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.
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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:
- Toll road
- Power plant
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.