When evaluating an income investment, should you analyze it with the discount cash flow model?
Do You Have a 100% Accurate Crystal Ball?
Many will argue with me, but unless you happen to know the future, I doubt it's worth the time and effort.
Discounting is like compounding money, but going in the opposite direction.
Here's what I mean. Chances are, you've seen tables showing you how much an investment of $1,000 would be at various times in the future assuming you earn an average of X%.
Usually, the point is to get you to understand the power of compounding investing income, and I'm all in favor of that.
Discounting Works Backward From the Future to the Present
However, when you're discounting, you turn that on its head. Instead of asking how much $1,000 will be in 10 years if you get a 5% return, you ask how much you have to invest today to have $10,000 in 10 years if you can get a 5% return.
Another way of saying it, is asking how much $10,000 10 years from now is worth now (assuming the 5% return). That is known as the present value.
If you win a lotto jackpot in a state that allows you to take a cash option, the lottery officials will pay you the present value of the jackpot spread over years. It will be a lot less than the advertised jackpot (but don't complain -- nobody will feel sorry for you!)
It can get more complicated. You can ask, how much money will you have to invest now to receive $50 next year, $60 in 2 years, and so on for years in the future. Then you add those totals up to come up with the present value of an investment that will generate that much cash every year.
Come Up With Your Estimate of the Present Value
What many stock analysts do, including Warren Buffett, is come up with some estimate of how much a stock that pays dividends will actually pay every year in the future. They'll add that up for every year. They'll use an estimated interest rate that's risk-free, such as what Treasury bonds are paying. Some of them also assume a sale of the stock after so many years, and estimate what its value will be at that time.
That total is the stock's present value -- according to the analyst.
Compare Its Present Value to the Market Price -- Over or Under?
If the current market price of the stock is below its calculated present value, then you should buy it. If the current market price of the stock is above its calculated present value, don't buy it.
I hope you see some major problems with this model:
1. The interest rate is only an estimate. What Treasuries pay in future years will fluctuate up and down. And nobody knows what the rates will be in future time periods.
2. Nobody knows for sure what future dividends will be. You can look at the company's present dividend and how much it has, historically, raised them every year, but there's no guarantee that will continue to be increased by that average every year. There's no guarantee it will be raised or even paid at all throughout the future.
3. The time period used is also somewhat arbitrary. How long will you hold the stock? Twenty, thirty, forty or more years? So long as it continues to pay dividends, I advise holding the stock, to avoid paying capital gains taxes.
Twenty years sounds like a long time, but unless you're over 70, you stand a good chance of living that much longer. If you're young, you should be planning to hold stocks for a hundred or more years.
And even if you die, you can leave the stock to your heirs and advise them to hold on. If your portfolio pays them enough money and you've educated them well, hopefully they'll listen.
If you assume a holding time of "forever," the present value of a income investment is "infinite."
Therefore, any price is worth paying, because you'll be rewarded throughout eternity.
However, not many of us can wrap our minds around that. And not many people yet believe they're going to live forever.
Select the Best That's Available Now, With Diversification
So I believe the only practical course for investing for income is to buy a wide selection of the best choices available. You don't know which companies are going to do best in the future, and you can't know that no matter how many spreadsheets you run, so there's no point in trying. Just reduce your risk by diversifying.
Use your time to make more money with which to invest instead of trying to predict the unpredictable.
Compare Relative Yields
If you really want to evaluate income investments, compare their relative yields. If they're both the same kinds of securities (you can't compare stocks to bonds this way, or ordinary stocks to units in Master Limited Partnerships), all other things being equal, the one with the highest yield is the best buy. It may not pay the most next year, but you can't predict that.
Buy an income investment, don't sell so long as it sends you checks, and keep reinvesting until you're wealthy.
Author Resource:
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