The essence of investing in a nutshell

March 22, 2022
by Noriyuki Morimoto

An asset is something that generates cash flow, and the value of an asset is the present value of future cash flow.

The value of real estate is the present value of future rent income, and the value of bonds is the present value of interest and principal redemption payments. The value of a stock is the present value of future dividends, but when no dividends are paid, the retained earnings are reinvested in the business, and the value of the stock increases only to the extent that the expected value of future dividends increases.

If the amount of future cash flow and its certainty change, the value of the asset will change, and the change in value will lead to a change in price. In principle, prices are formed based on the value of assets, but in practice, value and price can differ, and it is not unusual for the two to diverge significantly.

Investment is first and foremost about receiving the cash flow generated by an asset. Therefore, as long as the asset has value, that is, as long as it generates cash flow, the investment cannot result in a loss.

If an asset’s ability to generate cash flow declines, the value of the asset declines. Investment is, secondly, to protect the ability to generate cash flow.

If the asset’s ability to generate cash flow becomes stronger, or if the certainty of cash flow increases, the asset’s value will rise. Therefore, investment is, thirdly, an effort to improve the quantity and quality of future cash flows.

This is extremely important for private investments where the attributes of the asset can be changed. For example, in real estate investment, investing in renovations, improving tenant policies, or reducing management costs can increase future cash flow and raise asset value. Similarly, in private equity investment, active involvement in management can lead to improved business cash flow for the investee company, making it more valuable.

Public stocks and bonds are essentially unalterable in their attributes, but active involvement is possible to a certain extent. For example, as a major shareholder, making shareholder proposals is an expression of your efforts to increase the value of your shares. However, there are limits to such activities. This is why we replace stocks with those of higher value. Higher-value stocks are those with larger and more stable future cash flow potential.

In selecting stocks and assets, replacing them with ones of higher value is a basic part of investing. In addition, based on the premise that value and price can be different, replacing the same value with a lower priced one is also an important investment behavior. This is the fourth element of investment.

 

[Category /Strategic Investment]