Saturday, February 04, 2006

Even your house has a p/e ratio !!

Your house has a p/e ratio too. Shocked, well not if you know your finance well. A p/e ratio or price (you pay)-to-earnings (net profit per year) ratio simply put is -

  • a ratio that tells you that the number of years it will take for the asset in question to earn you back your initial investment.
A more simpler explanation can be given by looking at a fixed deposit at a bank. Lets say Mr.X deposits Rs.100,000 with the State Bank of India at an annual interest rate of 10% (or in this case it would be Rs.10,000 per annum). The p/e ratio of this bank deposit will thus be 100,000/10,000 = 10 times. A simple math would also tell you that given the rate at which you earn your net income (assuming no re-investment), the deposit should earn you the initial investment (Rs.100,000) in 10 years.

Thus, any asset that has an earning stream can be valued by its p/e ratio. Lower the p/e ratio, quicker will you earn your investment back. Value stocks are usually defined as the ones with lower p/e ratios. One of the important principles of Benjamin Graham was investing in stocks with low p/e ratios.

Coming back to the example of a house that has a capability of earning a rent. So for example, a house that costs - Rs.10,000,000 and can earn an annual rent of Rs.500,000 then it is said to be quoting at a p/e ratio of 20 times.

I read an interesting paper on valuation of investments in homes. Here is a small extract from the paper -

You may not think about it when you buy a house, but it’s the same thing. 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. Ask yourself how much the house could currently be rented for on an annual basis. Divide the seller’s asking price by this rental number. That’s the p/e ratio, the ratio of price to earnings. If a $500,000 house could generate $25,000 in annual rental earnings net of maintenance and management, then the p/e ratio is 20.

I know it’s hard to think this way. Unlike stocks, investments in homes do not come with quarterly earnings statements. Unlike stocks, the price of your home is not listed in the Wall Street Journal every day, which allows you to keep it on your books at whatever price suits your current mood.

You can download this paper from here. I had prepared a small presentation on p/e ratios and how growth in earnings affect p/e ratios. You may find it useful.

3 comments:

Naveen Mandava said...

A couple of things from my econ knowledge.

1> Do you consider the opportuntity cost of the p?
2> If you have a distribution of possibilities how do you calculate the p/e ratio?

Regards,

Rahul Vyas said...

Hi Ravi
I appreciate your work done so far now.
But I think there should be some links and articles that would make a person who is not very familiar with the field of finance and world economy.
This comment is after considering the level of education of mine.

Regards,

Ravi Purohit said...

Naveen,

1> Do you consider the opportuntity cost of the p?

With the assumption that one buys a house purely as an investment (with no intention of staying there), you would definitely assess the opportunity cost of buying a house, just like one does before investing in stocks. Only if the p(achieving higher returns) > (returns from other available options) would one invest in stocks/a house.

Ofcourse, like in stocks, one can further complicate this by including what we call as margin trading. Borrow at a lower cost to finance the house (which can include the tax benefit one gets on housing loans), if the house yields greater return. Use of leverage.

2> If you have a distribution of possibilities how do you calculate the p/e ratio?

The second answer is a little easier to answer. One will always go for Max(various points at which the house can be rented out). The rent should also include the interest income pple derive from the deposits that they take. Its not just the 'pure' rent but also the interest income of the deposit that should count as an income.