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Saturday, 4 February 2017
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Love or Money

There is one basic Darwinian principle that my parents failed to teach me and it is this. If faced with two equally attractive potential mating partners for life, marry the rich one!

These days of course partner selection has become something altogether more sophisticated, although I have to tell you, there is still something missing. You can search up looks, personality, sense of humour, interests and all the other data that these websites collect, but nowhere does it give you a financial valuation of the prospective partner.

The first thing you do on Carsales.com or Realestate.com.au is work out the value of what you are buying or selling. It’s a dollar amount. For instance, a 2012 Holden Commodore SV6 VE Series II Automatic is, according to Carsales.com, worth between $16,500 and $18,600 depending on how many miles it has on it.

Why can’t you do the same thing with partners? It’s not as if money isn’t a factor when looking for a partner, it’s a big factor, so why not add in a “Potential Partner Valuation” (PPV) section to the websites. If we could search by earning capacity plus assets adjusted for time to retirement it would save a heck of a lot of bother for some people and add some real value to the dating services provided online. It wouldn’t be hard to do is a PPV. It’s a two-step process.

This is how it would work based on one of the core principles of valuing companies. 

First of all you need the following data:

  • Current net worth. Add up all the assets, house value (what’s left after the divorce) less mortgage debt, plus bank accounts, Superannuation balance, business valuation (if there is one) plus other depreciating assets like cars, SUP boards, household goods less any liabilities like credit card bills. The current net worth in cash and assets is the easy bit of the valuation.

But on top of current net worth you should now add in the discounted value of all future salary payments and this is how that is done.

You need the following inputs:

  • Current salary per annum less tax = one year’s cash flow = we’ll call it CF (cash flow). CF1 is the cash flow in year one, CF2 is the cash flow in year two. You may have to adjust the CF amounts in different years for salary rises but we’ll assume a constant salary.
  • Number of years they will be earning that salary = “n
  • The inflation rate = “r

Your potential partner (PP) can now be valued.

How to value future earnings:

Let’s assume the current salary is $100,000 and that doesn’t include Super (to keep it simple). You could do the same calculation to value the Super contributions and add it to the PP valuation. But for now let’s use $100,000 straight.

If you CLICK HERE you will find a salary calculator for Australia. For a $100,000 salary the post tax, post Medicare levy take home is $73,368. So if your PP got paid annually (to keep it simple) and was paid in arrears then in 12 months they would be worth an extra $73,368.

But in terms of spending capacity, with inflation at say 5% (to keep it simple – government statistics on inflation are a lie by the way), $73,368 in one year’s time will not buy the same amount of stuff as it would today, at the beginning of the year. In a year’s time everything that costs $1.00 now will cost $1.05 (thanks to inflation). So $73,368 in one year is going to be worth less than it is today because everything costs more. But you are trying to value your PP today, so you have to adjust future money, future earnings, for inflation.

The way you do that is simply to divide $73,368 by 1.05. This gives you a value of $69,874. In other words, $73,368 is actually only worth $68,784 in today’s money (in terms of spending value today). So your PP may be on $100,000 a year, but if they only work for one year it actually only adds $69,874 to the total valuation, to their current asset value. Here is the formula where PPV is the Potential Partner valuation:

Now you can do the same thing for the next year’s salary. The next year they earn another $100,000 or another $73,368 after tax. But they only get that in two year’s time. If inflation is 5% in both years then thanks to inflation the value of $73,368 reduces twice by dividing by 1.05 twice.

That reduces the value of a $100,000 salary paid at the end of the second year to $66,546. Add that to the value of the first year’s salary ($69,874) and you get $136,420. So the present value of two year’s of earning a $100,000 salary adds $136,420 to the value of a Potential Partner.

It looks a bit like this:

This is not a complicated calculation and you can see that depending on how many years they have left earning money the value of a PP can be calculated as follows where “n” is the number of working years and “r” is the inflation rate:

So depending on their salary (or earning capacity more accurately) you could begin to value potential partners in dollar terms rather than on good looks. In fact you can build a matrix….like this – this is how much a potential partner is worth depending on their earning capacity and the number of working years left:

So to explain, someone earning $100,000 with ten years of their working life ahead is worth $566,528 in current spending money terms. Someone earning $1,000,000 a year for the next 50 years is worth $10,164,315 dollars.

If the CEO of Carsales.com is reading this, you should be running the slide rule over eHarmony and assessing the enormous potential of rolling out your value based car search engine on the eHarmony Potential Partners database.

But dating aside, all we have really done here is explain to Members the core financial tenet used to value an asset and the root of all stock valuations done by research analysts.

They use slightly different terminology but the principle is the same.

In company valuation terms analysts do discounted cash flow valuations to calculate the Net Present Value (NPV) of a company’s future earnings using a discount rate to discount future cash flows into today’s money. Having calculated the NPV of future earnings they would then add in other assets and come up with a valuation for a company. They then divide that by the number of shares on issue and lo and behold you have the analyst’s Target Price. That’s where the target prices come from.

You now hopefully understand this core principle which is used to value any financial asset. It is called a DCF, or discounted cash flow valuation.

Of course it gets more complicated than this, in particular there are a million theories and a lot of rubberyness in deciding what discount rate to use. Inflation is rarely the basis of the discount rate. When comparing investments valuers look at what they could be earning elsewhere with less risk or the same risk. So a baseline discount rate is not the inflation rate it’s the risk free rate of return, or the return an investor could get in something like a government bond over the same period. Other investors use higher discount rates depending on their assessment of an expected return from other investment options they have. The theory is endless as anyone who has studied WACC will know - (Weighted average Cost of Capital) - it is a whole other body of theory on how to calculate a discount rate depending on a host of factors.

The other rubberyness in company valuations comes from the guesswork involved in calculating future earnings. They are after all forecasts and who can calculate what earnings will be in 50 years. You can’t, so the valuations end up making a host of assumptions about the terminal growth rate in earnings (a huge guess) and use that to come up with an NPV (Net Present Value) for a company which translate into a value for its shares.

Intrinsic valuations use the same basic principles. I have written about (CLICK HERE) the beauty of coming up with a complicated and therefore clever sounding intrinsic valuation for a company and the inherent inaccuracy in the assumptions made. Intrinsic values are presented as this smartypants number that only a guru could calculate and through that it gains a respect of which it is not worthy.

But you knew that.

Back to the Potential Partners.

Whilst you can value the earning capacity and the current assets of a PP and put that on a dating website, some PP’s, like many companies, will have a negative value. My dog for instance. It’s not an asset. It earns nothing and its asset value is nothing. It cost $1,000 and the Net Present Value of all its dog food and vet bills for 16 years I have conservatively valued at minus $4,335, plus the initial negative, the upfront cost of $1,000. It turns out that if my dog as a puppy was on a dating site for dogs its net present value would equal minus $5,335. 

Then we come to the children. I cannot bring myself to calculate the net present value of one of my Children….once you do a DCF on a kid you will quickly realise that they are possibly the worst financial decision you could ever make.

It turns out that if your Potential Partner is a spender not an earner then this whole calculation works the other way around. Put that on a dating website and see what happens. Is eHarmony listed? Carsales.com should buy it and add Potential Partner Valuations. It would be a first and it would explode.


DO I HAVE TO VALUE COMPANIES MYSELF?

You do not need to do your own intrinsic valuations. You do not need to read the Intelligent Investor and work out what Warren Buffett does (no one really knows anyway) and you do not need to resort to an excel spreadsheet and formulas. Because a lot of people have already done that for you and all you need to know is what they have worked out its worth.

The reasons you don’t have to do the valuation yourself:

  • You don’t have the time.
  • You don’t know how to do it.
  • The analysts are smarter than you.
  • There are maybe 10 accepted ways to calculate value – which one is best? No-one knows except in hindsight, for this type of stock in this type of industry its one and for others it’s another.  
  • There are so many assumptions in a valuation that no one valuation is ever ‘right’ except in hindsight.
  • There are so many variables in some calculations, they cannot possibly be accurate.

Its only when you have back engineered an intrinsic valuation of a company that you begin to realise the flaws in the assumptions. The RRR or required rate of return is the big assumption for intrinsic value calculations. But once you have seen the valuation of a stock like BHP move by $5 for a 1% change in RRR, which is an assumption pretty much pulled out of someone’s bottom, do you start to understand the integrity of ‘value’ calculations. They are an opinion. 

You want to know the opinion because it tells you what the market thinks about valuation, which is an important piece of information, but the money is not in what the market sees now, the money is in you guessing where their assumptions are wrong and what is going to happen next (the iron ore price goes up for instance) that the valuers didn’t expect and what impact that would have on their valuation.  

STOCK BOX VALUATIONS

There are a number of subscription products we use that carry intrinsic valuations. There is one in our STOCK BOX that usually reflects a good average of other people’s valuations. We collect valuations along with broker target prices and broker valuations (different) derived from reading rather than skimming the research. Basically you should be able to get a handle on what some smart people think the company is worth, right or wrong from our STOCK BOX. 

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