to drop as the fundamentals of income-based valuation reasserted themselves.

Taking an income focus in your investment strategy

All other things being equal, the price of an asset will move towards its income-based value over the long-term. That's how investors make money - buying an asset when its price is lower than its value and selling when it is priced beyond its value.

And real investment opportunity comes from buying into those companies whose earnings potential is still not reflected in their price. That is, by identifying hidden value.

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