Some basic laws of finance to help you spot a wealth opportunity

In the latest of a series of articles, former lawyer and City money man Peter Alcaraz provides a 'starter kit' to help develop your commercial nous.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple among wealth managers, business schools and private individuals wishing to develop their personal finance skills. 

• How you can achieve financial freedom more quickly
• How to calculate your real net worth
• How to calculate your total future needs and retire early
• How to keep a firm grip on cash flow and preserve your wealth
• How you can generate more surplus cash flow
• Rules and strategy for achieving financial freedom quickly
• How being contrarian can help you win the wealth game

I was often described in my early years at work as "commercial," by which I think people meant "understands value and the point of the exercise and sets out to achieve it in the most efficient and quickest way possible."

Commercial nous allows you to spot a wealth opportunity and pare it off the bone like a skilled butcher with a filleting knife. It is the standout talent required in the wealth game, but what is it, and were you born commercial? 

I think it is something you can learn by studying others and practicing. Reading books alone won't get you there but a grasp of some basic laws of finance helps. My book The Wealth Game - An ordinary person's companion contains a starter kit which is too lengthy and involved to repeat now but here is a sample...

Finance Basics

The time value of money

Money has a time value, and the first principle of finance is this: a pound today is worth more than a pound tomorrow.

You can put today's pound in a bank that pays interest. At any point in the future, it will have earned a return, making the bank balance greater than a pound. Let’s say that the bank pays interest of 5% per annum. Over a year, the value of your £1 deposit will grow to £1.05, calculated as follows, where r is the rate of interest:

Value of investment after one year, or future value (FV) = £1 × (1 + r) = 1 × 1.05 = £1.05.

By choosing to deposit the money, you have given up the opportunity to spend £1 today in return for the chance to spend £1.05 in a year’s time. This is called the time value of money (TVM).

In the second year, you earn interest on both your original £1 and the 5p interest earned in the first year. This is called a 'compound rate', and the interest earned is compound interest. For each year of compounding, the formula adds 1 to the interest multiplier, so after 3 years, the calculation is £1 × 1.053; after 10 years, it is £1 × 1.0510, and so on:

FV of £1 after 2 years = 1 × (1.05 × 1.05) = 1 × 1.052= £1.10,
FV of £1 after 3 years = 1 × (1.05 × 1.05 × 1.05) = 1 × 1.053= £1.16,
FV of £1 after 4 years = 1 × (1.05 × 1.05 × 1.05 × 1.05) = 1 × 1.054= £1.22,
FV of £1 after 5 years = 1 × (1.05 × 1.05 × 1.05 × 1.05 x1.05) = 1 × 1.055= £1.28.

After 10 years, the calculation is £1 × 1.0510= £1.63. This is easy to calculate on any financial calculator.

While the FV formula shows how your money will grow in the future at any given interest rate, another calculation is needed to show how much a future sum is worth today. You need to be able to determine present value (PV). Do this by reversing the FV formula:

FV = PV × (1 + r)t becomes PV = FV / (1 + r)t.

In these formulas, t is the number of years, and r is the interest rate that, in this formula, is called the 'discount rate'.

If a three-year investment delivers a future value of £1.16, and your target return is 5% per annum, the present value of that sum can be found with the following equation:

PV = £1.16 / (1+0.05)³= 1.16 / 1.05³= 1.16 / 1.16 = £1.

Instead of dividing future value by (1 + r)t, you can equally multiply it by 1 / (1 + r)t, an expression known as the 'discount factor'. In this example, the discount factor after the third year is 1 / (1.05)³= 0.86, and multiplying this by FV £1.16 produces a PV of £1.

The practical applications of these equations for personal finance are endless. Several examples are given in my book.

Inflation

Inflation, a rise in the prices of goods and services, affects all asset values. As a simple rule, if returns for an asset are variable, its value and price will rise with inflation. If returns for an asset are fixed, its value and price will fall with inflation.

So, property, company shares, commodities, and other tangible appreciators, as a class, will rise with inflation, because their income and capital values are free to rise with it, while cash, fixed interest accounts, and bonds whose income returns are fixed and that do not attract capital growth will fall with inflation.

You should know the current rates of inflation and have a view of where it is heading over the next one to three years.

Use the present value (PV) formula to calculate the effect of inflation on your cash by simply substituting the rate of inflation for your target annual return or discount rate, r. If inflation is running at 3% per annum, the spending power of today’s £1 in ten years will be as follows:

PV = FV / (1 + r)t= 1 / 1.0310= 1 / 1.34 = £0.74.

Over a quarter of its value is lost!

Risk and Return

Every day, we are faced with choices, and as a commercial operator, you quickly learn ways of assessing one course of action versus another. For matters that have a financial consequence, most people, consciously or not, apply some kind of risk-versus-return analysis.

In finance, the concepts of risk and return are inextricably linked. Somehow, you must learn to measure returns more accurately and to identify and compare the associated risks. By doing this, you will be able to compare the performance and value of one asset against another and choose the most appealing one based on your requirements. It is one of wealth's holy grails, the key to financial success, and (unsurprisingly) impossible to master. You can only hope to get better and better over time and make fewer and fewer mistakes.

One of the formulas I use most is that used to calculate the 'compound annual growth rate' (CAGR) produced by an investment. Let's assume that an asset costs £100,000, and you know (or project) that it will deliver back £150,000 after tax and selling costs in five years.

The net return is £150,000 − 100,000 = £50,000. Expressed as a percentage, this is £50,000 / 100,000 × 100 = 50%.

The arithmetic average rate of return per year over the five years is 50 / 5 = 10% per annum, and this is ok as a rough rule of thumb but it ignores the compounding effect and overstates the rate you would actually need to turn £100,000 into £150,000 over five years. Applying the future-value formula from earlier proves this:

FV = £100,000 × (1 + r)t= 100,000 × (1.1)5= 100,000 × 1.61 = £161,000.

The actual rate required to deliver a gain of £50,000 is 8% and is calculated by rearranging the FV formula. Instead of calculating the future-value effect over time of a given compound interest rate, you now need to calculate the rate itself, given a future value. The rearranged formula that produces the CAGR, where t is the time period in years, is as follows:

CAGR = (ending value / starting value)(1/t)− 1

CAGR = (150,000 / 100,000)(1/5)− 1 = (1.50.2) − 1 = 8%.

You can either use a financial calculator for this or one of the online compounding calculators.

Remember that a productive appreciator such as rental property or dividend paying share produces an income return as well as a capital return so add the annual post tax yield on the asset to its overall return.

Price against Value

The terms price and value are commonly interchanged, but they are different.

Value is the material or monetary worth of the asset. Price is the material or monetary payment for sale and purchase of the asset. As a buyer, I ask, "What can I get it for?" As a seller, I ask, "What can I get for it?"

So price is the end product of a process, the outcome of an exchange between buyer and seller. It doesn't exist until the bargain has been struck. "Asking" or "list" price is no more than an invitation to buyers who may accept or turn it down or demand more attractive terms. Value, however, exists whether or not it is realized. In a world of constant change, neither value nor price can be anchored to in safety, but of the two, price is infinitely more fickle, as we'll see.

Recognition of this difference invites questions: What determines value and price? How do they behave relative to the other? Do they converge, and if so, when? And under what circumstances will they diverge most?

Price and value converge in an exchange when perfect information is available to all and the market operates efficiently.

Price and value diverge most when information is imperfect or unequally distributed and the market is inefficient.

Value is only as good as the price you can achieve when you sell, so you need a confident and supported view of both. On a sale and purchase transaction, price trumps value, because it is actual rather than theoretical. Price doesn't change value; it simply varies your wealth through its proximity to value.

If you can buy assets at prices below their value or sell them at prices exceeding their value, you are onto a good thing. If you can do both, you have a winning formula. You can hunt the optimal circumstances for your purchase or sale-go where the money isn't to buy, and take your asset to where the money is to sell-or, if the asset is immovable (like a house), buy when the money isn't there, and sell when it is.

The price equation has three components that are quite different to those of value: first, the level of supply versus demand for the asset; second, the amount of money circulating to fund the purchase; and third, the desire of the buyer and seller to deal.

Prices are highest when these factors combine in one of three ways:

1.    Demand for the asset exceeds supply.

2.    Buyers are awash with money, either their own or borrowed.

3.    Buyers are keener to buy than sellers are to sell.

Prices are lowest when these factors combine in one of three ways:

1.    Supply of the asset exceeds demand.

2.    Buyers are short of money.

3.    Sellers are keener to sell than buyers are to buy.

In practice, the three operate according to their own rules. They may all converge in one direction or another, such as in times of economic boom or bust, or head in opposite directions. The exchange between buyer and seller determines the final price.

As an exchange between buyer and seller determines the price of an asset; different circumstances of exchange can produce different prices. Here’s an example:

Aunt May has inherited a painting she doesn’t want.

(1)    She is desperate to raise cash quickly to pay overdue winter fuel bills. Her neighbour has a friend who buys and sells art, so she invites him around. The dealer privately believes it to be worth £1,500 but offers £500. Accepting the offer, Aunt May is pleased and buys her neighbour a bottle of wine as a thank-you.

(2)    The painting doesn't suit her house, and is getting in the way. She advertises the painting in a local free paper with a brief description. Three people come to see it, including the dealer. She asks them to make an offer if interested, and at the end of the week, she'll take stock and reply to them. Our dealer offers £500. A private collector offers £750. At the end of the week, Aunt May rings both, and after a few rounds of private bidding, she secures a price from the collector of £1,250. She is delighted with the result and buys herself a new coat.

(3)    On a whim and without any particular intent to sell, she sends the painting to Sotheby's, which researches its history and provenance and values it at £2,500 to £3,500. Sotheby's enters it in its upcoming Old Masters Sale and advertises it online and via catalogue to its worldwide clients three weeks ahead of the sale date. A dealer has recently made a big profit on the sale of a sculpture and is feeling rich. On the night of the auction, despite lots of competition, the dealer prevails at a hammer price of £6,000. After the auctioneer's selling commission of £1,800 (25% of price + VAT at 20%), Aunt May's net proceeds are £4,200. She is over the moon and goes to Florence for a week's vacation.

This offers lessons for buyers and sellers.

Sellers

Don't be in a hurry, and never be a forced seller.

Know what you are selling and its value, or get someone who does know to help you.

Educate buyers so that they have the same knowledge as you.

Make sure that the buyer who can value it most gets to see it.

Generate plenty of competition, and run a process that delivers the highest price available in the market.

Buyers

Know what you are buying and its value.

Find a seller who doesn’t understand the asset as well as you do.

Buy off market.

Learn to spot a seller in a hurry.

Don't let surplus money in your pocket colour your view on value.

Fear and greed

Sometimes called fear and hope, these two powerful human responses are important drivers behind two of the three components of the price equation, feeding most directly into the desire of buyer or seller to trade and, in turn, to supply and demand.

Fear - This is the fear of losing money, missing out on gains, being the last one holding an asset that no one wants, falling behind others, feeling stupid, looking stupid, and failing.

Greed or hope - This is the greed or hope for gathering money, making gains, being the first one into an opportunity, beating others, feeling clever, looking clever, or success.

Studies and the evidence on the ground confirm that these sentiments are toxic, penetrating via every sense organ, and highly contagious, spreading rapidly through human contact and media. Local outbreaks and wider epidemics are common.

Between fear, hope, and greed lies confidence, which occupies the broad centre ground, occasionally turning a few degrees one way or the other.

Fear and greed drive divergence between price and value. If prices are driven higher than underlying values, sellers benefit, and buyers overpay. If they plunge below values, sellers lose, and buyers benefit. Investors who panic will lose either way.

Investors love predictability. In a world of uncertainty, volatility and price swings, one thing remains predictable: human emotions. A philosophy of being different, emotional resilience, and taking contrarian positions come into their own here.

Growth platforms

A growth platform is a home for your cash in which additional value will automatically accrue by virtue of someone else's effort or market forces. You can add more value through your own efforts, but this is optional. In the classic division of capital and labour described by Adam Smith in The Wealth of Nations, you become capital provider and charge for it.

Appreciators are growth platforms, and productive depreciators can also be if their cash generation exceeds their depreciation, but unproductive depreciators and consumables are not. The more effective the growth platform, and the more surplus cash you allocate to it, the faster you will build your wealth pot.

In the quest for O, all your available surplus cash should be directed to appreciators.

Many growth platforms exist, each with its own particular characteristics, but they tend to fall into two camps:

1.    A profit-seeking enterprise combining some mix of human labour, know-how, technology, process, premises, plant, equipment, and stock

2.    A tangible commodity for which demand outstrips supply over time, such as gold, diamonds, oil and gas, or land and property

The first is dynamic and generates value through its own activities; the second has utility value but is primarily the passive recipient or beneficiary of value created elsewhere. There is a distinction and distance between the asset and the primary wealth-creating force.

Residential property provides shelter, but its financial value is created because someone has acquired the money to buy it. It acts like a net to skim wealth generated from elsewhere. An enterprise may benefit from inflation or market forces, but the primary driver of its value is profit generation. However, they generate or attract value, both types of growth platform can add to your wealth.

Your financial involvement in either type may also be active (as an owner, a manager, or a developer), or passive (as a direct investor or lender or indirectly via a fund). You might use cash to start a business or to acquire part or all of an existing private one, you might buy shares listed on a stockmarket, or you might buy a fund that holds a variety of company shares.

Similarly, you can take direct ownership of residential property to develop, improve, and sell; to rent out; to live in; or just to hold. Alternatively, you can buy passive exposure to it through a fund.

From the outset, you should understand how your chosen growth platform generates value and where you sit in the investor-lender hierarchy. What are your rights and obligations, and where is the scope for value gain or leakage? Are you a collector or a builder?

One requires judgement, discipline, and buying skills; the other demands these skills plus many others, not least time and energy. For the ordinary person working hard to earn and save money in the first phase of the game, it is hard to do anything other than collect.

Why are they so important?

Growth platforms bring valuable outside help such as labour and enterprise, market forces and price inflation. These powerful allies start working for you, leveraging your own wealth-generation efforts from the moment you acquire them, and they carry on while you own them, possibly long after you have slowed down or stopped earning money from your own labour.

They don't discriminate between players and are available to anyone with the money to buy or establish them.

The second reason for their importance is defensive. Over time, unless your assets grow at least as fast as inflation, they will lose value. Growth platforms provide the solution.

But which growth platforms? Read next week to find out….

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.