Start from the money the asset actually pays out and the return you require, and the price falls out of the division. The simplicity is real, and it conceals the same growth assumption everything else makes.
11 min read · Level 3
Yield-based valuation is generally recommended to people who find modelling intimidating, and that recommendation gets the risk exactly backwards. Its arithmetic is a single division, so it can be performed without understanding, and a method that can be performed without understanding will be. Everything difficult has been pushed into two places where it is easy not to look: what counts as income, and what growth is embedded in the required yield. A discounted cash flow at least forces both of those into visible cells, where a reader can object. A capitalisation rate hides them inside one number that sounds like a market fact. The claim worth arguing with is that the simplest available method is the most dangerous one to hand to somebody new, and that the right order is the reverse of the usual one - understand what the division is standing in for first, and only then enjoy how quick it is.
Yield-based valuation runs the arithmetic of investing in reverse. Instead of asking what a price implies, it starts from the income an asset produces and the return you require, and divides one by the other to get the price you would pay.
In property the required return is called a capitalisation rate, and the income is net operating income - rent after every cost of running the building except financing. In shares the equivalents are the dividend yield and the earnings yield, the latter being simply the price-to-earnings ratio turned upside down.
The method is genuinely different from the others in one respect: it begins with money that is actually received rather than with profit, which is an accounting construction. That is its main claim to honesty, and it is a real one.
Because it converts every asset into a comparable form. A property at a 6% capitalisation rate, a share at a 6.25% earnings yield and a bond at 6% are now expressed in one vocabulary, and the question 'which of these is worth owning' becomes answerable in a way it never is when one is quoted as a multiple and another as a price per square foot.
And because the required yield is the input you have the most right to an opinion about. You cannot know how fast a business will grow, but you can say with some confidence what return would make an investment worth making to you, given what else is available.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
A small commercial property. Gross rent is 72,000 a year. Management, maintenance, insurance, local taxes and an allowance for periods when it stands empty come to 24,000, so net operating income is 48,000.
At a required yield of 6%, the value is 48,000 divided by 0.06, which is 800,000.
Now the mistake that costs the most money in property, and it takes one line to make. Applying the 6% to the GROSS rent instead gives 72,000 divided by 0.06, or 1,200,000. That is 1,200,000 over 800,000, or exactly 50% too much, and there is nothing in the arithmetic to indicate anything went wrong.
Now the sensitivity, which behaves like every other method. At 5% the value is 48,000 over 0.05, which is 960,000. At 9% it is 48,000 over 0.09, which is 533,333. Moving the required yield from 5% to 7% - 685,714 - takes 274,286 off, which is 28.6% of the 960,000. From 5% to 9% the value falls 44.4%, almost by half, on an income figure that never changed.
The required yield is not a market fact you look up. It is a judgement, and it is doing exactly what the discount rate does in a discounted cash flow.
And here is the assumption the simplicity hides. Your total return from an income asset is the yield you receive plus the rate at which that income grows. So if you require 9% in total and you believe the rent grows 3% a year, the yield you need today is only 6% - and the value is 800,000. If you believe the rent cannot grow at all, you need the whole 9% in yield today, and the value is 533,333. The 266,667 difference between those two, which is 33.3% of the 800,000, is entirely the growth assumption. It was never written down anywhere.
The same structure appears in shares. Take a share priced at 40, paying 1.60 a year in dividends and earning 2.50. The dividend yield is 1.60 over 40, which is 4.0%. The earnings yield is 2.50 over 40, which is 6.25% - the reciprocal of a price-to-earnings ratio of 16.0. The payout ratio is 1.60 over 2.50, or 64%, so 36% of earnings are retained.
If that retained 36% earns 10% inside the business, the income can grow at 0.36 times 10%, which is 3.6% a year. Add that to the 4.0% dividend yield and the implied total return is 7.6%. Every figure there is arithmetic from four observable numbers, and the only judgement is the 10% - which is precisely where the argument about this share should be.
The first mistake is capitalising the wrong income. Gross rent instead of net, profit instead of distributable cash, a figure that includes a one-off. In the example above that single substitution overstated the value by 50%.
The second is treating a market capitalisation rate as a fact about the asset rather than a price set by current conditions. Yields move with the cost of borrowing, and a yield imported from a period of cheap money values an asset at a price that period supported.
The third is forgetting the maintenance the income depends on. A building generating 48,000 net is doing so because somebody spends money keeping it habitable, and a yield calculated before a roof that is nearly due describes an income that will not persist.
The fourth is capitalising income that is not durable. The method assumes the income continues; applied to a business with one customer, a lease with two years left, or a dividend already exceeding earnings, the assumption is the entire valuation and it is not stated anywhere in the formula.
The fifth is comparing a yield with a bank rate without noticing that one of them can fall to zero. A 6% yield on an asset whose income can disappear is not comparable to 6% on an obligation that must be paid, and quoting them side by side is how they get confused.
Every cost of ownership except financing comes out first - management, maintenance, insurance, tax, and a realistic allowance for periods without a tenant or customer. This step is where the method is won or lost; the division afterwards is trivial.
Start from a return you could get with far less uncertainty, then add what this asset's specific risks are worth to you. Writing it down before you see the answer is the same discipline as fixing a discount rate first, and for the same reason.
Required total return minus expected income growth gives the yield you need today. Write both halves. Whenever a yield-based valuation looks generous, the generosity is almost always sitting in an unstated growth number.
Compute the value two points either side of your figure. Here that band runs from 960,000 to 685,714 - the same kind of range every other method produces, and the same reason to report a band rather than a figure.
One tenant leaving, one customer lost, one dividend suspended. Work out what the asset is worth on the reduced income, because the formula treats the income as permanent and nothing else in the calculation will raise the question.
On assets held mainly for the income they produce - property, income-paying shares, lending, infrastructure - and whenever you want to compare assets of completely different kinds in a single vocabulary.
Avoid it on assets whose return is expected to come from appreciation rather than income, and on anything whose income today is unrepresentative - a business in its first profitable year, a property let below market rent, a company paying out more than it earns. The formula will still divide, and the answer will describe an income that does not exist.
A shape that recurs in property purchases made by first-time buyers is a yield calculated from rent with only the obvious costs subtracted. Management, insurance and maintenance are usually remembered; what gets left out is the allowance for months without a tenant, the cost of finding the next one, and the periodic large repairs that do not occur every year but are certain across a decade. Each omission looks small on its own, and together they routinely account for a meaningful share of gross rent, so the yield presented at purchase describes an income the property will never actually deliver in an average year.
A yield is only as honest as the cost list beneath it. Build the list before the division, and include the costs that do not occur annually but are certain over the holding period.
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