Personal Finance 1: valuation and present value
by George Hatjoullis
The Economics series of Gestaltz blogs introduced the uninitiated to the world of macroeconomics (and a bit of microeconomics). The series was, by and large, well received but probably of limited relevance to most individuals. Personal observation has brought home how poor is personal finance literacy. This is a serious flaw given the (government) policy trend towards more people taking direct responsibility for their own finances. The trend away from defined benefit to defined contribution pension arrangements is a good example and many probably do not know the difference. The Personal Finance series of blogs will try to offer some basic education in these areas.
The first place to start is with valuation; what is something worth? First, value is not price. Price is something we all pay but value is relative. We all pay a given price for water but the value of water per se may far exceed what we pay for it. It depends on the context. The value is relative. Second finance is concerned with monetary value not intrinsic or aesthetic value. It asks what someone should be willing to pay for an asset as an investment. An investment in finance is something that promises a monetary return. Someone may love a house as a home but it may not be a good investment. It may benefit from general house price inflation but it may lag other locations. Personal finance is about the sordid business of money.
The main asset each individual has is of course themselves, or more precisely, their capacity to sell their time and skill and effort. Unfortunately, as work is a social activity, earning capacity is affected by social values as well. Employment legislation may try to limit this effect but it rarely succeeds completely. Gender, physical appearance, status etc may all affect the remuneration of otherwise equally matched employees. Remuneration has a social dimension as much as skill or effort. However, finance has little to contribute to this debate.
The average wage in the UK is around £26500 p.a. So what is the average worker’s human capital worth? Assume the average worker will be continually employed for 40 years. What is the average wage for forty years worth today? The total earned is £1.06 million but the value of this income stream today is worth much less. In part it depends upon the rate of interest. Assume the long-term rate of interest is 3.5%. The present value of the average wage is then approximately £570k. If I can lend money at 3.5% then I can generate a cash flow equal to £26.5k p.a. (ignoring transaction costs). How does this work? I charge 0.2917% of the outstanding balance per month (3.5/12) which yields interest income of £1663 in month one and so I require £545 loan repayment. This gives a monthly salary of £2208 which, times 12, is £26500 p.a. (well £26496 to be precise but ignore rounding). Each month the interest is a little less because the principle is less but the repayment is increased to ensure the total payment is £2208 per calendar month. The process continues each month for forty years until the loan is repaid.
One can introduce a lot more features into this calculation but the objective here is to illustrate some simple principles. Assets are about income streams and valuation is about the cost of replicating these streams of income, at least in the world of finance. So what about a house you might retort (derisively)? It does not generate an income stream when occupied by the owner. A house generates a rental stream whether the owner lives in it or lets it out. The owner must live somewhere and if the house is owner occupied then one views the house as generating a rental stream that the owner pays to herself. Incidentally, this is rather tax efficient and is probably one reason owner occupation is so highly sought in the UK. The tenant pays rent out of taxable income and the landlord is liable for tax on rental income. The landlord is also liable for capital gains tax on the sale of the property. Owner occupation avoids all these tax liabilities in the UK. The increase in renting is good news for the tax man. However, I digress. One can impute a rental value for a property and this can be a basis for valuation. One can even impute a rental value for a work of art.
Another fundamental concept that has slipped in during the above illustration is present value or the time value of money. The total income received over 40 years is over £1m but the present value is only £570k. A pound in 40 years is not worth as much today. The reason is the power of compound interest. I do not need to invest a pound today to have a pound in 40 years. How much I do need to invest depends upon the rate of interest. If the rate of interest had been 3% then the sum needed to replicate the average wage would have been closer to £620k. If the rate of interest had been 4% then the necessary sum would have been closer to £530k. The present value of an income stream rises as interest rates fall and falls as interest rates rise. The reason is that the lower interest rate compounds more slowly over time. The amount needed today to get £1 in 40 years is thus greater.
The valuation process in practice is far more complex. The employee may not be continually employed and the debtors may not pay back the loan on time (or at all). Inflation is clearly a consideration. These complications will be introduced in due course and in the appropriate context. The take from this first lesson should be:
1. Asset values are about replicating income streams
2. The present value of a given income stream depends upon the length of time the stream is expected to last and the rate of interest over this period.
3. The value of income streams rises as interest rates fall and vice versa.
4. One should also add that in a low interest environment it is good to be employed!