Investment
Investment is time, energy, or matter spent in the hope of
future benefits actualized within a specified date or time frame.
Investment has a different meaning in
finance from that in
economics.
In finance, investment is buying or creating an asset with the expectation of capital
appreciation,
dividends (profit),
interest
earnings, rents, or some combination of these returns. This may or may
not be backed by research and analysis. Most or all forms of investment
involve some form of risk, such as investment in equities, property, and
even fixed interest securities which are subject, among other things,
to
inflation risk. It is indispensable for project
investors to identify and manage the risks related to the investment.
Overview
In
finance, investment is the purchase of an
asset or item with the hope that it will generate income or appreciate in the future and be sold at the higher price.
[1]
It generally does not include deposits with a bank or similar
institution. The term investment is usually used when referring to a
long-term outlook. This is the opposite of trading or
speculation,
which are short-term practices involving a much higher degree of risk.
Financial assets take many forms and can range from the ultra safe low
return
government bonds to much higher risk higher reward international
stocks. A good
investment strategy will diversify the
portfolio according to the specified needs.
The most famous and successful investor of all time is
Warren Buffett. In March 2013
Forbes magazine had Warren Buffett ranked as number 2 in their
Forbes 400 list.
[2]
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 very successful
hedge fund manager in the 1970s and 1980s that spoke of a similar approach.
[3]
Another thing they both have in common is a similar approach to
managing investment money. No matter how successful the fundamental pick
is, without a proper money management strategy, full potential of the
asset cannot be reached. Both investors have been shown to use
principles from the
Kelly criterion for money management.
[4] Numerous interactive calculators which use the Kelly criterion can be found online.
[5]
In contrast, dollar (or pound etc.) cost averaging and
market timing are phrases often used in marketing of collective investments and can be said to be associated with speculation.
Investments are often made indirectly through
intermediaries, such as pension funds,
banks,
brokers, and
insurance companies. These institutions may pool money received from a large number of individuals into funds such as
investment trusts,
unit trusts,
SICAVs
etc. to make large scale investments. Each individual investor then has
an indirect or direct claim on the assets purchased, subject to charges
levied by the intermediary, which may be large and varied. It
generally, does not include deposits with a bank or similar institution.
Investment usually involves diversification of assets in order to avoid
unnecessary and unproductive risk.
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.
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
Business
revolves around the factor of investing; financially, time, in the
future and successful investors will generally focus on certain
fundamental metrics for their gains. A
value investor is aware that when considering the health of a
company,
the fundamentals associated with it, are a highly influencing factor.
They include aspects related to financial and operational data,
preferred by some of the most successful investors; for example,
Warren Buffett and
George Soros. The financial details, such as,
earnings per share and sales growth, are essential aids for an investor in determining stocks trading below their worth.
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.
An instance, in which the price to earnings ratio has a lesser
significance, is when companies in different industries are compared. An
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.
Debt equity and free cash flow
For investment purposes, an essential factor relates to how a company
finances its assets, especially if it involves a sizable value stock
and is a situation in which debt/
equity ratio
has a significant influence. Similar to the P/E ratio, the debt/equity
ratio, indicates the proportion of financing, a company has obtained
from debt; for example,
loans,
bonds and equity, such as, the issuance of shares and stock, which vary
between industries. An indication to investors that all is not
financially sound with a company, relates to above-industry debt/equity
figures, particularly if an industry is experiencing a challenging,
adverse business environment.
A factor that sometimes remains unaware to investors is that the
earnings of a company generally do not equal the amount of cash
generated. This is due to companies reporting their financials
utilising,
Generally Accepted Accounting Principles (GAAP). It is a standard framework of guidelines for the financial accounting practices used in any given jurisdiction.
International Financial Reporting Standards (IFRS) are commonly used, worldwide.
Free cash flow is a metric that determines for an investor the sum of
actual cash remaining in a company after deduction of any capital
investments. In general, it is preferable to for a company to boast a
positive free cash flow, but similar to the debt-equity ratio, this
metric assumes greater significance in a difficult business environment.
Basics of the profit line
Arguably, the most commonly utilized valuation metric is
Earnings Before Interest, Tax, Depreciation and Amortization,
generally referred to as “EBITDA.” This metric relates to the basic
profits made, prior to the influences and intricacies of accounting
deductions becoming issues of the true profit line of a company. This
particular metric is recognized as the primary standard of private
mergers and acquisitions.
For a company competing in a high growth industry, an investor could
expect a significant acquisition premium, which is a buyout offer,
several times over the most recent EBITDA. In various instances, it has
been known for private equity firms, to pay multiples of up to 6-8 times
the EBITDA. However, some buyers could make the decision that even
given these relatively high valuations, the offer from a buyer does not
take into consideration past expenditures and future potential product
growth.
In certain cases, an EBITDA may be sacrificed by a company, in order
for the pursuance of future growth; a strategy frequently used by
corporate giants, such as, Amazon,
Google and
Microsoft,
among others. This is a business decision that can impact negatively on
buyout offers, founded on EBITDA and can be the cause of many
negotiations, failing. 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.
