On today’s show we’re talking about the notion of valuation or what is sometimes called price discovery.
I was 13 years old when I got my first taste of price discovery. In Istanbul Turkey there is the largest covered bazaar that comprises over 61 streets and over 4,000 vendors. The vendor was trying to sell me a metal sword and a negotiation ensued. I was a rookie at this, but my father knew the game and by the end of a 5 minute negotiation we settled on a price that was about 1/3 of the original asking price. The seller was grumbling the whole time as he wrapped up my purchase. I left his shop confident that I had just got a great deal. As I reflect back on it now, how much was that souvenir really worth? It’s worth what I paid for it. Did I pay too much? Did I get a great deal? I have truly no idea.
There is the story of Honus Wagner played in major league baseball for 21 seasons, most of that for the Pittsburg Pirates. He was one the first five players to be inducted into the National Baseball Hall of Fame in 1936.
On October 31 of last year, one of 50 Wagner baseball cards sold for $1.4M dollars. It’s not the most expensive version of that card to ever sell. The most expensive one sold for $3.25M. The scarcity is part of what drives the notion of value. If there were 1,000 of these cards, they would be worth much less. It’s because there are only 50 remaining in existence that drives the notion of value. Maybe the baseball card worth 2.5 cents, the cost of the paper and ink to print it?
When you buy shares in a public company, you’re buying a fraction of a company, that presumably has the ability through its active ongoing business to generate a profit for its owners. As a shareholder, you’re an owner. You would think that the value of a business is somehow tied to its ability to generate a profit. A business that generates a lot of profit should be worth more than a business that generates very little profit.
Tesla Stock is currently trading at 1,667 times earnings. That means that if Tesla remained at the same level of profitability, it would take 1,667 years to earn your initial investment back, and that’s assuming of course that the company paid out 100% of its earnings in dividends to investors. At that point, I’m starting to wonder which is a better deal, Tesla stock or the baseball card?
The notion of value has become distorted.
A single family home in an expensive neighborhood is worth $1M because we all agree that it’s worth that much.
This is what is called price discovery. If a house on the street sells for $100,000 more, now all of a sudden everyone on the street thinks their house is worth $100,000 more.
But the world of real estate investing is different than the world of residential home ownership. It might seem to the uninitiated that they’re similar. But they’re quite different.
You see if an apartment rents for $1,500 a month, that rent check clears every month. If you have a 100 unit building, then you have 1,200 transactions that closed over the past 12 months. There is no speculation about what the apartments will rent for. There is hard data. So when it comes to valuation, if rental properties are valuing at a 6% cap rate, then you can easily determine what a property is worth. You have lots of data from hundreds and hundreds actual transactions that settled each and every month.
So what is a piece of real estate worth? Is it merely the result of negotiation, or perhaps the real estate business that is wrapped around the property is worth a multiple of its net income, its ability to generate a profit.