Doing nothing is hard. You never know when you’re done.
If you’re looking to retire early, there are several ways to get there. One is to amass a portfolio that is so much larger than the safe withdrawal rate that you never really have to worry about capital gains or dividends. If Mark Zuckerberg retired today, that’s what his approach would be. Another is through careful management of a portfolio, rebalancing for your optimum asset location and allocation, and keeping an occasional eye on the markets.
Another approach is PIRE, or passive income, retire early. This is a combination of dividends, interest, and passive income to create cash flow sufficient to pay your ongoing expenses.
While dividends and interest are easy to figure out, the passive income piece is not.
Passive income can come in a number of ways:
- Rental real estate, assuming that you’re handing everything off to a property manager.
- Royalties. These could be from intellectual property, such as royalties from a song, or from real property, such as mineral rights on a piece of land.
- Start your own income generating website (#aff). This could be a blog with some ads thrown on it, or it could be a much more complicated supplier website like a drop shipper.
- Start or fund a business with preferred returns. As long as the business generates sufficient operating cash flow, you could get dividend checks from it.
- Purchase an annuity. This is the simplest one. Hand over chunk of money. Receive checks, usually until the end of your or your spouse’s life.
It’s tempting to assume that your passive income stream that you create will provide the same amount of payments for the rest of your life. If that was the case, then the calculation of the present value would be easy: the annual payment / the risk free interest rate (often a 3 month Treasury bill – inflation). So, let’s say that you created a website, and it generated $5,000 per year until the earth ended. Long term, the 3 month Treasury bill is 4.32%, and historical average inflation from 1914 through 2019 has been 3.24%. So, your $5,000 per year infinite money spinner would be worth $461,391.10.
Better get to work building that awesome website (#aff), right?
Not so fast.
How Do I Value a Passive Income Stream?
While there’s value in creating that passive income stream, the reality is that the spigot of cash coming from it probably won’t last forever. After all, while the singers of Macarena made a ton of money when it was released, they probably don’t make much anymore (although, if they invested wisely, they’re probably still fabulously wealthy).
If you want to build something that is truly passive, then you’re either going to have to a) hire other people to work on it (such as in a small business) and then share the profits via wages and, likely profit sharing or an ESOP, or you’re going to have to accept that once you take your hand off the tiller, the stream of income will decay over time.
Let’s take that website idea for a minute.
Some estimates show that traffic to unrefreshed content decays approximately 50% annually.
So, let’s take that wonderful website that generates $5,000 in ad income per year. Well, at least, in the beginning, it does.
By year 20, it generates $0.01 in income for you.
In total, it makes you $10,000.07.
However, that doesn’t make the website worth $10,000.07 to you today.
A dollar now is worth more than a dollar later due to the impact of inflation reducing the purchasing power of money.
So, how do you figure out the value of this magic website?
It takes a couple of steps.
First, you need to figure out what your asset allocation is.
Let’s say that you’re at a point where you’re investing 75% in equities and 25% in fixed income.
Then, get the returns of both.
I use the historical S&P 500 annual average return of 9.24% for equities and the historical Barclay’s bond index average annual return of 4.62% for fixed income.
Then, multiply each return by your weighting to get a weighted return.
In this case, you’d have 0.75 * 9.24% + 0.25 * 4.62%, or a 8.09% weighted return for that asset allocation.
Now, go to a spreadsheet like Google Sheets and enter in the expected annual returns in a row or a column. Then, use the NPV function and the weighted return, along with the returns to get a net present value. That means what you would pay today for that future stream of cash.
In this case, our website would be worth $8,608.10.
However, the only certainties in life are death and taxes.
You don’t know if your website is going to make that much.
It could be Facebook or Instagram and take off.
So, there’s uncertainty in that stream of revenue.
Let’s say that you feel pretty strongly that you have a niche and something unique to say or sell, so there’s a 75% chance you could get to that stream of revenue.
Discount that valuation by 25%. In this case, we now have a website that has an expected value of $6,456.08.
If you know the value of your time, then you know how long you would be willing to work to get that stream of income. If you don’t know the value of your time, read the article I just linked to!
Let’s say that the value of your time is $100 per hour.
To build this website, you’d be willing to spend about 64 and a half hours on it.
If you wanted to build a house, calculating the value (albeit changing the expected income stream) would be a similar approach.
If you wanted to write the Great American Novel, calculating the value would be a similar approach.
So, next time you have an idea for the Next Big Thing, you should have a good idea of how to figure out how much time to put into building it.
Did you ever build a passive income stream? How did it go? Did you spend enough time on it, or too much? Let’s talk about it in the comments below!