To be successful, investors must be able to quickly evaluate deals. Learn how to evaluate stocks vs websites vs real estate, and other income investments
This is a common question among investors. And although most people believe that buying something below market price is a good deal, that’s not always the case. This is especially true when it comes to income investments, where cash flow plays an important role. So investors need a simple method to figure out what a good investment is. In this article we’ll discuss how to evaluate stocks vs websites vs real estate.
Price Vs Value
To start with, it is important to understand the difference between price and value. Warren Buffet explained it simply.
“Price is what you pay, value is what you get.”
Warren Buffet
Let’s use a couple of examples.
1) Assume investor A buys an income real estate property at a price below market value, but in the end this investment is not producing positive cash flow.
2) Assume investor B buys an income real estate property atabove market value, but in the end this investment is producing good cash flow.
On the surface, it may seem that investor A got a better deal, because he paid a price below market. If both investors were interested in flipping the properties, then investor A would be in a better position. However, we are looking at this from an income investment point of view. And as such, what really matters is how much income (cash flow) each investor is getting relative to the price paid. This being the case, investor B is in a better position.
There could be other possibilities at work. One reasonable possibility is that investor A purchased a project and intends to make some improvements to his property, which could result in higher rents and therefore higher cash flow.
The Need for a Simple Method to Evaluate Stocks vs Websites vs Real Estate
In a previous article, titled ‘How to Improve Creative Thinking in Business to Get Win-Win Deals,’ I discussed the importance of developing a habit of using ‘what if’ scenarios to find opportunities. To really benefit from this concept we need to be able to evaluate hundreds, if not thousands of deals. Thus, it is necessary to have a simple method to filter out the promising deals from the hundreds of bad deals.
One of the simplest methods used to evaluate an investment can be illustrated by the Price-to-Earnings ratio (P/E), which is often used as a general way to compare stocks. Using P/E ratios to evaluate stocks is one of the first thing new investors learn about stocks. It certainly was one of the first things I learned, as a teenager. This simple metric is a function of price and earnings.
Absent other factors, the lower the P/E, the better. For example, if a stock has a price of $100 per share and Earnings of $5 per share, then the P/E for that stock is 20.
P/E = 100/5 = 20
If the same stock drops to $50 per share, then its P/E would become 10.
P/E = 50/5 = 10
It helps to point out that the inverse of the P/E ratio can be used to understand the earnings as a percentage of price. In other words, a P/E ratio of 20 translates to earnings as a percentage of price of 5%.
E/P= 20/100 = 5%
As it turns out, looking at earnings as a percentage of price is a common way to evaluate other investment types, including websites and real estate. However, when evaluating other investment types, people utilize different terminology. Specifically, when it comes to real estate, investors are used to looking at metric called Capitalization Rate (Cap Rate). This metric is also a function of earnings as a percentage of price. The Cap Rate formula is as follows:
Cap Rate = NOI/Price
Although the numerator NOI (Net Operating Income) has a different term, for our purposes this term also represents earnings.
Justifying P/E Ratios for Residential Real Estate Evaluation
Before going too far, I want to address the fact that properly evaluating an investment requires a lot more than looking at price and earnings. But what we are doing here is learning a quick way to assess many opportunities in a short amount of time. Then, once we find something that has potential we can dive in deeper.
If you are somewhat familiar with real estate you may know that Cap Rates are typically used in the context of commercial real estate, and not on residential real estate.
When it comes to residential real estate people determine the value of a home based on what other similar homes sold at and curb appeal! However, investors should evaluate such properties based on price and earnings. Thus, in this case it would be necessary to estimate the yearly earnings an investor can expect if the investment home is rented out.
As discussed earlier, P/E ratios are typically utilized in the context of stocks, and not in the context of real estate. Perhaps for this reason, I could not find much written on the use of P/E ratios for evaluating real estate. However, I wanted to include at least one source of information for those of you that may be a bit skeptical. In an article titled ‘Bubble Trouble? Your Home Has a P/E Ratio Too,’ UCLA economics professor Edward E. Leamer, addresses P/E ratios for real estate.
“The price you pay should reflect the present value of future rent. You should go through the same mental calculation in purchasing a home as in purchasing a stock.”
Edward E. Leamer
Examples of How to Evaluate Stocks vs Websites vs Real Estate
Let’s discuss a few evaluation examples expressing earnings as a percentage of price. As illustrated earlier, if a stock has a Price of $100 per share and Earnings of $5 per share (annual), then the P/E ratio of that stock is 20. In fact, the average P/E ratio for stocks in the S&P 500 index, for the last 90 years, is 20. Translated to earnings as a percentage of price we arrive at 5% (see E/P example above)
Stocks = 5%
As for websites, according to Empire Flipper’s market report from 2019, online businesses have been selling for about 2x yearly earnings. Please note the report shows monthly earnings. I converted monthly earnings to yearly earnings by dividing by 12 to remain consistent with the other examples. Therefore, if a website makes $1,000 in earnings it generally can be bought for about $2,000. Thus, earnings as a percentage of price equate to 50% ( that’s $1,000/$2,000). That’s great value, at least on the surface.
Websites = 50%
As for real estate, lets assume a property has a Net Operating Income of $7,000 and a Value (or Price) of $100,000, then the cap rate for this property is 7%. And as indicated in the chart below, a market cap of 7% is fairly in line with the commercial real estate market. And just to be clear, Market Cap is essentially a function of Earnings as a percentage of Price.
Commercial Real Estate = 7%
Important Differences Between Asset Types
In the three examples noted above, I used earnings and prices that are representative of the three asset types we have been discussing. Namely, stocks have earnings as a percentage of price of 5%, Websites have earnings a percentage of price of 50%, and real estate has earnings as a percentage of price of 7%. Therefore, it seems investing in websites is the way to go.
However, there are some very important differences between asset types that need to be accounted for. For the most part, these differences are easier to understand when comparing real estate to other investment types. Below are some differences worth noting.
- Passive Vs Active: Owning stocks is definitely more passive than owning a few rental houses.
- Financing: When buying real estate you can leverage your money by using financing. In other words, you can buy a $100,000 property with less than $20,000 out of pocket.
- Taxes: Real estate provides some very unique tax advantages
- Depreciation: Let’s just say depreciation plays a role in real estate, but not so on stocks and websites.
- Liquidity: You can cash out your investment faster if you own stocks than real estate.
- Entity Status: If you are making money from a website or from real estate you can create a legal entity (LLC, Corporation, etc). These entities provide protections and certain tax advantages.
- Stability: Stocks react to multiple market forces, one of which is monetary policy changes. Websites can become obsolete or lose traffic fairly quickly. On the other hand, income producing real estate, but particularly land, can be significantly more stable.
- Knowledge: Investing in stocks takes a lower level of knowledge than investing in real estate. And for me, investing in websites takes a lot more learning than investing in real estate. Indeed, websites do require a much higher level of technical expertise.
Next, I want to expand on the first two bullet points (passive vs active and financing). But, if you want to get a more solid handle on what kind impact taxes, depreciation, and such have on real estate returns, I’d like to recommend an article titled ‘Hidden Returns of Rental Real Estate – 30%+ ROI A Year Smokes the Pants off Stocks/Mutual Funds‘ by Lane Kawaoka. Lane is great at explaining things in simple terms.
Striking the Right Passive Balance
To start with, I want to highlight that based on our bridge to financial freedom strategy, our goal is to own multiple income streams. Because our time is a finite resource, the only way to manage multiple income investments is if these are somewhat passive. So, passive investments are of much appeal to those seeking financial freedom.
However, pure passive income investments are generally limited to things like bonds, stocks, etc. On the other hand, real estate and websites do require a degree of active involvement. And of course, there are investments that are not passive at all, because they require significant active involvement. Examples of these type of investments are businesses such as hotels, restaurants, etc.
My website investing experience is very limited, but I can tell you that I find myself spending much more time my on my website investments than my real estate investments. However, I am hopeful that things will get a lot better once I learn more and can leverage my knowledge. In addition, I do spend a significant amount of time writing these articles, because I enjoy doing so.
Certainly, we all want the highest return we can get and we also want the most passive form of investment, but unfortunately we can’t have it both ways. Thus, we need to strike the right passive balance. If you are working 60 hour per week at your current job, then perhaps you should be looking for the most passive investments.
The Power of Leverage in Financing
Leverage is a great way to illustrate the enormous impact financing of an investment can have on the overall investment strategy. Let’s use the earlier example, where we looked at a property with a Price of $100,000, a Net Operating Income (NOI) of $7,000 and a resulting cap rate of 7%.
Now, let’s assume we utilize financing to purchase this property and that the required down payment is $10,000. Using an amortization calculator we can quickly determine the loan monthly payments on a loan of $90,000. As shown below, the total payment for one year is $3,571 in interest and $1,585 in principal, for a total of $5,156 per year.
Thus, the new calculation for earnings as a percentage of price, where price is really cash out of pocket should be:
(7,000 - 5,156)/10,000)=18.4%
This is an 18% return on our cash. In fact, this metric is called Cash on Cash (COC). Not only that, each year we are also paying down principal at a rate starting at $1,585 per year. The amount paid to principal increases every year as the loan balance decreases. But, if we were to account for this benefit, on year one alone, we would obtain an additional 15% return on our cash.
(1,585/10,000)=15.9%
However, real estate investors don’t pay much attention to principal reduction, because this is inherit to the business. But, if the intent is to compare real estate to other asset types, then principal reduction should definitely be factored in.
In short, by using the power of leverage the real estate example went from 7% earnings as a percentage of price to 33% (that is 18% + 15% as a percentage of price).
Leveraged Commercial Real Estate = 34%
And, what if you could purchase an income producing property with no money down? Then leverage would be infinite, provided that the property has positive cash flow. 0% down deals do exist, but they must be pursued. I have made 0% down offers before, though I have yet to close on that kind of deal.
Last, the strategy behind utilizing leverage is to use aslittle money out of pocket to buy one property and then use the income andequity from that property to leverage again to acquire more incomeproperties.
What is a Good P/E Ratio, Market Cap Rate, or Cash on Cash Rate
P/E ratios, market caps and COC values provide points of reference to compare investment opportunities. Ideally, these metrics are used only to compare similar asset types. However, in this article I showed you that as long as we are looking at the asset price as a function of earnings or vice versa, then these metrics can be utilized broadly. But keep in mind this is just a first step in looking at valuation.
As I am sure you are aware some stocks trade at very high PE ratios, because investors are betting on future earnings improving. Amazon stock may be a good example. It wouldn’t make sense to compare the PE ratio of Amazon to the PE ratio of Pepsi. These are two very different animals.
The same principle applies to cap rates. Cap rates for properties in growing cities will tend to be lower because it is presumed there is more demand (which causes higher rents) and it is presumed that the properties will appreciate. Conversely, cap rates in rural areas will tend to be higher.
Also, cap rates for market niches where there is a lot ofcompetition, such as apartment buildings will be lower than market niches wherethe completion is lower, such as RV camp grounds. Thus in order to properly utilize this toolyou’ll need to have a good sense of what the going cap rates for the area andmarket niche of your interest.
Ultimately, what every investor should be concerned with is COC, or an equivalent metric. If you can get COC of 15% or higher on your investments, then you’ll be well on your way to financial success. Such rates are possible provided there is a good spread between the property’s Cap Rate and the mortgage interest rate AND when provided the cash out of pocket amount is kept to a minimum. Interestingly, even experienced investors fail to realize there are creative financing alternatives that will result in very attractive COC returns.
In conclusion, to know what a good P/E ratio or a good market cap rate is, you must compare several similar asset types. And the next step is to figure out the best possible financing terms to achieve an attractive COC rate.
The Bottom Line
This brings us back to where we started. To be successful an investor needs to be able to evaluate many deals, perhaps hundreds, if not thousands. And the only way to do this effectively is to filter out the promising deals from the rest. How to evaluate stocks vs websites vs real estate? Use price and earnings as a starting point.
What to invest in? I can only answer this question for myself, but perhaps these answers can help you identify your own situation. Do keep in mind that I can change my mind on any of this at any given time.
Stocks and Mutual Funds
I prefer to stay away from stocks. In my opinion, there are too many forces that can drive the price of a stock without regard to valuation. Mutual funds can provide a little more stability than stocks and can be good investments. However, to me, the returns aren’t that exciting. Having said all of this, I own stocks and mutual funds in my retirement account. Also, if I were starting as an investor I would definitely be making monthly contributions to a few good mutual funds to put my money to work while searching for better opportunities.
Websites
Interestingly enough, doing research for this article has been a little of a paradigm shift for me. I am now more interested in this market than before writing this article. Website investment requires a lot less capital than real estate investing and it provides huge upside potential.
One thing I had not mentioned before is that online business can be leveraged in various ways. One website with great traffic can be used to launch other websites, obtain mailing lists, and even promote a real estate business, or any other type of business.
The challenge for me is the lack of technical knowledge. However, this shouldn’t be a barrier because I can always partner with someone that knows this market and because I am continuing to learn about the market.
Real Estate
I see myself continuing to invest in real estate. To me, real estate investing brings less risk than website investing. And real estate still provides excellent returns. Seller financing deals with little cash out of pocket can be amazing deals.
Moving Forward
Finally, once we have identified a market, it is time to identify a few promising opportunities. And the next step is to dive deeper into evaluation and due diligence. I intend to write about deal valuation and due diligence in future articles. And I also intend to discuss real life examples.
As always, please drop me a note and let me know what other areas of business and finance you’d like to explore. Then I’ll write more about your suggested topics as we pursue knowledge, financial success, and financial independence together. In addition, you can also follow me on Twitter at @Cash_Keen
