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Investment Valuation & Analysis
Finance > Investment Valuation & Analysis
Table of Contents
Abstract
Keywords
Overview
Applications
Issues
Conclusion
Terms & Concepts
Bibliography
Suggested Reading
Abstract
This article focuses on the fundamental concepts involved in
investment valuation and analysis. The basic process of invest-
ing and key investment terminology will be introduced, followed
by a discussion of applications to different types of investments,
such as stocks, bonds, and money markets--and their relative
advantages and disadvantages, such as rates of return, safety,
liquidity, and tax features. Tools for interpreting the rate of
return values, and other issues for understanding the complexi-
ties of analyzing an investment program, such as risk, growth,
value, and financial reporting, are also discussed, as is the need
for careful diversification in any investment program.
Overview
Simply put, an investment is the use of money (capital) to create
more money. Individuals and companies make investments to
earn profit that can be spent, saved, or re-invested, depending
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on the investor’s strategic goals. Investing decisions are made
based on factors such as the amount of available investment
capital, the duration of the investment period, the level of risk,
and the desired rate of return (yield) on the investment. Inves-
tors typically refrain from the consumption (use) of the invested
capital while it is creating more money.
Investment Earnings
Successful investments earn money in one or both of two ways.
Appreciation
The first way is through the appreciation (increased value) of
an asset that has been purchased, such as a stock that is sold at
a higher price than at which it was purchased. The difference
between the purchase price and the sales price, minus brokerage
commissions and taxes, is referred to as a capital gain. Thus, if
100 stocks are purchased for $10 a share and later sold for $15
a share, the value of each share has increased by $5—and the
stock’s owner has made a capital gain of $500. Investments may
be held for days, weeks, months, or many years in order to make
desired gains. Unsuccessful investments may never earn profits
and are considered capital losses.
Interest & Dividends
The second way investments earn money is through interest or
dividends. Interest is money paid to a lender for the use of the
lender’s money over a specified period of time at a particular
percentage rate. Investors who put money into savings accounts
receive interest from the banks that use and hold their money.
Dividends are portions of a company’s profits that are paid to
shareholders who own interests in the company. For example,
if you own 100 shares of a company that pays $1.50 per share,
every year you would receive a check for $150. If a stock or a
fund pays no dividends, then an investor relies on its potential
for growth, or appreciation, over a longer period of time.
Because so many investment options are available, and since
investing money can be risky, it is important to understand the
potential value of an investment. Investors therefore are con-
 Investment Valuation & Analysis Essay by William J. Wardrope, Ph.D.

Applications
Keywords
Value in Different Types of Investments
Appreciation The value of an investment to the investor is contingent upon a
Income Statement number of factors. An investment portfolio, or the collection of
investments, should be sufficiently diversified to minimize risk
Asset
and achieve the best possible return. Safety is one factor in deter-
Individual Retirement Account mining if the investment has value to an investor; rate of return
Balance Sheet is another. Different types of investments meet these goals in
different ways.
Inflation
Deposits
Bond
Interest
The safest type of investments—also typically the lowest-per-
forming type—is a deposit with an insured commercial bank.
Capital A savings account is a perfect example of a simple, but secure,
Intrinsic Value investment, but one which makes comparatively little return.
Another form of a deposit—a certificate of deposit (CD)—usu-
Capital Gain
ally earns a slightly higher rate, but “locks” in the invested funds
Investment for a specified amount of time, such as three months, six months,
Capital Loss a year, or longer. In the case of the savings account and the CD,
the bank essentially borrows the investor’s money and uses it
Mutual Fund to further its own investment activities. The primary advantage
Cash Flow Statement of this type of investment is that commercial banks insured by
the Federal Deposit Insurance Commission (FDIC) guarantee
Portfolio
depositors that their money is safe; if the bank folds, the Federal
Certificate of Deposit government covers the depositors’ losses.
Pre-tax Basis Bonds
Diversification
Bonds represent another type of investment. Bonds are loans that
Price-Earnings Ratio investors make to companies or some level of government for
Dividend use in a capital project, such as a new highway, new construc-
tion, or a new utility system. Bonds are given ratings—from AAA
Rate of Return/Yield to C—by services such as Moody’s and Standard’s to denote
Equity their level of safety and are usually offered in denominations of
$1,000. The bonds pay a specified rate of interest while being
Risk
held, and upon completion of the funded project, the principal is
Federal Deposit Insurance Corporation returned to the investor. Bank deposits, as well as money market
Risk-Return Tradeoff accounts, bonds, and Treasury bills produce what is known as
fixed income, that is, the investor can expect to receive a certain
Fixed Income amount of payback for the money he or she has loaned.
Tax-sheltered Investments
Stocks
Growth Stocks
Stocks, on the other hand, produce taxable dividends, but they
Stock also allow an investor to “own” a portion (share) of the company
Valuation and vote, in the case of common stock, in company decisions.
This type of investment is considered equity. Historically, the
Value Stocks
stock market has outperformed most other types of investment
strategies, but also contains the highest risk and requires the most
cerned with valuation, or the process of determining the current astute monitoring and patience.
worth of an asset. In general, valuations can be made on a vari- Mutual Funds
ety of factors, such as how much money the company has, how
it manages its money, how it plans to manage its money in the Another major type of investment is a mutual fund, which is a col-
lection of stocks, bonds, and other securities that are purchased
future, or how much the company’s holdings are worth. The
by a financial manager, who sells shares of the collective group
following sections of this article cover different types of invest-
of investments to individuals and companies. A wide variety of
ments and some of the factors involved in their valuation.

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 Investment Valuation & Analysis
funds exist, including very conservative (secure) investments, or
more speculative (riskier) investments. Mutual funds may offer
opportunities to invest in large-cap companies (companies with
high capital), or companies with less capital—mid-sized caps or
small caps. Generally, the more capital a company has, the safer
the investment may be, because they have greater assets to cover
for losses if one should occur.
Rate of Return (Yield)
The value of an investment is often determined on the basis
of how much money it will make over a period of time. For
example, a stock offers a return, a rate that is represented by
the difference of the purchase price and the sales price, plus any
dividends it earns during the period of ownership. This figure is
referred to as the holding’s Rate of Return, or yield, which may
be calculated as follows:
Ending Price – Beginning Price + Dividend
__________________________________
Beginning price
For example, an investor buys stock for $1,000, sells it later for
$1,200, and earns $100 in dividends while holding it. At the
time of the closing, the owner has $1,300 instead of the $1,000
with which the investment began. Using the above formula, the
investment has achieved a .3 or 30 percent return rate. This rate
might or might not be considered “good,” depending on how
long it took to return that rate, and what other more profitable
uses the investor could have made with the money had it been
used in another investment.
A yield must also be evaluated in terms of inflation. Rates of
return can be calculated either as nominal (not adjusting for
inflation) or real (adjusting for inflation). The value of the nomi-
nal rate is reduced by the amount of inflation that exists during
the holding period—so if a fund yielded an 18 percent nominal
rate and the inflation rate was five percent, the real rate of return
would be thirteen percent. The yield must also be analyzed in
terms of its tax consequences, as a portion of that return will be
taxed as dividends or interest. Thus, the “whole picture” must
be taken into account when placing value on the return of an
investment.
Issues
Risk
Nearly every type of investment contains some element of risk,
or the degree of uncertainty on the return of an asset—in other
words, the likelihood that the investment will not lose money.
Part of the valuation process is to determine how much risk an
investor is willing to take, and how much chance there is that the
investment will fail. Investors who are risk averse are reluctant
to make investments that have high risk; investors who are “risk
tolerant” are more comfortable making higher-risk investments.
The Risk-Return Tradeoff (Kapoor, Blabay & Hughes, 2007) is
a helpful concept for deciding if an investment is worth making:
Is the potential benefit of the investment worth the chances of
losing it?
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Essay by William J. Wardrope, Ph.D.
Investment risk comes from many sources. Keown (2003) iden-
tifies seven sources of risk:
• Interest rates during the lifetime of the investment;
• Inflation rates;
• The company’s risk in operating the business;
• The company’s management of its debt;
• How much money the company can produce (liquidity);
• The performance of the overall market;
• Political and regulatory issues;
• The exchange rate of the currency, and;
• Call risk—or the possibility that a lender will “call in” its
loan early.
Any of these sources, or perhaps all of them, influences the value
of an investment that could fail because of events internal or
external to the company.
Growth, Value, & Intrinsic Value
Investments can be evaluated on the basis of their current market
value but also in terms of their growth potential. For example,
investors might choose growth stocks because they believe that
over time, these stocks will develop steadily and substantially.
Growth stocks may pay little or no dividends, as their growth
objectives lead them to re-invest all of their earned capital; many
technology companies are growth-oriented. Value investments
are those that are can be purchased at a low price (hence, they
are “undervalued”), may have relatively high rates of return,
and are characterized by low price-to-earnings ratios (P/E). In
general, making such investments (which is called “value invest-
ing”) is more beneficial than making growth investments (Chan
& Lakonishok, 2004) and are long-term (Kwag & Lee, 2006).
Finally, investments with intrinsic value are those about which
there is an “underlying perception” of future worth or potential—
but making this type of investment, which is usually speculative,
is highly subjective and often risky.
The Value of Tax-Sheltered Investments
The value of tax-sheltered investments (tax-deferred or tax-free
investments) cannot be overstated. A tax-deferred fund, such as
many pension programs that are set up by employers, allows the
investor to contribute money on a pre-tax basis; in other words,
an individual’s taxable income would be lessened by the amount
of money contributed to such an fund; he or she would not actu-
ally pay taxes on the contribution until they reached a specified
retirement age, thus allowing the money to grow over a period of
years without being taxed each year. Depending on tax brackets,
as much as $14,000 of a person’s yearly salary can be set aside,
pre-tax, for retirement. The cumulative effect of these contribu-
tions and the growth they incur over a period of years or decades
can dictate the quality of life retirees will experience when they
retire and at what age they can retire.
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 Investment Valuation & Analysis
Other forms of tax-advantaged investments would include cer-
tain Federal, state, or municipal bonds, the proceeds from which
normally are not taxable within the jurisdictions they are offered.
For example, income from a state-issued bond would usually be
exempt from that state’s tax structure. Also, individual retirement
accounts (IRAs) allow individuals to contribute to accounts that
earn interest but allow them to avoid paying taxes on that income
until they reach a specific retirement age, usually 59 ½ years.
Also, depending upon an investor’s tax bracket, the contribu-
tions an individual makes per year to an IRA may be deductible
from that year’s income tax. Thus, significant value of an invest-
ment is usually found not by how much money it makes, but how
much money it makes efficiently.
The Value in Financial Reporting
Companies seeking investors—either directly through stock
purchases or through financial management funds—are required
by the Securities and Exchange Commission (SEC) to disclose
key financial information about themselves. This information is
designed to help an investor ascertain the value of an investment
by analyzing the firm’s liquidity, financial leverage, efficiency,
and profitability (Madura 2006). This data is made available, in
print on company websites, through several forms, including:
• Annual Reports—documents which disclose a company’s or
fund’s activities for a calendar year, including its strategic
decisions, acquisitions, new investments, etc.
• Balance Sheets—documents that report a firm’s financial
condition as of a particular date.
• Income Statements—reports of revenues and expenses for a
specified period and which summarize the profit or loss for
that period.
• Cash Flow Statements—ledgers that show all money going
in and out of an organization.
These documents testify to how a company manages its debt, its
growth, its investor obligations, and its assets. Additionally, once
investors become part of an organized investment program, the
issuing organization provides quarterly reports which reflect how
the investor’s money, collectively with other investors’ money,
has been spent, how much it has grown, and what the net gain
or loss has been. This information can be compared to general
market data that can be accessed through Yahoo! Finance, Motley
Fool.com, MSNmoney, the New York Stock Exchange web site,
or other financial resources, so each investor can make his or her
own evaluation of the investment’s performance. Careful, regu-
lar monitoring of any investment is a necessity for ensuring the
success of any investment program.
Conclusion
The value of any investment is relative—what is a highly valuable
investment to one person or company is not necessarily valuable
to another. Choosing investments is contingent upon what the
goals of the investment are, such as risk, yield, duration, liquid-
ity, and tax consequences (Nickels, McHugh & McHugh, 2008).
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Essay by William J. Wardrope, Ph.D.
Most financial planners believe that younger investors—people
who have a longer period in which to make money and recover
losses—should be more assertive in their investment activities.
On the other hand, individuals or companies with high incomes
might seek investments that pay tax-deferred or tax-free returns.
Financial planners advise diversification of portfolios to achieve
the best value for investments.
Terms & Concepts
Annual Report: A summary of annual financial information
from a company’s performance and expected performance.
Appreciation: The increased market value of an asset over
time.
Asset: Any possession that has value in an exchange.
Balance Sheet: A document showing a firm’s assets, liabilities,
and equity for a specified period of time.
Bond: A certificate showing that an investor has loaned a com-
pany money to be paid back upon a specified maturity date.
Capital: Money invested in a firm.
Capital Gain: The difference between the net cost of a security
and the net sales price, if the cost is less than the price.
Capital Loss: The difference between the net cost of a security
and the net sales price, if the cost is more than the price.
Cash Flow Statement: A document reporting the money going
in and coming out of a firm.
Certificate of Deposit: A type of savings account that is issued
by a commercial bank that earns interest over a specified term
(e.g., three months, six months, etc.)
Diversification: A mix of different investments designed to
minimize an investor’s overall risk.
Dividend: Payment to shareholders that reflects part of a firm’s
profits.
Equity: Ownership in a firm.
Federal Deposit Insurance Corporation: Government agency
which guarantees depositor’s bank accounts.
Fixed Income: Money from an investment that produces a regu-
lar payment of the same amount.
Growth Stocks: Ownership of companies with strong earnings
or earning potential.
Income Statement: A report of a firm’s revenues and expenses
over a specified period of time.
Individual Retirement Account: A type of savings that allows
investors to receive tax deductions during the year of their con-
tribution and to defer taxes until a certain age is reached.
Inflation: The rate at which the general level of prices for goods
and services rises.
Page 4
 Investment Valuation & Analysis Essay by William J. Wardrope, Ph.D.

Interest: The price paid for borrowing money. Kapoor, J. R., Dlabay, L. R., & Hughes, R. J. (2007). Personal
Intrinsic Value: The present value of a firm’s expected future finance, (8th ed.). New York: McGraw-Hill.
net cash flows less the rate of return.
Investment: The use of money to create more money. Keown, A. J. (2003). Personal finance: Turning money into
Mutual Fund: Pools of money managed by an investment com- wealth. Upper Saddle River, NJ: Prentice Hall.
pany.
Pre-tax Basis: Condition in which money is set aside for invest- Kwag, S. W., & Lee, S. W. (2006). Value investing and the
ment before taxes are imposed on it, thereby reducing the tax business cycle. Journal of Financial Planning, 19(1),
liability.
64-71. Retrieved September 25, 2007, from EBSCO
Price-Earnings Ratio: The price of a stock divided by the per- Online Database Business Source Premier. http://search.
share earnings of the stock. ebscohost.com/login.aspx?direct=true&db=buh&AN=1942
Portfolio: A group of assets held by an investor. 4117&site=bsi-live
Rate of Return: Gain or loss of an investment over a specified
time, expressed as a percentage over the initial investment cost.
Madura, J. (2006). Personal finance, (2nd ed.). Boston, MA:
Risk: Degree of uncertainty of return on an asset. Pearson Education.
Risk-Return Tradeoff: The potential advantage of an invest-
ment relative to the level of risk incurred by making it.
Money.cnn. (n.d.). Retrieved September 20, 2007 from: http://
Stock: Ownership (equity) of shares in a company. money.cnn.
Tax-sheltered Investments: Funds, such as IRAs, which allow
the investor to defer or avoid taxes on returns.
Nickels, W. G., McHugh, J. M., & McHugh, S. M. (2008).
Valuation: The process of determining the current worth of an Understanding business, (8th ed.) New York: McGraw-
asset or company.
Hill Irwin.
Value Investing: Purchasing stocks that are considered to be
undervalued.
Suggested Reading
Value Stocks: Stocks that are undervalued and usually produce
high dividends.
Yield: (See Rate of Return). Benninga, S. (2000). Financial modeling, (2nd ed.). Boston:
Massachusetts Institute of Technology.

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Essay by William J. Wardrope, Ph.D.

William Wardrope is an Associate Professor of Economics and International Business at the University of Central Oklahoma. He is an
author of numerous publications and has made over 200 presentations at professional conferences on topics in business, globalization,
communication, and curriculum.

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