Evaluating Investments

By whatever method is used, keeping track of how money is spent, especially when investing, is necessary for success. Two of the best ways of evaluating investments are “the net present value and the internal rate of return” writes Samuel L. Baker in 2000 in an article,  “Perils of the Internal Rate of Return. “

The difference between the price paid up front and what is paid out in fees and interests and what the dividends paid defines the *net present value system. It is one of the often used measurement methods for understanding how investments are paying off or are not paying off.

Here is how it works: First calculate what the annual rate of income from the Pepsi stock, the Google stock, or stock from one of the newer, hard to assess, stocks, or from whatever stock one wants to evaluate, or even some other investment where the rate of dividends are puzzling, exceeding expectations, or at rock bottom, is. Next subtract the amount paid, plus whatever interest payment was made. In other words, subtract all expenses in acquisition and maintenance.

The labeling is deciphered by the interim, the present, which is the present value, the results obtained are the NPV, or the net present value. Of course this changes, so this will need be calculated at least annually, or better still, when a newer opportunity awaits and the decision must be made to keep or to sell. One of the downsides to this method is that it gives no hint of any flexibility or to probabilities of what it might do.

Another way of evaluating investments is the *internal rate of return (IRR).  This is a somewhat different approach to figuring how valuable an investment is, in that  it looks not at the overall picture of a stock, bond, or other potential money making holding as a means of deciding whether to keep or to sell.

It’s the “flip side of the NPR” according to the Value Based Management web site. The main difference is in the calculation  being stated in dollars and cents or Euro’s as opposed to percentages. The IRR is used to show the positive or negative value and is often more conclusive when deciding the future of that stock or deal.

While competent financial dealers use both methods to acquire knowledge  as guidelines for future use, each has its own particular place in portfolio assessment. When deciding whether to invest, NPR should be used when it is positive. IRR should be used cautiously, if used at all in these situations. The reasoning for that is no one should get so far ahead of themselves as to want to predict what the internal rate of return will be, but more appropriately to be satisfied with the present value.

No matter the method of calculation used, there is always room for error. The rule that most adhere to, when decision making is the financial problem of the moment, is to use money that one can afford to lose. Then if expectations are not met, at least a roof will remain over the family and a good lesson in investing has probably been made.