Investment Valuation & Analysis
This article focuses on the fundamental concepts involved in investment valuation and analysis. The basic process of investing and key investment terminology will be introduced, followed by a discussion of applications to different types of investments, such as stocks, bonds, and money markets — and their relative advantages and disadvantages, such as rates of return, safety, liquidity, and tax features. Tools for interpreting the rate of return values, and other issues for understanding the complexities of analyzing an investment program, such as risk, growth, value, and financial reporting, are also discussed, as is the need for careful diversification in any investment program.
Keywords Appreciation; Income Statement; Asset; Individual Retirement Account; Balance Sheet; Inflation; Bond; Interest; Capital; Intrinsic Value; Capital Gain; Investment; Capital Loss; Mutual Fund; Cash Flow Statement; Portfolio; Certificate of Deposit; Pre-tax Basis; Diversification; Price-Earnings Ratio; Dividend; Rate of Return/Yield; Equity; Risk; Federal Deposit Insurance Corporation; Risk-Return Tradeoff; Fixed Income; Tax-sheltered Investments; Growth Stocks; Stock; Valuation; Value Stocks
Finance: Investment Valuation
Simply put, an investment is the use of money (capital) to create more money. Individuals and companies make investments to earn profit that can be spent, saved, or re-invested, depending on the investor's strategic goals. Investing decisions are made based on factors such as the amount of available investment capital, the duration of the investment period, the level of risk, and the desired rate of return (yield) on the investment. Investors typically refrain from the consumption (use) of the invested capital while it is creating more money.
Successful investments earn money in one or both of two ways.
The first way is through the appreciation (increased value) of an asset that has been purchased, such as a stock that is sold at a higher price than at which it was purchased. The difference between the purchase price and the sales price, minus brokerage commissions and taxes, is referred to as a capital gain. Thus, if 100 stocks are purchased for $10 a share and later sold for $15 a share, the value of each share has increased by $5-and the stock's owner has made a capital gain of $500. Investments may be held for days, weeks, months, or many years in order to make desired gains. Unsuccessful investments may never earn profits and are considered capital losses.
The second way investments earn money is through interest or dividends. Interest is money paid to a lender for the use of the lender's money over a specified period of time at a particular percentage rate. Investors who put money into savings accounts receive interest from the banks that use and hold their money. Dividends are portions of a company's profits that are paid to shareholders who own interests in the company. For example, if you own 100 shares of a company that pays $1.50 per share, every year you would receive a check for $150. If a stock or a fund pays no dividends, then an investor relies on its potential for growth, or appreciation, over a longer period of time.
Because so many investment options are available, and since investing money can be risky, it is important to understand the potential value of an investment. Investors therefore are concerned with valuation, or the process of determining the current worth of an asset. In general, valuations can be made on a variety of factors, such as how much money the company has, how it manages its money, how it plans to manage its money in the future, or how much the company's holdings are worth. The following sections of this article cover different types of investments and some of the factors involved in their valuation.
Value in Different Types of Investments
The value of an investment to the investor is contingent upon a number of factors. An investment portfolio, or the collection of investments, should be sufficiently diversified to minimize risk and achieve the best possible return. Safety is one factor in determining if the investment has value to an investor; rate of return is another. Different types of investments meet these goals in different ways.
The safest type of investments-also typically the lowest-performing type-is a deposit with an insured commercial bank. A savings account is a perfect example of a simple, but secure, investment, but one which makes comparatively little return. Another form of a deposit-a certificate of deposit (CD)-usually earns a slightly higher rate, but "locks" in the invested funds for a specified amount of time, such as three months, six months, a year, or longer. In the case of the savings account and the CD, the bank essentially borrows the investor's money and uses it to further its own investment activities. The primary advantage of this type of investment is that commercial banks insured by the Federal Deposit Insurance Commission (FDIC) guarantee depositors that their money is safe; if the bank folds, the Federal government covers the depositors' losses.
Bonds represent another type of investment. Bonds are loans that investors make to companies or some level of government for use in a capital project, such as a new highway, new construction, or a new utility system. Bonds are given ratings-from AAA to C-by services such as Moody's and Standard's to denote their level of safety and are usually offered in denominations of $1,000. The bonds pay a specified rate of interest while being held, and upon completion of the funded project, the principal is returned to the investor. Bank deposits, as well as money market accounts, bonds, and Treasury bills produce what is known as fixed income, that is, the investor can expect to receive a certain amount of payback for the money he or she has loaned.
Stocks, on the other hand, produce taxable dividends, but they also allow an investor to "own" a portion (share) of the company and vote, in the case of common stock, in company decisions. This type of investment is considered equity. Historically, the stock market has outperformed most other types of investment strategies, but also contains the highest risk and requires the most astute monitoring and patience.
Another major type of investment is a mutual fund, which is a collection of stocks, bonds, and other securities that are purchased by a financial manager, who sells shares of the collective group of investments to individuals and companies. A wide variety of funds exist, including very conservative (secure) investments, or more speculative (riskier) investments. Mutual funds may offer opportunities to invest in large-cap companies (companies with high capital), or companies with less capital-mid-sized caps or small caps. Generally, the more capital a company has, the safer the investment may be, because they have greater assets to cover for losses if one should occur.
Rate of Return (Yield)
The value of an investment is often determined on the basis of how much money it will make over a period of time. For example, a stock offers a return, a rate that is represented by the difference of the purchase price and the sales price, plus any dividends it earns during the period of ownership. This figure is referred to as the holding's Rate of Return, or yield, which may be calculated as follows:
Ending Price — Beginning Price + Dividend Beginning price...
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