Evaluating an Asset
There are three ways to evaluating an asset:
- Greater fool theory
In real estate, they call it comparable sales. In paper assets (stock/bonds) it is the most recent transaction. The implication is the current price represents fair market value because it's the price willing buyers and sellers are trading at. The problem is, it's absolutely useless for indicating bubbles because it really only tells you what other fools are willing to pay for something.
In real estate, this would be the replacement cost analysis (how much it would cost to rebuild a structure net of depreciation). In stocks, its book value or a measure of the underlying assets. This is a very important measure of risk because it tells you the premium or discount you're paying relative to what the underlying asset is worth.
In real estate, income is measured as noi (net operating income) or often measured as gross rent multiplier. In the stock market, it's the PE (price-earnings ratio). Income is the best valuation measure for indicating risk. The value of any asset is worth what it earns. Meaning it measures present worth based on the future benefits of ownership.
Interesting conclusions develop when you compare and contrast all three evaluation methods together. Price and investment value are two separate and distinct things that should never be confused. Failure to make this distinction will eventually cost you money.