May 4, 2006

Analysing the assumptions

One approach to analysing stocks, bonds or even real estate is to look at the valuations and figure out the assumptions built into the price. It helps to analyse these assumptions and check if you buy into them. It also helps if one has a good sense of history and asset values in the past.
Let me take the example of the top tier IT companies like infosys, Wipro etc. These companies sell at a PE of 30+. So in effect the market seems to be ‘assuming’ the following
a) return on capital of 40%+ for the next 10 years
b) A compounded growth of 18%+ for the next 10 years
c) Maintenance of margins in the 20%+ range
Now it may be possible that these companies would achieve some of these expectations. But to justify their valuations they have to achieve all of them. Ofcourse the top tier IT companies are atleast doing fairly well and may even deserve a high valuation. One can find a number of mid-cap and small cap companies which are riskier, but valued at even higher valuations. The current earnings growth is being projected for quite a few of these companies well into the future. The same is being done for commodity companies like cement, steel too.
Lets take another example outside the stock market. Lets look at the current investment favourite ‘real estate’. Now if you believe like me that the value of any asset is the sum of all cash flows to eternity, an apartment selling at 60 lacs for an area of 2000 sqft would have the following assumption (3000 rs / sqft is not a very high rate these days)
a) 6% rental yields on the capital invesment of 60 lacs.
b) Growth in the yield (read rentals) at around 8-9% per annum
c) Terminal sale of the property after 30 years with a 9% appreciation per annum, with a discount of 10% for the older property.
What all of the above means is that
a) rental of Rs 30000 per month
b) A hike in the rental of around 8-9% per annum
c) The property will sell for 7.2 crs after 30 years (net present value is 95 lacs with an inflation of 7% per annum)
So for an apartment to justify a return of 8-9% total return at the current prices, the above should hold true. Whether it does or not, depends on ones view of the above ‘expectations’ in terms of rentals


Anonymous said...

Please change the layout of your posts as well as the links on the left. The current layout is difficult to read for a long time (maybe reducing the length of each line would make it better - for example, instead of having 25 words on every line, having about 15 words would e better). Since your posts are a little "long", readability should be given high priority.

Thanks! :)

Rohit said...


actually the format of my posts has got messed up and i am not able to fix it.
the post preview looks ok, but when i publish it, it look all jumbled

Anonymous said...

Hi Rohit, Its hard to believe that the assumptions can effect this much on market pricing. The way you have analyse the real estate I feel scared. If this really happend what will the value of the money. But looking back at the history this may become reality. Like 20 years before the salaries of the people were in hundreds p/m and now they are in thousands and even in lacs p/m. God knows.

kaho pyare said...

I have one question -
why you are assuming 9% appreciation in the value of house.

if you just want to beat inflation, with 7% rental yields and no appreciation (assuming 7% inflation), your investment should be worth it.
OR else with no rental yield and 7% appreciation - this is also worth it.

If you get "anything above" this (like 7% appreciation and 1% rental yield) - it should be good investment.

PS - I beleive this "anything above" depends on risk-return ratio. if there is 0% risk, I will be fine with 1% as well.

Rohit said...

9 % lies between stock market long term returns and Fixed income return. but no scientific basis around it.
acutally a better idea would be to pick a range of no. , say from 6 % to 15 % and work out the numbers and see how they look.
that would give an indication whether the property is overvalued or undervalued.
it would also give an idea of the risk involved

Anonymous said...

Your desired return from appreciation in the value of the house would really depend on whether you look at it as a pure investment (and hence need it to work within your portfolio) or whether you have bought it for other reasins (security etc) in which case your required return should be lower.

By the way I think the rental yield in your calculation should be closer to 4% (based on current trends) and that increase in rent at 8-9% p.a. is rather high.

Do check out my analysis of real estate. Have used a similar methodology as yours but in reverse so that I determine the % appreciation required to make the investment worthwhile.

Deepak Shenoy said...

From a Bangalore viewpoint, getting Rs. 30 K p.m. for a 60 Lakh apartment is just not happening. I am currently trying ot rent out two apartments - and I get approximately 0.3% per month of the current market value (12K per month for a 40L apartment etc). Meaning, approximately 3.6% per year.

Also note that the rental has a cost associated with it, of approximately 0.5% per year (painting, plumbing, property tax etc.) and when you add taxation (70% of rentals received is taxed) the post tax return is approximately 2.3%. This is less than current inflation!

Cash flow wise, read my real estate analysis at : I've tried to prove that on a cash flow basis, borrowing for a house is negative, both with leverage and considering opportunity cost.

Rental yields typically grow 6% per annum, at least in Bangalore. Right now, there's a surplus of apartments available, and the situation doesn't look much better in the near future (2008) so I would imagine that getting 6% also would be quite dicey.

Getting a 9% appreciation per year looks achievable, but my experience shows that certain flats sold in 1994 in Bangalore for 35 lakhs are priced at 52 lakhs now. (there was a severe downgrading of prices in the interim). 50% is not much if it's over 10 years. Real estate is a cyclical, and frankly the concept brokers and builder tout, that "Space is a limited commodity" is bogus; prices will head downwards or stay stagnant as supply of high cost housing overrides demand.

But i like the way you look at it; it's all about how much you expect.

Deepak Shenoy said...

Rohit, How to get back to appropriate formatting:

1) Go to blog settings
2) Click the "formatting" tab
3) Change "Convert Line Breaks" to "Yes"
4) Save, and republish your blog.

Rohit said...

deepak, thanks for the tip for reformatting my blog.

i used the real estate example only to highlight my point.

personally i find real a difficult way to make money as i travel too much, find real estate not liquid enough and not comfortable with renting out due to bad tenancy laws