How to Evaluate Investments

While investors choose investments for a variety of purposes, they are primarily concerned with the question, “what’s in it for me?” The rate of return is typically the primary concern in evaluating investments. The most common evaluation methods – Net Present Value (NPV) and Internal Rate of Return (IRR) – revolve around returns. In addition, such decisions or opportunities can be assessed according to their various attributes, investment goals, and fundamental or technical analysis.

• Fundamental and technical analysis

Fundamental analysis of an investment assesses the external factors and characteristics of an investment object that might affect it. For example, fundamental analysis for a stock investment involves analyzing critical ratios (like Earnings per Share and Price to Earnings Ratio) that indicates the financial health of the enterprise. With currency trading, this might involve exchange rates and the strength of economies. Technical analysis is concerned about the price movements of the investment, disregarding the value of the investment. Technical analysis is critical in determining market trends, which affects the potential or profitability of a particular opportunity.

• Net Present Value (NPV)

The NPV of an investment decision or opportunity disregards the nominal return of an investment. Instead, it looks at the return of an investment in terms of its present value (value in today’s dollars). The NPV method goes a step further than discounting for inflation and other value-affecting conditions. It also subtracts the initial value of the investment. The purpose of undertaking an NPV calculation is to determine whether a project or investment opportunity has a positive NPV. Only if a positive outcome is possible, would the opportunity be profitable. Although an investment opportunity might have a positive nominal return, after discounting it is possible that a negative NPV can result.

• Internal Rate of Return (IRR)

The IRR, also known as the economic rate of return, uses the concept of the NPV in its calculation, and is very useful for investment comparisons as well. Naturally, opportunities with higher IRRs are more desirable. The IRR is determined by setting the Net Present Value of the investment to zero. This means that there might be a degree of variance between the actual return and Internal Rate of Return.

The IRR is applicable when an investment is required to produce an income stream. Therefore, it is important to reliably establish one before attempting an IRR calculation. The income stream is then revaluated using a discounting rate (typically for inflation). The IRR is the rate of return that makes the sum of the PVs of the income stream equal zero. At its simplest, the IRR looks at the rate of return required to recoup the real value of an investment.

For example, assume that a $100,000 investment in a mutual fund is used for income purposes. For simplicity, the investment yields $6,000 (a 6% return). However, $6,000 in one or two years would be worth less than $6,000 today. As a result, the IRR represents the average rate of return (higher than 6%) that would ensure that the real value of the investment is returned. Naturally, the IRR is primarily effective in comparing different types of investments – since comparing similar investments might not necessarily require the IRR method.

• Investment attributes

In addition to the rate of return, other attributes that investors can use to evaluate investments include:

Marketability – How attractive the investment would be for trading purposes

Liquidity – Whether the funds can be easily withdrawn, traded or sold

Investment period – The length of the investment should be in alignment with stated investment goals

Taxes – Taxes affect the real rate of return and should also be added to inflation as a discounting factor

Risk – Greater reward bears greater risk. Risk should be assessed in terms of risk tolerance and objectives of investment.

Convenience – The ease of making and managing the investment. Investing in art is less convenient than a mutual fund investment.

Despite all the techniques and methods available, on a personal level, it is necessary to evaluate investments against investment goals and in light of the investor’s risk tolerance. However, careful analysis of an investment using the various evaluation techniques and methods available can help investors make better investment decisions.