In economics, investment is the accumulation of newly produced physical entities, such as factories, machinery, houses, and goods inventories.
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.
In macro economics
In macroeconomics, non-residential fixed investment is the amount purchased per unit time of goods which are not consumed but are to be used for future production (i.e. capital). Examples include railroad or factory construction. Investment in human capital includes costs of additional schooling or on-the-job training. Inventory investment is the accumulation of goods inventories; it can be positive or negative, and it can be intended or unintended. In measures of national income and output, "gross investment" (represented by the variable I ) is a component of gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports, given by the difference between the exports and imports, X − M. Thus investment is everything that remains of total expenditure after consumption, government spending, and net exports are subtracted (i.e. I = GDP − C − G − NX ).
Non-residential fixed investment (such as new factories) and residential investment (new houses) combine with inventory investment to make up I. "Net investment" deducts depreciation from gross investment. Net fixed investment is the value of the net increase in the capital stock per year.
Fixed investment, as expenditure over a period of time (e.g., "per year"), is not capital but rather leads to changes in the amount of capital. The time dimension of investment makes it a flow. By contrast, capital is a stock—that is, accumulated net investment to a point in time (such as December 31).
Investment is often modeled as a function of income and interest rates, given by the relation I = f (Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest.
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. 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. 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. 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. Numerous interactive calculators which use the Kelly criterion can be found online.
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.
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.
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.
Types of investment
Types of investments include:
- Capital gains tax
- Diversification (finance)
- Foreign direct investment
- List of countries by gross fixed investment as percentage of GDP
- List of economics topics
- Mortgage investment corporation
- Rate of return (ROR, a.k.a. ROI)
- Socially responsible investing
- Specialized investment fund
- Hassett, Kevin A. (2008). "Investment". In David R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267.
- Editor. "Investment Definition". Investopedia. Retrieved 31 March 2013.
- Editor. "Forbes 400: Warren Buffett". Forbes Magazine. Retrieved 1 March 2013.
- Thorp, Edward (2010). Kelly Capital Growth Investment Criterion. World Scientific. ISBN 9789814293495. Retrieved 2010.
- "The Kelly Formula: Growth Optimized Money Management". Seeking Alpha. Healthy Wealthy Wise Project.
- Jacques, Ryan. "Kelly Calculator Investment Tool". Retrieved 7 October 2008.
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