Investment Valuation and 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 & Analysis

Overview

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.

Investment Earnings

Successful investments earn money in one or both of two ways.

Appreciation

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.

Interest & Dividends

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.

Applications

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.

Deposits

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

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

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.

Mutual Funds

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

For example, an investor buys stock for $1,000, sells it later for $1,200, and earns $100 in dividends while holding it. At the time of the closing, the owner has $1,300 instead of the $1,000 with which the investment began. Using the above formula, the investment has achieved a .3 or 30 percent return rate. This rate might or might not be considered "good," depending on how long it took to return that rate, and what other more profitable uses the investor could have made with the money had it been used in another investment.

A yield must also be evaluated in terms of inflation. Rates of return can be calculated either as nominal (not adjusting for inflation) or real (adjusting for inflation). The value of the nominal rate is reduced by the amount of inflation that exists during the holding period-so if a fund yielded an 18 percent nominal rate and the inflation rate was five percent, the real rate of return would be thirteen percent. The yield must also be analyzed in terms of its tax consequences, as a portion of that return will be taxed as dividends or interest. Thus, the "whole picture" must be taken into account when placing value on the return of an investment.

Issues

Risk

Nearly every type of investment contains some element of risk, or the degree of uncertainty on the return of an asset-in other words, the likelihood that the investment will not lose money. Part of the valuation process is to determine how much risk an investor is willing to take, and how much chance there is that the investment will fail. Investors who are risk averse are reluctant to make investments that have high risk; investors who are "risk tolerant" are more comfortable making higher-risk investments. The Risk-Return Tradeoff (Kapoor, Blabay & Hughes, 2007) is a helpful concept for deciding if an investment is worth making: Is the potential benefit of the investment worth the chances of losing it?

Investment risk comes from many sources. Keown (2003) identifies seven sources of risk:

  • Interest rates during the lifetime of the investment;
  • Inflation rates;
  • The company's risk in operating the business;
  • The company's management of its debt;
  • How much money the company can produce (liquidity);
  • The performance of the overall market;
  • Political and regulatory issues;
  • The exchange rate of the currency, and;
  • Call risk-or the possibility that a lender will "call in" its loan early.

Any of these sources, or perhaps all of them, influences the value of an investment that could fail because of events internal or external to the company.

Growth, Value, & Intrinsic Value

Investments can be evaluated on the basis of their current market value but also in terms of their growth potential. For example, investors might choose growth stocks because they believe that over time, these stocks will develop steadily and substantially. Growth stocks may pay little or no dividends, as their growth objectives lead them to re-invest all of their earned capital; many technology companies are growth-oriented. Value investments are those that are can be purchased at a low price (hence, they are "undervalued"), may have relatively high rates of return, and are characterized by low price-to-earnings ratios (P/E). In general, making such investments (which is called "value investing") is more beneficial than making growth investments (Chan & Lakonishok, 2004) and are long-term (Kwag & Lee, 2006). Finally, investments with intrinsic value are those about which there is an "underlying perception" of future worth or potential-but making this type of investment, which is usually speculative, is highly subjective and often risky.

The Value of Tax-Sheltered Investments

The value of tax-sheltered investments (tax-deferred or tax-free investments) cannot be overstated. A tax-deferred fund, such as many pension programs that are set up by employers, allows the investor to contribute money on a pre-tax basis; in other words, an individual's taxable income would be lessened by the amount of money contributed to such an fund; he or she would not actually pay taxes on the contribution until they reached a specified retirement age, thus allowing the money to grow over a period of years without being taxed each year. Depending on tax brackets, as much as $14,000 of a person's yearly salary can be set aside, pre-tax, for retirement. The cumulative effect of these contributions and the growth they incur over a period of years or decades can dictate the quality of life retirees will experience when they retire and at what age they can retire.

Other forms of tax-advantaged investments would include certain Federal, state, or municipal bonds, the proceeds from which normally are not taxable within the jurisdictions they are offered. For example, income from a state-issued bond would usually be exempt from that state's tax structure. Also, individual retirement accounts (IRAs) allow individuals to contribute to accounts that earn interest but allow them to avoid paying taxes on that income until they reach a specific retirement age, usually 59 1/2 years. Also, depending upon an investor's tax bracket, the contributions an individual makes per year to an IRA may be deductible from that year's income tax. Thus, significant value of an investment is usually found not by how much money it makes, but how much money it makes efficiently.

The Value in Financial Reporting

Companies seeking investors-either directly through stock purchases or through financial management funds-are required by the Securities and Exchange Commission (SEC) to disclose key financial information about themselves. This information is designed to help an investor ascertain the value of an investment by analyzing the firm's liquidity, financial leverage, efficiency, and profitability (Madura 2006). This data is made available, in print on company websites, through several forms, including:

  • Annual Reports-documents which disclose a company's or fund's activities for a calendar year, including its strategic decisions, acquisitions, new investments, etc.
  • Balance Sheets-documents that report a firm's financial condition as of a particular date.
  • Income Statements-reports of revenues and expenses for a specified period and which summarize the profit or loss for that period.
  • Cash Flow Statements-ledgers that show all money going in and out of an organization.

These documents testify to how a company manages its debt, its growth, its investor obligations, and its assets. Additionally, once investors become part of an organized investment program, the issuing organization provides quarterly reports which reflect how the investor's money, collectively with other investors' money, has been spent, how much it has grown, and what the net gain or loss has been. This information can be compared to general market data that can be accessed through Yahoo! Finance, Motley Fool.com, MSNmoney, the New York Stock Exchange web site, or other financial resources, so each investor can make his or her own evaluation of the investment's performance. Careful, regular monitoring of any investment is a necessity for ensuring the success of any investment program.

Conclusion

The value of any investment is relative-what is a highly valuable investment to one person or company is not necessarily valuable to another. Choosing investments is contingent upon what the goals of the investment are, such as risk, yield, duration, liquidity, and tax consequences (Nickels, McHugh & McHugh, 2008). Most financial planners believe that younger investors-people who have a longer period in which to make money and recover losses-should be more assertive in their investment activities. On the other hand, individuals or companies with high incomes might seek investments that pay tax-deferred or tax-free returns. Financial planners advise diversification of portfolios to achieve the best value for investments.

Terms & Concepts

Annual Report: A summary of annual financial information from a company's performance and expected performance.

Appreciation: The increased market value of an asset over time.

Asset: Any possession that has value in an exchange.

Balance Sheet: A document showing a firm's assets, liabilities, and equity for a specified period of time.

Bond: A certificate showing that an investor has loaned a company money to be paid back upon a specified maturity date.

Capital: Money invested in a firm.

Capital Gain: The difference between the net cost of a security and the net sales price, if the cost is less than the price.

Capital Loss: The difference between the net cost of a security and the net sales price, if the cost is more than the price.

Cash Flow Statement: A document reporting the money going in and coming out of a firm.

Certificate of Deposit: A type of savings account that is issued by a commercial bank that earns interest over a specified term (e.g., three months, six months, etc.)

Diversification: A mix of different investments designed to minimize an investor's overall risk.

Dividend: Payment to shareholders that reflects part of a firm's profits.

Equity: Ownership in a firm.

Federal Deposit Insurance Corporation: Government agency which guarantees depositor's bank accounts.

Fixed Income: Money from an investment that produces a regular payment of the same amount.

Growth Stocks: Ownership of companies with strong earnings or earning potential.

Income Statement: A report of a firm's revenues and expenses over a specified period of time.

Individual Retirement Account: A type of savings that allows investors to receive tax deductions during the year of their contribution and to defer taxes until a certain age is reached.

Inflation: The rate at which the general level of prices for goods and services rises.

Interest: The price paid for borrowing money.

Intrinsic Value: The present value of a firm's expected future net cash flows less the rate of return.

Investment: The use of money to create more money.

Mutual Fund: Pools of money managed by an investment company.

Pre-tax Basis: Condition in which money is set aside for investment before taxes are imposed on it, thereby reducing the tax liability.

Price-Earnings Ratio: The price of a stock divided by the per-share earnings of the stock.

Portfolio: A group of assets held by an investor.

Rate of Return: Gain or loss of an investment over a specified time, expressed as a percentage over the initial investment cost.

Risk: Degree of uncertainty of return on an asset.

Risk-Return Tradeoff: The potential advantage of an investment relative to the level of risk incurred by making it.

Stock: Ownership (equity) of shares in a company.

Tax-sheltered Investments: Funds, such as IRAs, which allow the investor to defer or avoid taxes on returns.

Valuation: The process of determining the current worth of an asset or company.

Value Investing: Purchasing stocks that are considered to be undervalued.

Value Stocks: Stocks that are undervalued and usually produce high dividends.

Yield: (See Rate of Return).

Bibliography

Bodie, Z., Kane, A., & Marcus, A. J. (2007). Essentials of investments. New York: McGraw-Hill Irwin.

Chan, L. K. C., & Lakonishok, J. (2004). AddedValue and growth investing: Review and update. Financial Analysts Journal, 60, 71-86. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12246106&site=bsi-live

Heughebaert, A., & Manigart, S. (2012). Firm valuation in venture capital financing rounds: the role of investor bargaining power. Journal of Business Finance & Accounting, 39(3/4), 500-530. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=74089137&site=ehost-live

Investopedia.com. (n.d.). Retrieved September 20, 2007 from: http://www.investopedia.com

Kapoor, J. R., Dlabay, L. R., & Hughes, R. J. (2007). Personal finance, (8th ed.). New York: McGraw-Hill.

Keown, A. J. (2003). Personal finance: Turning money into wealth. Upper Saddle River, NJ: Prentice Hall.

Kwag, S. W., & Lee, S. W. (2006). Value investing and the business cycle. Journal of Financial Planning, 19, 64-71. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19424117&site=bsi-live

Loughran, T., & Wellman, J. W. (2011). New evidence on the relation between the enterprise multiple and average stock returns. Journal of Financial & Quantitative Analysis, 46, 1629-1650. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=71818602&site=ehost-live

Madura, J. (2006). Personal finance, (2nd ed.). Boston, MA: Pearson Education.

Money.cnn. (n.d.). Retrieved September 20, 2007 from: http://money.cnn.

Nickels, W. G., McHugh, J. M., & McHugh, S. M. (2008). Understanding business, (8th ed.) New York: McGraw-Hill Irwin.

Thollot, S., & Huh, E. (2013). PE fund valuation: What CCOs need to know. Compliance Reporter, 61. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87507889&site=ehost-live

Suggested Reading

Benninga, S. (2000). Financial modeling, (2nd ed.). Boston: Massachusetts Institute of Technology.

Damodaran on Valuation: Security analysis for investment and corporate finance. Hoboken, NJ: John Wiley & Sons.

Investing with insiders. (2007). Dow Theory Forecasts, 63, 1-2. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26290898&site=bsi-live

Koller, T. (2006). Valuation workbook: Step-by-step exercises and tests to help you master valuation. Hoboken, NJ: John Wiley & Sons.

Private equity: How long can the perfect storm last? (2007). Financial Executive, 23, 6. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://arch.ebscohost.com/login.aspx?direct=true&db=buh&AN=26471868&site=bsi-live

Wang, P. (2007). Why bad returns don't make a fund bad. Money, 36, 70-72. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26590522&site=bsi-live

Essay by William J. Wardrope, Ph.D.

Dr. William Wardrope is an Associate Professor of Economics and International Business at the University of Central Oklahoma. He is an author of numerous publications and has made over 200 presentations at professional conferences on topics in business, globalization, communication, and curriculum.