Imagine I had a magical box. Once a day I could open it up and inside would be £10 that I could have.
How much would you be willing to pay to buy this box from me?
I’ve asked the question to a few people and got answers ranging from £1000-£5000 based on various bits of napkin maths. The reason I came up with the question was because I was looking at whole businesses for sale. Instead of a magical box with £10 in it each day it was a ready made business with £1000 in it each day. So how much should these companies be valued at?
One of the most common valuation methods seems to be 3x profits. Using this the magic box would be worth (£10 * 365 days) * 3 years = £10,950
That number is a lot higher than most people would have answered to the question. But there’s more to it. This box takes no effort to run whereas a business will have problems. some staff may decide to suddenly quit or a competitor opens up across the road or one of 1000 different events might happen which requires you to do work to fix. The magical box wont have these problems so it should be worth more.
If we raise the valuation method to 6x profits to account for it never having business problems the box becomes worth £21,900. Does that sound expensive to you or like a bargain?
You should also remember that once you have the box you have the option of selling it to someone else in the future. So for £21,900 you get an asset worth £21,900 and then £10 a day. Almost sounds like money for nothing if you look at it that way.
This is the same sort of question you should be asking yourself when buying assets in the real world. For example a saving account that gives you 2% interest is the same as paying £1000 for a magic box that gives you 5 pence every day. Or £1000 in premium bonds is the equivalent of a magical box that sometimes gives you nothing on some days and sometimes gives you a few pounds but on average gives you around 3-4 pence every day.
If you apply this magic box analogy to some of the savings and investments you have you may be surprised and what value you’ve given them.