The Magic Box Part 1

What is the value of something that reliably and consistently produces ever increasing amounts cold hard cash? This is something the market struggles with everyday in regard to blue chip dividend paying stocks, but for some reason investors are usually more focused on the market price itself, not the item that is being traded. So instead of talking about shares, let’s instead talk of a ‘magic box’.

Imagine that there was a box that spat out money every year, say $100. Moreover, imagine that each year the box would increase its output, so that $100 paid in the first year became (say) $106 the following year and so on. The question I have for you is, and what we discuss in the DividendKey; what would you pay for this wondrous item?

Is it reliable?

Of course you would probably want to closely examine the history of the box and ensure that it has demonstrated a reasonable degree of reliability. And sure enough on closer inspection you learn that the box has increased its output by approximately 6% each year on average, even though there were a number of years in which the money ejected was reduced or remained static. The other thing to consider is that, like anything, the future is not guaranteed, so you never know if the box will continue working indefinitely into the future.

Are there other options?

Of course the box isn’t the only thing you could invest your money in (and in fact your financial advisor may well caution you against magic boxes). You could instead choose a term deposit or bond; investments that are virtually risk free and currently offer reasonable yields of about 5.5%. You could even just put your money in the bank and earn interest. These and other assets are competing for your investment dollar, and the valuation of the box will therefore be a relative one.

What is the yield?

Given that there is some uncertainty with this mysterious box you would probably expect a higher return than other income investments to compensate you for the added risk. Perhaps you may only be willing to pay about $1500 for it, as this will provide you with an expected yield of 6.67% in the first year.

Then again, maybe $1500 is cheap when you consider that the box seems to work ‘in perpetuity’; in other words it doesn’t ever seem to expire. Contrast this with bonds that expire at some point and as such do not show any appreciation in value between inception and expiry (although they can fluctuate in the interim).

And again, the money spat out by the box continues to increase on average over time, something that doesn’t happen with most other assets. As such you could expect to not only resell it at some stage down the track, but it’s reasonable to expect you could sell it for a higher value than what you paid for it. Students of the DividendKey know this only too well.

As you can see, there are many things a rational investor would consider, and it doesn’t take long before the valuation process starts to get reasonably complicated. And of course, the true worth or ‘intrinsic value’ of the box is a subjective thing. In essence the value of the box will be in the eye of the beholder.

Buying a magic box

Let’s say for the sake of example that you do acquire this mystical item for a tidy $1500, and duly receive a crisp $100 note after 12 months (an initial yield of 6.67% as expected). The second year brings even greater rewards:

Over five years the box has increased its output by 35% paying out $135 in cash in the final year, which is an average increase of just over 6% each year. Based on your purchase price, you have received a total of $579 over the period, which is 39% of the initial purchase price. In regard to the 5th year only, you received a yield of 9% ($135/$1500). Few investors would be disappointed with this outcome.

But surely you would have still done better with a higher yielding, yet safer, investment in a bond. Not necessarily, as the box itself has value and can be sold to other eager investors...

Ensure you read the next Trading Tutors Newsletter to see why. In the meantime checkout more at www.dividendkey.com.au

Make the markets work for you

Andrew Page