Paying too much for a good thing

Everything in the ownership track was about telling a good asset from a poor one. This lesson is the sentence that has to be said immediately afterwards, because on its own the previous work will lose you money.

A good asset bought at the wrong price is a bad investment. Not a disappointing one — a bad one, in the arithmetic sense, producing a return below what you could have had for less trouble.

The same cash, at two prices

A small business will hand you 10,000 a year for fifteen years and then close. Assume for the moment that the 10,000 is certain, which it never is — this is about the price, so everything else is held still.

The asking price is 120,000. Twelve times the annual cash, for a business producing it reliably. That sounds reasonable, and reasonable is exactly the kind of judgement worth converting into a number.

Debt amortisation

≈ Hypothetical model, not a forecast

The full repayment schedule for a fixed-rate debt paid off in equal instalments.

It assumes

• The 10,000 arrives in full every year for fifteen years without a single miss.
• The business is worth exactly nothing at the end of the period.
• There are no costs of buying, holding, running or selling the business.
• Nothing about the payment grows, shrinks or moves with inflation.

It ignores

• Arrangement fees, late fees and early-repayment charges
• Any rate that moves, resets or reverts partway through
• Payment holidays, arrears and renegotiation
• Tax relief on interest, which exists in some places and not others

Leave the price at 120,000 and the term at fifteen years. Move the rate until the yearly payment lands between 9,900 and 10,100 — that rate is the annual return the asking price implies.

Amount borrowed120,000

Annual interest rate800%

Payment each period

14,020

Number of payments

15

Total handed over

210,293

Of which interest

90,293

Interest as a share of everything paid

0.429

Balance at the end

0

• Capital not yet returned
• Return earned so far

◷ Not there yet — keep moving the controls.

Under three percent a year.

A reliable business, a real cash flow, and a price twelve times the annual take produces a return that would embarrass a savings account in many periods. There is nothing wrong with the business. The price took the whole of the return.

Now move the price to 90,000, leaving everything else alone, and find the rate again. It comes out around seven percent. A quarter off the price has more than doubled the return, and the business did not change in any way.

That ratio is worth sitting with, because it is the argument for caring about price at all. Analysis of the asset can move your estimate of the cash flow by some percentage. The price moves the return by considerably more, and unlike the cash flow, you know it exactly.

Predict

An asset is growing its cash flow quickly and is priced at forty times this year's cash. What is the buyer necessarily assuming?

Choose one answer

That the growth continues long enough for the cash to catch up with the priceThat someone will pay even more laterThat the business is of unusually high qualityNothing — the multiple is set by the market

Lock in answer

Two ways to lose money on a good asset

Paying a price that requires the good case. If the price only works when things go well, then the good case is not your upside, it is your break-even. Everything you were hoping for has already been paid for, and what is left for you is the downside plus a small share of anything even better than expected.

Paying a price with no room for being slightly wrong. Estimates of future cash are wrong in both directions and by more than people expect. A price that delivers an acceptable return only if the estimate is accurate is a price that delivers a poor one under quite ordinary error. The gap between the price and the value is not just where the return comes from — it is the tolerance on the whole calculation.

Why good assets are usually the expensive ones

It would be convenient if the quality and the price were unrelated. They are not: an asset that is visibly excellent is visible to everyone, and other buyers push the price to where the return is ordinary.

This produces the central and genuinely difficult tension of the whole subject. The asset with the best economics is usually priced so that its return is unremarkable. The asset priced attractively usually has something wrong with it. Both statements are true most of the time, which is why anyone claiming a general rule — buy quality, buy cheap — is describing a preference rather than a method.

The two honest positions are that you have found a case where the market's worry is overdone, or that you are paying a fair price for a fair return and not attempting to do better. Both are respectable. The position that is not respectable is paying a high price for a high-quality asset and calling the quality a reason the price does not matter.

Check

Two people buy stakes in the same excellent business four years apart, one at twelve times its cash flow and one at thirty. Both hold for a decade and the business performs exactly as both expected. What separates their outcomes?

Choose one answer

Nothing much — the business performed and both were right about itThe price, which is most of the difference in their returnsThe four years, since the earlier buyer compounded for longerIt cannot be known without the exit price

Check answer

Worth remembering

• Quality determines the cash an asset produces; price determines how much of that cash is your return.
• In the worked example, a reliable cash flow bought at twelve times its annual amount implied a return under three percent a year.
• Cutting the price by roughly a quarter more than doubled the implied return, with no change to the asset.
• A high multiple is a compressed forecast, and it can be turned back into the years of growth it assumes.
• The gap between price and value is both the source of the return and the tolerance for being wrong.