Producing Second Hand Cars, Managing Your Mortgage, Educating Your Children and Saving the Planet

The business performance of car rental agencies was historically volatile. Part of this was simply due to the inability of car rental agencies to predict client behaviour. However, this did not explain all of the variance in their business performance. It was only as the rental companies began to realise that their business was not just to provide a service, i.e. renting cars, but that they also were producing second-hand cars. It was the understandable misunderstanding by the rental companies of this facet of their business that was causing them so many problems. We can learn from this.

The initial understanding of these companies of their business focussed only on the acquisition and use of assets. They neglected the disposal of the assets. This error, or cognitive bias, is perhaps unsurprising, as the disposal of an asset almost seems a byproduct of the main business operation. Most people if asked to describe the operations of a car rental agency would likely make the same mistake.

To understand how this can affect business decisions, you need to consider the total loss in terms of price between buying a new car and the price of selling it some years later in the second-hand market, called the residual value. If you want actual direct market pricing, try the Kelly Blue Book. But you don’t need a third-party pricing service to explain to you that the second-hand market price of different car models depreciate at different rates.

For example, it not hard to understand that the second-hand car price of a Ferrari will drop significantly in percentage terms as soon as the car leaves the dealer’s lot. On the other hand a Volvo can be expected to retain quite a lot of its value in percentage terms.

Understanding this particular dynamic is not hard. People who are interested in Ferraris and can afford them will want to buy a new car. After all, when do the super rich accept buying second-hand? There is of course a market for second-hand Ferraris, but they will be the not so super rich, meaning the price needs to drop tremendously. After all, part of the cachet of owning a Ferrari is signaling that you are super rich. Buying it second-hand doesn’t help.

On the other hand a Volvo is a good, dependable car that attracts sensible buyers. Sensible buyers don’t care about the cachet of new, they care about quality and an appropriate price for that quality. This is why a Volvo will hold its value far better than a Ferrari. Just check the Kelly Blue Book.

Let’s bring this back to car rental agencies. Companies that initially focussed only on rental income might decide that when it comes to, say, Mercedes-Benz automobiles that the top end S-class model was the best option, as they could generate the greatest rental income from it.

It was only after years of commercial challenges that rental agencies began to understand that the loss on the asset value, i.e. Purchase price minus residual value, was significant relevant to the rental income. The focus of these companies moved from only looking at acquisition cost of the asset and rental income to also include the disposal, or residual, value of the asset. In simple terms, maybe the mid-level C-class with its more Volvo like characteristics and therefore stronger residual value might be the better asset to acquire.

This epiphany led to a revolution in the business. Asset (car) selection began to include residual value concerns. First was which cars had greater residual value. Important as this was, it was the tip of the iceberg.

What was the cost of maintaining these cars? What sales conditions where optimal? A car sold at 30,000 km mileage (is the metric equivalent kilometrage?) may create more value than one sold at 50,000 km even though the latter generates a lot more rental income. This would be the case if the second-hand car market demand was much greater at 30,000 km than at 50,000 km and therefore the difference in residual value more than made up for rental income differences.

What does this mean to you? Beginning with a personal car purchase, usually a large expenditure, the conventional analysis of price, quality, and cachet value takes on an all new dimension: residual value. Even if all you care about is cachet value, this enhanced analysis is important. Frequently buying a new car has cachet value similar to buying an ultra expensive car.

I don’t know what the comparative value of hanging on to an 8 year old Ferrari is relative to buying, say, a Lexus every 2 years but at least understanding the relevance of the residual value of cars allows the budding status seeker to make fiscally astute decisions.

The importance of understanding the relevance of the residual value of an asset is not confined to just cars. Consider the usually greatest asset purchase of an individual: their house. From a purely financial point of view, it usually makes sense to turn over your house, selling it every few years and buying a new one. Most people don’t think this way, but at the very least understanding residual value issues is critical for managing one’s mortgage. If the residual value drops below the outstanding mortgage you will go negative equity and the banks will often demand a cash equity infusion to reverse such a situation.

Even if you don’t want to keep trading the house you live in, you should analyse renting your home and trading another home as an asset, something that I’ve discussed earlier.

The Ferrari residual value issues provides a useful analogy for all the people who are investing in real estate. You might think that buying deluxe is the right thing to do, but remember that deluxe buyers usually want new, but middle class are more than happy with pre-owned. Just calculate your best estimate for residual values. This explains why a predominantly middle class real estate investment makes far more sense than a deluxe real estate investment.

This thinking can, and should, be applied to most investment decisions. It shouldn’t necessarily be applied to everything. For example, it can be applied to your child’s education. Usually, people look at the educational fees (rent), the quality of education and the cachet of the institution’s name. In a purely financial analysis what is missing is the residual value: how much can my child command in salary after graduation? That is a fantastic financial analysis. I’m not sure that it is the best parental, or humanist, approach.

A final thought on the usefulness of residual value. Critics of free market capitalism complain that as an economic system capitalism depletes resources in an unsustainable manner. Maybe the issue is not that managers don’t have morals, but that they have not been educated on the importance of residual value. Looking at rent income whilst ignoring residual value is a mistake any way you look at it.