how to choose good investments? investing must know tips
The. First thing we need to do is to make sure we have a good understanding of, what we are talking about so. What is an investment, the. Most common, definition of, an investment, is that someone, is, spending, money or putting. Aside money for, a certain period of time in order to get back more money than, he or she originally. Invested, if, we analyze the definition, in detail we can identify three. Key elements, and three, key words the. First one is, that there is an original, sum of money that, will be spent or put aside which, is called the capital the. Key word here is, capital, the. Second is that time will, play a part in it no, matter how long or short that, time is the. Key word here is time, the. Last element, is that at the end of the investment, period you will be getting something back, from your investment, it, is called a return, and the, key word here is return. It. Is by the analysis. Of those three elements capital. Time, and return, that you can differentiate, good, investments. From bad ones, this. Definition, is as I said the most commonly, used in, reality, an investment. Has a much broader meaning first. Of all it's not limited to money of course. Many investments, involve money in one form, or another but. There are many other types of investments out there let's. Look at our three key words to dig deeper, into that thought let's. Start with capital. Capital. Sometimes. Also called the principal is an asset, that you process and that, you can dedicate to an investment, opportunity it. Can come in the form of money time. A machine, an office, a vehicle, a patent, it. Is pretty much anything that you can own and that, has a value, maybe. You're asking yourself why is time in that list after all does, time have a value let. Me answer that question right away yes. Time, does have a value, the. Way to look at it is that when you dedicate your time to an activity, or to, an investment, you are preventing. Yourself from doing, something else such, as making money for example, therefore. By, investing, your time you have decided, to cut yourself off of a, source of money and in essence it is not much different from spending money now let's, discuss our second, keyword time, or, actually let's not discuss it after. All time is what it is whether, it is for just 1 second, or 10 years or even more there, is nothing more to it, the. Third keyword is return just. As for capital, a return. Can come in many forms it. Can come as money time machinery, office, space and pretty much anything that has a value to you so. What we just learned is that an investment can, involve any single, has a value not just money and can, return anything, that has a value again. Not just money it, is also interesting to note that the nature of your capital can, be different, from the nature of your return for. Example, you can invest time and get, money back in return. As we, have seen every, investment is expected to deliver a return I'd. Like to take some time now to discuss, in more detail what we mean by return, the. Word return, is usually understood as a positive return meaning. That it is bigger in value than the capital, originally. Invested, the. Definition, of a return is actually broader than that and does, not always mean it is positive, you. Can have positive as, well as negative returns. Or, no. Returns at all if. What you get from your investment, is equal to the capital invested, then. You're, not making any return, if, it's higher than the capital, then you're making a positive return if. You're getting a lesser amount than the original, capital you, are making a negative return, the. Return is the difference, between what you invested, the capital and, what, you're getting back from your investment. Let's. Take a concrete example to, illustrate this, let's. Say you're investing, a thousand, dollars into a project and, get, back from it eleven, hundred dollars in, one year the. Difference, between the thousand dollar capital and the, resulting. $1,100. Is 100 dollars this. Is the return you have made, usually. Returns. Are displayed, in percentages, per, year so, in our example because. We have generated, 100, dollars in one year for, a starting, capital of 1,000, dollars we, can say that a 10 percent return per year, has been generated, the. Formula, to calculate the return in percentage. For 1 year investment, is the following. Return. Divided. By, capital, you. Can also calculate it, by taking, the N value, divided. By capital, minus. 1 those. Two formulas, provide. The exact same result. For. A multi-year, investment, the, formula, is a bit different you.
First Have to calculate the, N value, divided. By the capital, and then. You have to take it to the power of 1. Divided. By the number of years you take, all of that and do. - one to. Illustrate, the multi-year formula, let's, assume that investment, happened, over, the course of two years instead, of one then. We would have calculated the return percentage in, the following way, first. Divide. 1100. By. 1000. Take. This result and put it to the power of. 1/2. Which. Is the number of years, take. This result. Minus, one is. Equal to four. Point nine percent. So. This investment, is. Producing. Over the course of one year a 10%. Return but. If it is producing, its return, over the course of two years then. It's an average of four, point nine percent return. Per year. If. We take back now the one year example, but. Assume we are getting back nine hundred dollars in the end our. Return, becomes, then a loss of $100. In. Percentage, terms this. Becomes a minus ten, percentage, return it. Is a negative return. $900. Divided, by, $1,000. Minus. One is, equal to minus. 10 percent, now. Let's put one thing out of the way right now a positive. Return is, not sufficient, by itself to, qualify, as a good investment, this. Is a shortcut that, is commonly, made but. Other factors, need to be taken into, considerations. Such. As other options available to you for example. A good, investment, is much more than just getting a positive return on an investment, if. For example you invest. $100,000. For 10 years and get, 100,000. And $1, in return, at the end of that period of time I bet. You will question whether that investment, made sense in the first place and you know what I'm completely, there with you investing. $100,000, is a very significant, amount of money and it is not worth your while to invest it on a project that produces, a single dollar of return, over the course of 10 years the first, reason why we intuitively, understand. That this is not a good investment is because we know we could have made much more money by investing in somewhere else and that, is, the first additional criteria, to making a good investment decision, to. Make a good investment we, must compare, the investment, opportunity, to other comparable, opportunities. To, make sure we put our money in the right place as a, simple example anyone. Can have a saving account and usually, the interest, rate on those accounts range, from 1%, to 2% per, year and sometimes. A bit more let's. Assume here our saving, account generates, two percent interest, per year by. Putting our money on a saving account we, know for sure we, will be making a 2 percent return per year knowing. That why. Would we want to take on a project that yields anything, less than that another. Aspect of making an investment decision is the level of risk associated, with, the project to be undertaken, not. All projects, yield a positive return in many, projects, have a potential, to make you lose money buying. Stocks for example, on the stock exchange, holds, no guarantee, of seeing any money back so. If for example you, had an opportunity to invest your money on a project. Yielding, a 2% return per year with some level of risk why. Would you invest in it when, you know you have a risk-free option, with a saving account for a 2% return per year as well I would. Not invest in such a project and neither would you by. The way let's, add here, a new keyword to our list risk. Taking. On a risk your project, should yield a higher return to, compensate, you for the risk you are taking I.
And It sounds, logical safer. Bets yet, less return than riskier, ones, the. Last criterion, to making an informed investment. Decision, is related. To the pace at which you will be getting the return, will. It be the same amount every year will, it be increasing, over time or, will, you be getting it all at the end when. You get the return from the project, is going to have an impact on the overall return, of your project, we. Will see in a later chapter why the faster, you get the return and the more attractive the investment, would be to. Summarize when, comparing, projects, the return in itself is insufficient. To determine if, it's a good or bad investment. Decision the, elements, to be considered are, does. The project have a positive, return on investment, what. Are all the investment, opportunities, available to you and what return, do they yield, what. Level of risk are you comfortable, with is. The return sufficient, to compensate you for the risk we're taking and at, what pace will you be getting the return, making. The difference, between an investment, opportunity that, is suitable, to you and one, that is not will, require a financial. Methodology, that you will learn in the next chapter called the net present value or NPV as well, as applying, personal, judgment, on the strategy of the project, both. Are essential to selecting, projects, that will meet your return expectations. You. In this, chapter we will learn about the financial, methodology. Called, the net present value or NPV which. Is widely used by, finance, professionals, to assess investment, opportunities. The. NPV, is actually a mathematical formula. Which combines, the capital invested, the. Pace at which the, return is generated, the, expected, return and the, risk lever to produce a single number result, that determines, if an investment, is worthwhile that. Formula, computes, all of the inflows, of money and outflows of money of the project, those. Are called cash flows so for example the, capital that you invest, is a negative, cash flow since, you're spending, money and any, financial return, will, be a positive cash flow since, you are receiving money if. The result of that calculation is, equal, to 0 or greater it's, a good investment if, it's negative then, it's not how. Great does that sound a mathematical. Formula, that tells you how good an investment, is well, there's a trick to it and a big one the, formula, in itself is not the most important, aspect, of the mtv methodology, it is how you determine the factors, you put into it that will make your NPV reliable. For. Example, you will need to assess the risk associated with, the project, there's, no precise science, to determine risks. But there are ways to do it which, we will see in a later video the. Same goes for the expected level of return no. Science, but ways to do it in, this chapter we will look into how, to best assess each of the NPV, factors, so, that when we get into calculation. Time we have the most robust, information gathered, so that our NPV, calculation and.
Ultimately, Our investment, decision, is based, on the best information available. At the time of the decision. The, objective of the NPV formula is, to calculate if an investment, is creating value or not to. Achieve that the formula adds up all the money that is spent and all the money that is received, as part of that investment, if. There is more money received, than money spent then it leaves you with a positive, result which, means that it's a good investment there's. One tricky piece though to this which is that you cannot simply add up all the money spent and money received as part of your project because, those inflows, and outflows of, money do not occur on the same date you. Might want to ask me why it matters, since money is money anyway, well. The reason is that time, changes. The value of money let. Me explain, of, course a $1 bill is, and will always be a one dollar bill so, how can a one dollar bill see its value change, while still being a one dollar bill the. Key to this question, is in what you can do with that one dollar bill let's. Take a practical example if. I give you one dollar today you. Can go and put it on saving, account at the 2%, return per year and get, back one dollar in two cents next, year on the. Other hand if, I give you one dollar in one year you, will only have one dollar in one year this. Example shows, that one dollar received, today has, more value to you than one dollar received, in one year in a, dollar received, next, year is worth more than a dollar received in two years and the same goes on indefinitely, the. Earlier you receive that dollar and the higher its value is to you because, you have the opportunity, to do something with that money, knowing. That it can be difficult to know if you're better off receiving, $1,000. Today for, example or, $1,100. In one year if. For example you, have access to an investment, opportunity that. Yields 10 percent return per year, then, your $1,000, received, today can, be invested, and in one year be turned into $1100, in, that case it would be the exact same thing to you to, receive $1,000. Today or. $1,100. In one year if. You have access to only a 5% investment, opportunity, then, your $1,000. Received today will, bring you only 1,000. Two dollars in one year in your den better of accepting, the $1,100. In one year since, should be making $50, more the. Timeframe at which you will be receiving, and spending, money is going to be making a big difference on the value you will be getting from your investment, the. NPV formula helps. You resolve this complexity, by, cancelling, the effect of time, on money if, for example an, investment. Will have all its outflows, and inflows, of money on the same day then, we would have no issue at all we would just add them all up and look at the result this, is exactly, what the NPV, formula does. For you it converts. All of the inflows, and outflows of, money to their value on a single date so, that time is not part of the story anymore if. You are wondering then, what, date is chosen in the NPV formula, the, answer is today. Investment. Opportunities, can have many dates at which we could convert the money but the easiest is definitely, to convert it to today's equivalent, in. A project, what we call today is the, first day on which the investment is made the. NPV formula is, the following, it. Looks complex but actually, it's not if, you look at it you can see that it's just a series of conversions. The. First element, of the formula, is, cash, flow of the first year divided. By one plus, the return, percentage, ^. The. Year at which you have received the cash flow its then followed, by the same conversion, for the second year just, replacing, the first year cash flow by the second year cash flow in taking. The lower part, of the formula, ^ to, the second year instead of the first year you, then add up all of those conversions. One by one until you get to the last year the, last element is the capital, since. It is money that you're spending it, needs to be subtracted, from the rest as you, can see in the formula, there, is no conversion made, to it the, reason being that your capital, is spent, at the beginning of the project in other terms, it is spent today, let's. Take an example imagine. You invest in a project that, requires a, $5,000. Upfront, investment. This, is your capital through. Detailed, analysis, you have determined that this project, would be generating, positive cash flows of, $700.
Per Year for, eight years the. Return you are expecting, from this project is at least five percent as you, know you have means to get such a return, through other opportunities. That could hold less financial, risk for you this, project, will require an, upfront investment. Of, $5,000. And will bring in over the course of eight years five. Thousand, and six hundred dollars, so, if we do the mistake to forget that time has an effect on the value of money we, can actually be led into thinking, that this is a good investment now. Let's use the NPV formula to, see if this project is worth investing, in so. NPV, is equal to seven, hundred dollars, divided, by one, plus, five, percent, which is our return to. The power of one. Since, this is the first year cash, flow plus. Seven, hundred dollars divided. By one plus the return of five percent to the power of two. For the second year we. Add up the same cash flows with, the same conversions. For every year until, we get to the last year then. We subtract, five thousand, dollars which is our initial investment we, compute all those elements together and, get, a result of minus. Four hundred and seventy five dollars and seventy, five cents as you. Can see the NPV, of that project is negative this. Means that it's not worth investing, in and you're better off pursuing, another, 5%. Return opportunity. If. You decide to do that project anyway, you, now know that, compared to the other 5% return opportunity. You will be losing money in, fact you will be losing the opportunity, to, make more money. Now, let's look at capital and cash flows every. Project starts, with an investment, and is expected, to generate money, over time this, materializes. In people, in companies, spending. And receiving, money during the lifetime of the project all. Those exchanges, of money are called cash flows because. The cash flows, out of your pocket when you spend it and flows into your pocket, when you receive it it's. Important, to note that a cash flow can be either positive or negative depending, on, where the money is going for. Example, the, capital is a negative, cash flow since, it's money coming, out of your pocket the, returns you would be getting from the project on the contrary, are positive, cash flows now. That we know what a cash flow is we, need to know where to find them the. Short answer is in your business plan, hopefully. This is the first thing you did before kicking off your project to, ensure that you have a complete understanding of the project and its chances of succeeding if, you, don't have one then, I suggest you prepare one not. Necessarily, a long and complicated one, but, enough to ensure you ask yourself, the right questions before. Putting at risk your investment, money in, each. Business plan there's, a financial projection, that summarizes, all the financial, elements, of your project and provides an estimated, balance sheet income, statement in, cash flow statement, you.
Won't Be surprised and when I tell you that it's in the last document the cash flow statement that. You will find the numbers you're looking for from. That document, you need to pick up the end of your totals, and feed, them into your NPV formula. Another. Key element to, calculating, in Vivi's in choosing the right rate, of return to be used and to, determine that's right, it is important, to understand, what it is representing. The, rate of return also, called, the discount rate is the, return level, that your project, is expected to beat if. For example you. Want to invest in a project that, delivers, more than 5% return per year then, 5% is, the rate you need to use then. The question is to know how to determine, what should be the right to beat of course. We, all prefer 20%. Return rates, rather, than 5%, ones but, it's key to stay clear of wishful, thinking, and use, some guidelines, to define a rate that. Is realistic and that will ensure you select projects. That are good fits for you first. Of all it's, a matter of the investment, opportunities, that are available to you for. Example, there's, one investment, opportunity, we all have access to and this, is to put our money on a saving, account interest. Rates on saving accounts vary from bank to bank so, let's imagine you have an account that delivers, two percent of interest per year then. Since. This opportunity, is always available to you it, sounds logical that, you would want to invest only, in projects, that yield more than 2% per year. By. Using a 2 percent return in your NPV calculation a positive, result would indicate that your project, will make you earn more money than, putting it on the saving account if. You have access to a 5 percent investment opportunity. You need to benchmark your projects, against, that right it's, very important. To benchmark your projects, only, to projects, you truly have access to and not, to projects. That you have heard of or that, are not accessible to you the, reason is that the, decision you're trying to make here is to, know where to invest your money so. It needs to be between two or more, opportunities. You can really choose from the. Second key you have to look for in a rate is in relation, to the level of risk the project holds the, relationship. Between risk and return is the following the, riskier, a project, is the, higher the rate should be if, a project is very, or even. Has no risk to it at all such. As putting your money on a saving account for example then. The reward for, putting your money there is going to be lesser then, if the project, is riskier, on the. Contrary if you decide to take up on additional, risk then. You would want to be rewarded for being brave, and receive, a compensation, for the risk you're taking the. Logic there is that the more risk you have in a project the, more return, you should be expecting, if. For example you. Have a very risky project. Yielding. 2 percent return per year the, same return you're getting on a saving account why. Would you want to invest in that project I would, rather play it safe and have a hundred percent guarantee of getting my money and my return back if. I'm to invest in a riskier project, I want, the return to be higher if. The return on that risk your project, is higher fine, but, the question then is, to, know if the return you're getting from that additional risk is sufficient, the. Answer to that question depends, primarily on, your appetite for risk we. Will see later on how to tackle it. You.