Investment Framework: Assets with Limited Lifespans

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Investing in assets with limited lifespans requires a different framework.

An investor’s choice

Consider an investor who is faced with the following choices:

Choice A: He can buy a freehold property A for $1 million that has an open market rent of $100,000 annually.

Choice B: He can buy a leasehold property B for $500,000 that has an open market rent of $100,000. There is only 3 years left on the lease.

Based on conventional valuation metrics, property A has a P/E of 10x while property B has a P/E of 5x. However, an investor who chooses property B over property A would have just committed himself to a $200,000 loss. This illustrates the importance of asset lifespan.

Common industries with limited life assets

Companies with concession- or licensing-based business models are the most relevant. These are often infrastructure businesses. Companies with operations in China are also more likely to have concession-based businesses. These include:

  1. Toll road
  2. Power plant
  3. Transport
  4. Property

The problem with target multiples

Conventional valuation multiples have a very fundamental assumption – that the assets will last forward. For example, the common price to earnings ratio represents the number of years it takes for an investor to recoup his investments through earnings. Conceptually, paying 10x P/E for an asset will only make sense if it is able to last more than 10 years. But it is not necessarily so that asset will last the said years for the investor to recoup his investments.

On the asset side, the asset value will decline to zero because of depreciation. Therefore, paying under book does not necessarily mean you are getting a good deal either. For example in the case of Choice B, even if any investor pays $400,000 for the property which is worth $500,000 (0.8x P/B), the value of the asset will still be worth 0 at the end of 3 years.

What should investors do?

You can tell the lifespan of a business by calculating the weighted average lease expiration (WALE) of the assets. As a rule of thumb, you should not pay a multiple higher than that figure. If a company has a WALE of 3 years, 5x P/E would be considered expensive.

Remember, reading off valuation multiples is not a form of investment analysis – always relate the numbers back to economic sense.

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Tee Leng is the co-founder and co-editor of ValueEdge. His investment articles have been published on ValueWalk, NextInsights and TheFinance.sg. Tee Leng is also the investment director of TwinPeak Capital, a private family office with 7 figures under advisement. Additionally, Tee Leng is the Director of NCK Global Capital and is a frequent guest speaker at institutions such as University College London (UCL) and at investment seminars held in Singapore.

3 COMMENTS

  1. sorry i meant to say XIRR instead of DCF.

    on your example, the devils advocate is that, if the 500k property earns a net income of 100k, it is good because it takes into consideration depreciation which means the cash flow is actually more.

    the question is always the price you pay. if you pay 600k for it, it might still be worth it cause the net income is 16% and higher than the cost of capital perhaps of 10%.

    • Like you said it really depends on price. Even if cash flow is higher because of depreciation, you still lose in terms of time value. So just because cumulative cash flow doesn’t necessarily means its good. My point is that you shouldn’t judge it based on normal standards.

      If earnings yield is 16% but it only has 1 year life span, you are only making 16% return on your capital with NO residual value. You end up still losing 84% of your capital, even though earnings yield > cost of capital.

      IRR would be good.

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