Given the recent media speculation around both the property and equity markets, with interest rates on the rise, we’re exploring the age-old debate Property vs Shares, by comparing the two as investments.
The article is my opinion on the two investments, with the use of a simple scenario.
How to value a property
When it comes to deciding on potential investments in either asset class, investors will use valuation methods to calculate a return on investment (ROI) they can expect.
The most common way for property investors to value a property is by calculating the capitalisation rate (commonly shortened to cap rate). The cap rate is found by dividing the net operating income (NOI) of a property over its market valuation (property price).
Most popular valuation methods
When investing in shares we need to remember we are investing in the underlying business, and as such need to determine the value of that business. As equity investors we do this in the hope of finding companies that are selling on the share market for less than their intrinsic value.
Many different valuation techniques can be used to value companies with the two most popular being the price to earnings (P/E) ratio and discounted cash flow (DCF) valuation. When valuing a business, the P/E ratio is the easiest and most used method. As you would have gathered by the name of the ratio, the P/E is calculated by dividing a company’s price by its earnings.
A Discounted cash flow provides a more in-depth value of the company by forecasting all future cash flows an investor can expect to receive from the company, discounted back into today’s dollar value.
Most popular valuation methods
I will focus on the valuation methods of the P/E and the cap rate as they are the most popular valuations used by investors. The P/E and the cap rate are also the inverse of each other so can make comparison across the asset classes a lot easier.
To put it simply the cap rate is the earnings yield of the property or business, and the P/E ratio is how much an investor is willing to pay for a dollar of the company’s earnings. With these two valuation methods in mind, we can now come to a like-for-like comparison of valuing a property compared to a business.
In this example, we will say that the property has $600,000 in debt on the balance sheet. I think this is a reasonable amount of debt given the average property buyer only requires a 20% deposit (sometimes less). To calculate the total value of a business we need to calculate the Enterprise Value (EV). This is done by adding the debt to the market value of the business or property. In this scenario we have an EV of $1.6m.
Let’s look at rent as our revenue, we can say that we will receive $700 per week in rent (average rent in Newcastle is $650). Assuming no vacancies this equates to $36,400 per year. If we conservatively say that expenses for the property are $5,000 per year (management fees, bills, repairs etc.), this gives us Earnings before interest, taxes, depreciation, and amortization (EBITDA) of $31,400.
When calculating the cap rate (NOI) is the preferred term but in this scenario EBITDA and NOI are very similar. So, if we use (EBITDA) over our current market value for the property, we get a cap rate of 3.14%. This tells us the potential Return on investment is 3.14%. But if we include the debt taken on for the investment that cap rate reduces to 1.96%.
Our EV and EBITDA calculated above place the property on an EV/EBITDA multiple of 51x. To keep it simple, we will ignore tax, D&A and interest payments, so we have a PE of 51x. This implies that with the profits earned from your property it would take 51 years to pay back the investment.
So, what is required for us to pay a PE multiple of 51x for an investment?
If earnings are growing fast enough e.g., at least 20%+ for the long term, we may be willing to pay this type of multiple. However, earnings growth rate for property is much lower. By saying we may achieve a 5% growth rate in our property’s earnings would be generous so why would we be willing to pay such a high multiple.
We can compare the property scenario above to two companies we own in the Oracle Emerging Companies portfolio.
Objective Corporation is a company we own with a similar PE to the property example above. Objective provides software predominately to public sector clients allowing them to become completely digital. Users can find, access, and share information securely from anywhere in the world, ensuring employees are kept up to date on all matters.
Like the property valuation, Objective is not cheap, at 50x earnings. The difference between Objective and the property is the rate of growth in earnings. Objective Corporation has historically grown its earnings by 28% p.a. over the past three years, compared to our expected rate of growth for the property of 5% (which as mentioned is ambitious). In these cases, we are happy to pay up for a quality business like Objective as the future earnings growth potential remains high. If Objective can continue to trade at 50x earnings, then the share price in our PE multiple will rise in line with earnings. This is where shareholders can achieve substantial returns on their investment.
If we come to the other end of the spectrum and try to find a “cheap” business in the portfolio it is hard to look past Kip McGrath. Kip McGrath is the largest provider of school aged tutoring in Australia and has significant market share in the UK. Based on our FY23 earnings forecast Kip McGrath can currently be purchased at a PE of 11x. I say this is cheap because we are forecasting Kip McGrath to triple its earnings from FY21 to FY23. This type of situation can provide two positive catalysts for shareholders with the price of the stock increasing with earnings combined with a higher PE multiple people are willing to pay for the business. This scenario is where equity investors should start to get excited.
The recent market volatility in the equities market may have spooked some people away from investing in shares. But this can be the time where businesses become cheap. I will leave you with the chart below of the ASX200 returns since the 1970’s. This provides a strong visual on the type of returns an equity investor can procure over the long term. If you are confident, like me, that the Australian and Global economies will be substantially larger in thirty years’ time, then a long-term investing strategy in the share market can create significant wealth.
Written by Jack Magann
Emergency Companies Portfolio Manager
Oracle Investment Management