Future benefits, for which a number of financial metrics serve as a proxy (e.g., free cash flow), are only meaningful when evaluated within the context of risk. In other words, a dollar of return from one type of investment may be worth more or less than a dollar of return from a different class of investment. For example, a dollar of return from a manufactured housing community investment is certainly worth more than a dollar of return from a technology start-up. Risk matters!
Even within asset classes, the required return differs based on the quality and characteristics of the future benefits stream. Often these benefits are reflective of underlying asset quality. A large, modern manufactured housing community that targets seniors in a Sunbelt state location requires a measurably lower required rate of return than small, single-wide “trailer park” that targets low-income residents in rural Indiana. Why? The explanation is found in the expected size, growth and certainty of the Sunbelt location property’s cash flows in comparison to those of the rural Indiana property.
Before you judge a return, be sure to evaluate it within the context of its embedded risk.
Posted on Sat, May 26, 2012
by Tim Moffit filed under