Investment Valuation:
Despite confusion about stocks, bonds, certificates of deposit, mutual funds,
and their respective options, there are basically two ways to
invest. Money can be lent for a specific rate in a debt, or
interestgenerating, investment.
Or an investor can own equity a share of an asset such as
a corporation, small business, real estate, or another property.
Generally, equity assets provide growth and a hedge against inflation, and debt assets provide income with relatively little protection from inflation. The ideal portfolio is diversified between both categories according to the clients objectives and tolerance for risk.
Any attempt at investment planning will underscore the point that the options are diverse and confusing. Nonetheless, it is essential to understand the different risks and returns of debt and equity investments.
Fundamental Investment Calculations:
Whether a planner gives investment advice or refers clients to money manager for advice, he or she should know several fundamental calculations used by investment advisers.
Market price is determined by supply and demand in the money and capital markets throughout the day. In general, the price of a stock is determined by investor expectations about the economy and interest rates and the growth prospects of the firm.
Earnings per share (EPS) is net corporate profit after subtracting expenses,
taxes, and interest, divided by the number of shares outstanding.
Investors place great weight upon the trend of earnings per
share, since present and future dividends depend on earnings.
In addition, the price of a stock reflects the expected growth
in earnings.
Price earnings ratio (P/E ratio) is calculated by dividing the market price of the stock by the earnings per share. Price earnings ratios vary widely among stocks, but in general stocks with higher P/E ratios indicate that investors anticipate higher growth. Price earnings ratios change throughout the market cycle. For example, at the stock markets 1987 peak, price earnings ratio of the Dow Jones Industrial average was 22.9 (22.9 times earnings). Two years later, in October 1989, the markets P/E ratio stood at13, leading some investment advisers to conclude that the market was not overvalued.
Net asset value per share is the net balance sheet value of the corporations depreciated assets, less liability and preferred stockholders claims, divided by the number of outstanding common shares. This calculation is used by investment advisers to determine the basic value of a share of stock if the corporation was to be broken up and its assets liquidated. Book value is not always a reliable indicator since assets are carried at depreciated cost rather than replacement value.
Nominal yield is the annual interest rate found by dividing the total annual interest by the face value of the bond.
Current yield is the annual interest divided by the current
price of the bond. Yield to maturity represents the total return
on a bond kept until it matures. Yields to maturity are listed
in bond tables in financial periodicals and are useful when
comparing investments with different maturities. Total return
for equity and bond investments is the sum of income plus capital
gain. Dividend yield is a percentage found by dividing dividends
at present price.
Return on Investment:
Return on Investment is a key, but rough, measure of performance. Although return on investment shows the extent to which earnings are achieved on the investment made in the business, the actual value is generally somewhat distorted.
There are basically two ratios that evaluate the return on investment. One is the return on total assets, and the other is the return on owners equity.
The return on total assets (ROA) indicates the efficiency with which management has used its available resources to generate income.
Return on total assets = net income
Average total assets
The Du Pont formula shows an important tie in between the profit margin and the return on total assets. The relationship is:
Return on total assets = profit margin X total asset turnover
Therefore,
Net Income = Net income X Net Sales
Average total assets Net Sales Average total assets
As can be seen from this formula, the return on total assets can be raised by increasing either the profit margin or the asset turnover. The latter is to some extent industry independent, with retailers and the like having a greater potential for raising the asset turnover ratio than do service and utility companies. However, the profit margin may vary greatly within an industry since it is subject to sales, cost controls, and pricing. The interrelationship shown in Du Pont formula can therefore be useful to a company trying to raise its return on total assets since the area most sensitive to change can be targeted.
Return on total assets = profit margin X total asset turnover
We know from our previous analysis that the profit margin has remained stable while asset turnover has deteriorated, bringing down the return on investment. Since asset turnover can be considerably higher, Ratio Company might first focus on improving this ratio while at the same time reevaluating its pricing policy, cost controls, and sales practices.
The return on common equity (ROE) measures the rate of return earned on the common stockholders investment.
Return on common equity = earnings available to common stockholders
Average stockholders equity
Return on common equity and Return on total assets are closely related through what is known as the equity multiplier (leverage or debt ratio) as follows:
Return on common equity = Return on total assets X equity multiplier
= Return on total assets X total assets
Common equity
Or = Return on total assets
1 Debt ratio
Measuring Total Return
Whether a client invests in debt or equity investments, it is best for the planner to help the client focus on the total return of an investment rather than just the yield from interest and dividends.
The total return concept is useful to apply to both debt and equity investments. Essentially, it is the sum of income plus capital gain which measures the actual investment return.
There are three types of income return from investment: interest (on debt investments), dividends (on equity investments) and rent (on real estate and other investments).
Interest may be simple or compounded. With compound interest, the interest on the investment also earns interest over time and results in a higher yield. The more frequently that interest is compounded, the greater the return to investors.
Dividends are distributions paid to corporate stockholders out of past or present earnings. Dividends are generally cash, but occasionally may be non cash distributions (stocks, bonds or other property). Dividend policies are determined by corporate directors and vary widely. The dividend yield of Standard and Poors 500 Stock Index is currently 3.3 percent of the market price. Small, growth companies may not pay dividends, preferring to reinvest earnings in the company.
Rent is money paid for the use of real estate or another
capital asset:
Capital gain (or loss) represents the price change in an asset during the holding period. Determine the capital gain by subtracting the price at the beginning of the holding period from the price at the end of the holding period. To find the percentage capital gain or loss, divide the capital gain by the price at the beginning of the holding period. On a financial calculator, simply enter the price at the beginning of the period and the price at the end of the period, and push the percent change button.
Total return is very important when recommending investment products. A high yield bond fund may promise a 12 percent return, but if interest rates rise and the price of the bond decreases by 10 percent, the actual total return to the investor would be 2 percent. Thus, a Treasury bill or money market fund which only paid an interest rate of 7 percent would have made a wiser investment.
Likewise, the stock of a small corporation may not pay any dividend at all, but the stock price may grow at 15 percent per year. This may be a superior total return compared with the stock of a utility company that pays a 7 percent dividend but only grows 3 percent annually.
Related Topics
1. Classification of Securities
2. Valuation of Marketable Securities
3. Investment Criteria
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