Investment

In general, to invest is to distribute money in the expectation of some benefit in the future – for example, investment in durable goods, in real estate by the service industry, in factories for manufacturing, in product development, and in research and development. However, this article focuses specifically on investment in financial assets.

In finance, the benefit from investment is called a return. The return may consist of a profit from the sale of property or an investment, or investment income including dividends, interests, rental income etc., or a combination of the two. The projected economic return is the appropriately discounted value of the future returns.

Investors generally expect higher returns from riskier investments.When we make a low risk investment, the return is also generally low.

Investors, particularly novices, are often advised to adopt a particular investment strategy and diversify their portfolio. Diversification has the statistical effect of reducing overall risk.

Investment differs from arbitrage, in which profit is generated without investing capital or bearing risk.

An investor may bear a risk of loss of some or all of their capital invested, whereas in saving the risk of loss in the value that is stated on a coin or note is normally remote.

Investment in stocks, property, etc. in the hope of significant gain but with the risk of significant loss, i.e. speculation, involves a level of risk which is greater than most investors would generally consider justified by the expected return. An alternative characterization of speculation is its short-term, opportunistic nature.

Famous investors

Investors famous for their success include Warren Buffett. In the March 2013 edition of Forbes magazine, Warren Buffett ranked number 2 in their Forbes 400 list.[1] Buffett has advised in numerous articles and interviews that a good investment strategy is long term and choosing the right assets to invest in requires due diligence.

Edward O. Thorp was a highly successful hedge fund manager in the 1970s and 1980s who spoke of a similar approach.[2]

The investment principles of both of these investors have points in common with the Kelly criterion for money management.[3] Numerous interactive calculators which use the Kelly criterion can be found online.[4]

Intermediaries and collective investments

Investments are often made indirectly through intermediary financial institutions. These intermediaries include pension funds, banks, and insurance companies. They may pool money received from a number of individual end investors into funds such as investment trusts, unit trusts, SICAVs, etc. to make large-scale investments. Each individual investor holds an indirect or direct claim on the assets purchased, subject to charges levied by the intermediary, which may be large and varied.

Approaches to investment sometimes referred to in marketing of collective investments include dollar cost averaging and market timing.

History

The Code of Hammurabi (around 1700 BC) provided a legal framework for investment, establishing a means for the pledge of collateral by codifying debtor and creditor rights in regard to pledged land. Punishments for breaking financial obligations were not as severe as those for crimes involving injury or death.[5]

In the early 1900s purchasers of stocks, bonds, and other securities were described in media, academia, and commerce as speculators. By the 1950s, the term investment had come to denote the more conservative end of the securities spectrum, while speculation was applied by financial brokers and their advertising agencies to higher risk securities much in vogue at that time. Since the last half of the 20th century, the terms speculation and speculator have specifically referred to higher risk ventures.

Value investment

A value investor buys assets that they believe to be undervalued (and sells overvalued ones). To identify undervalued securities, a value investor uses analysis of the financial reports of the issuer to evaluate the security. Value investors employ accounting ratios, such as earnings per share and sales growth, to identify securities trading at prices below their worth.

Warren Buffett and Benjamin Graham are notable examples of value investors. Graham and Dodd's seminal work, Security Analysis, was written in the wake of the Wall Street Crash of 1929.[6]

The price to earnings ratio (P/E), or earnings multiple, is a particularly significant and recognized fundamental ratio, with a function of dividing the share price of stock, by its earnings per share. This will provide the value representing the sum investors are prepared to expend for each dollar of company earnings. This ratio is an important aspect, due to its capacity as measurement for the comparison of valuations of various companies. A stock with a lower P/E ratio will cost less per share than one with a higher P/E, taking into account the same level of financial performance; therefore, it essentially means a low P/E is the preferred option.[7]

An instance in which the price to earnings ratio has a lesser significance is when companies in different industries are compared. For example, although it is reasonable for a telecommunications stock to show a P/E in the low teens, in the case of hi-tech stock, a P/E in the 40s range is not unusual. When making comparisons, the P/E ratio can give you a refined view of a particular stock valuation.

For investors paying for each dollar of a company's earnings, the P/E ratio is a significant indicator, but the price-to-book ratio (P/B) is also a reliable indication of how much investors are willing to spend on each dollar of company assets. In the process of the P/B ratio, the share price of a stock is divided by its net assets; any intangibles, such as goodwill, are not taken into account. It is a crucial factor of the price-to-book ratio, due to it indicating the actual payment for tangible assets and not the more difficult valuation of intangibles. Accordingly, the P/B could be considered a comparatively conservative metric.

Free cash flow and capital structure

Free cash flow measures the cash a company generates which is available to its debt and equity investors, after allowing for reinvestment in working capital and capital expenditure. High and rising free cash flow therefore tend to make a company more attractive to investors.

The debt-to-equity ratio is an indicator of capital structure. A high proportion of debt, reflected in a high debt-to-equity ratio, tends to make a company's earnings, free cash flow, and ultimately the returns to its investors, more risky or volatile. Investors compare a company's debt-to-equity ratio with those of other companies in the same industry, and examine trends in debt-to-equity ratios and free cash flow.

EBITDA

A popular valuation metric is Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA), with application for example to valuing unlisted companies and mergers and acquisitions.[8]

For an attractive investment, for example a company competing in a high growth industry, an investor might expect a significant acquisition premium above book value or current market value, which values the company at several times the most recent EBITDA. A private equity fund for example may buy a target company for a multiple of its historical or forecasted EBITDA, perhaps as much as 6 or 8 times.

In certain cases, an EBITDA may be sacrificed by a company to pursue future growth, a strategy frequently used by corporate giants such as Amazon, Google and Microsoft, among others. This business decision, based on EBITDA, can impact negatively on buyout offers and can cause many negotiations to fail. It may be recognized as a valuation breach, with many investors maintaining that sellers are too demanding, while buyers are regarded as failing to realize the long-term potential of expenditure or acquisitions.

Types of financial investment

Types of financial investments include:

See also

References

  1. ↑ Editor. "Forbes 400: Warren Buffett". Forbes Magazine. Retrieved 1 March 2013.
  2. ↑ Thorp, Edward (2010). Kelly Capital Growth Investment Criterion. World Scientific. ISBN 9789814293495.
  3. ↑ "The Kelly Formula: Growth Optimized Money Management". Seeking Alpha. Healthy Wealthy Wise Project.
  4. ↑ Jacques, Ryan. "Kelly Calculator Investment Tool". Archived from the original on 2012-03-20. Retrieved 7 October 2008.
  5. ↑ "The Code of Hammurabi". The Avalon Project; Documents in Law, History and Diplomacy.
  6. ↑ Graham, Benjamin; Dodd, David (2002-10-31). Security Analysis: The Classic 1940 Edition (2 ed.). New York; London: McGraw-Hill Education. ISBN 9780071412285.
  7. ↑ "Price-Earnings Ratio - P/E Ratio". Investopedia.
  8. ↑ "What is EBITDA".
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