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Last week we saw how the value of a cash producing ‘magic money box’ was something that was difficult to ascertain. Nevertheless the value of the box, purchased at $1,500, was certainly evident when one looked at the income that was produced, but the question posed was: could you not have done better with a higher yielding, yet safer, investment in a bond.
Consider the following...
A seller’s market
For some bizarre reason you feel as though you no longer want to own this box (it would be like selling a goose that lays golden eggs). In a fit of temporary insanity, you place the item on eBay along with a certified history of its production. In effect, because of the cash you have already received, you could sell it for only $921 and still break even.
The bidding process sees your magic box sold for $3,000, and you couldn’t be happier. Not only have you doubled your initial outlay, but you have received $579 in cold hard cash along the way! That’s a total investment return of $2,079 or 140%, which is great for a five year time frame.
With the benefit of hindsight, we can see that the initial cost of $1500 was an absolute steal; you could well have paid much more than that and still done well. Such is the worth of assets that work in perpetuity and that offer rising income returns.
Now you can see why even a higher yielding bond or term deposit doesn’t even compare. Imagine you instead invested in a bond paying out 9% per annum. That is $135 every year for 5 years, giving you $675 in total. That’s more than what the box produced, but at the end of the period you only get back the $1500 you initially invested. That’s a total return of 45%, well away from the 140% gain received from the magic box. Yield can be a very deceptive thing, and often acts to mislead investors. This is a key concept of the DividendKey course.
You could, however, argue that it is unreasonable to expect the punters on eBay to pay $3000 for the magic box, but I don't think so. Consider the following...
Seller’s remorse
Should the new owner receive $135 in the first year that will represent a yield of 4.5%. And chances are that the box will continue spitting out cash over time, indeed ever increasing amounts of cash, and this will not only provide a growing income return but it will ensure the box itself grows in value.
Fast forward another five years and assume the same growth in income (approximately 6%), and the eBay buyer would have a total income return of $763. Plus, if they sell the box to someone else expecting a similar initial yield of 4.5%, they could expect to sell the box for over $3800. Hardly reason to be disappointed, and certainly you could say that they paid a fair price for a quality asset.
So it would be understandable that, having sold the box, you would feel some remorse. You could have just kept it under the bed and continued to collect your cash. As a matter of fact, should the output of the box continue to appreciate at the same rate, you would be receiving about $182 in another 5 years hence, and could have every collected a tidy $1,511 in total over the total ten year period.
In effect, your original capital would have been returned to you and each year after that you would be getting money for nothing; money that would continue to come in at an ever increasing amount.
Next week
But what is the relevance of all of this? Of what use is the discussion of a magic box to investors in the real world? Next week, the third and final instalment will demonstrate that you too can buy your own magic money box, and show you why DividendKey students are so enamoured with things that produce steady and rising cash flows.
Make the markets work for you
Andrew Page
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