Professional Investment Services

Insights into Successful Investing – It's All About Income

Bonds, property, shares – wherever you invest, it's the income (both current and future that determines its value).

How do you decide whether a current price represents the real value for an investment?

A good place to start is assessing the asset's fundamental value. The fundamental value of any investment is the income it will produce – both now and into the future. That income might be rent on a property, dividends on shares or interest payments on bonds. Generally the price of an investment will rise and fall as a result of investor's belief in the size of the future income flow.

Interest rates, economic outlook, and market sentiment affect the price of investment precisely because investors expect them to have an effect on the future income of the investment. It is the job of the investment manager to weigh up all these factors before buying or selling an asset.

Price versus value

By sifting through vast amounts of information, the fund manager is seeking an asset's “intrinsic valuation”. By estimating the present day value of its future income streams – profits from a company, rents from a property and interest payments from a bond – a fund manager can arrive at a valuation that reflects the asset's current value. This analysis is known as discounted cash flow analysis.

All other things being equal, the price of an asset will move towards this value over time. That's how investors make money – buying an asset when its price is lower than its value and selling when it is priced beyond its value.

However, todays Amazon does have strong and growing sales (it sold goods worth $2.54 billion in the fourth quarter of 2004). Now that the dot.com boom – and the tech-wreck – are past, it’s valued more realistically on the basis of real earnings growth.
Holland’s famous so-called “tulipmania” in the 17th century is another example of this tension. According to the story, the price of one special, rare type of tulip bulb called Semper Augustus was 1,000 guilders in 1623, 1,200 guilders in 1624, 2,000 guilders in 1625, and 5,500 guilders in 1637. Another bulb was sold in February 1637 for 6,700 guilders. On these price levels one single tulip bulb could cost as much as a house on Amsterdam’s smartest canal, including coach and garden. The average annual income at the time was only 150 guilders. After the crash of 1637, prices are said to have fallen to less than 10% of their peak values and by 1739 prices had fallen to 1/200 of the peak price.

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The debate over valuation is also being played out in the Australian property market. Over the past few years, the yield on residential property (the rental income of a property generates compared to its price) has slipped to around 1%.

Historically this is the level at which property prices start to slide because returns from property become uncompetitive with other assets such as cash and shares. For most of 2003 and 2004 however, this valuation rule of thumb was ignored by investors and property prices continued to rise.

Over the course of 2004 and into 2005, property prices have dropped. It appears, once again, that the fundamentals of valuation have reasserted themselves. Over the long run they tend to do that.

Some valuation methods used by professionals

Discounted Cash Flow (DCF):
A valuation measure aimed at estimating the attractiveness of an investment opportunity. A DCF analysis estimates future cash flows and uses those estimates to calculate a company's value in today's dollars.

The price to earnings (P/E) ratio:
A valuation measure that compares a company's current share price with its earnings per-share. The P/E ratio is often considered a fundamental measure of the attractiveness of a particular share compared to other shares. Generally speaking, the lower the ratio, the lower the market's profit (or income) growth expectations. The P/E ratio is calculated as below:

Market value per share
Earnings per share (EPS)

The P/E ratio is often complemented by measures such as price to book (P/B) ratio which measures the value of the company based on the price (or market value) and the book value (that value of assets minus liabilities according to the company's accounting records).

Source BT Financial Group – Extract from “Ten Investing Truths”

Superannuation Contribution Splitting

In October 2005 the Federal Government released draft regulations which will see the introduction of superannuation contribution splitting from 1 January 2006.

The new regulations, once introduced, will allow people to split up to 100% of superannuation contributions made on or after 1 January 2006, with their spouse. Up to 85% of tax deductible contributions (including employer contributions such as super guarantee contributions, salary sacrificed contributions, and personal tax deductible contributions) may be split, and up to 100% of undeducted contributions may be split. As the name implies, the splitting regime only applies to superannuation contributions and not to previously accrued superannuation account balances.

Contributions may be split with a spouse (including a de-facto, but not including same-sex partners) provided the spouse receiving the contribution split is not retired, permanently incapacitated, or over 65 years of age.

The contribution splitting model adopted by the Government involves an “annual split”. That is, after the end of the financial year a person wishing to split all or part of their contributions made during the previous financial year* with their spouse will need to advise their super fund of their wish to split.

It is not mandatory for the superannuation fund trustees agree to a contribution split so it would be advisable to check with your superannuation fund prior to making contributions that are intended to be split.

Where you operate your own self managed superannuation fund, it is likely that the fund's trust deed will need to be updated before a contribution split can be affected.

Contribution splitting will enable many couples to build up superannuation in both partners names which, in turn, will lead to tax effective structuring of income streams in retirement, once the relevant legislation is gazetted.

*Between 1 January 2006 and 30 June 2006 for the 2005/06 financial year.

Source: Peter Kelly – Professional Investment Services