Investment Analysis25 Note1
DEFINITION OF AN INVESTMENT
Investment has different meaning in finance and economics. In finance, it is the
purchase of an asset or item with the hope that it will generate income or appreciate
in the future. The purchase of the asset is done with the motive that it will provide
income to the investor in the future or appreciate and be sold at a higher price.
Examples of financial investment include the purchase of shares (equity) of a
company by an investor who holds the shares for a period, and sell them at a gain
after they appreciate. During the period of holding the shares, the investor stands to
benefit from two sources, the dividend on the shares and the gain on the price of the
shares which is called capital appreciation or premium. These two combined
together form the expected returns from the investment. In economics on the other
hand, investment is more closely related to preference for saving money instead of
consumption. It is the purchase of goods that are not consumed today but are used
in the future to create wealth. The building of a factory for the production of goods
or services is a typical example of an economic or commercial investment.
Generally speaking, the term Investment can be defined to mean the employment
of funds on assets (known as securities) with the sole aim of earning extra income.
An investment can further be explained to include the allocation of money on assets
which are expected to yield some gain over a period of time. An investment is an
exchange of financial claim such as stocks, bonds for money. In summary,
Investment simply means using money to make more money.
For the purpose of this book, the terms investments, stocks and securities shall be
used interchangeably.
General characteristics of Investment
Most investment decisions are done fundamentally based on certain distinguishing
characteristics that accompany the investment products. Depending on the mode,
timing or scope of the investment proposal, it is generally believed that investment
products possess some of the following characteristics:
1. Money (fund) is used in the purchase of investments (securities). In making an
investment, the investor must have to part with money in exchange for a security or
stock. It is this stock that he keeps in place of his money as investment in whatever
venture he has made.
2. Return. Return is an important characteristics of investment It is the major
attraction why investors put their money into certain ventures. Return is the extra
income to be received from making an investment in a particular venture. Investors
generally prefer higher returns from their investments.
3. Risk. The fear arising from the mind of an investor as to whether he will derive
the benefits expected from his investment or not is what explains his level of risk.
This fear could emerge from the probability of threat, damage, injury, liability, loss,
or any other negative occurrence that could make the investor not to achieve the
objectives of his investment. In the investment horizon, Risk is best explained as the
difference between actual return and the expected return. Every investment decision
has some level of risk associated with it except the riskless investments which will
be discussed later in this book. But the higher the risks associated with a given
investment, the higher the returns and vice-versa..
4. Timing or Tenor. Most Investments are time-based. That is, they have a specific
time of commencement and time of maturity. The time frame factor gives investors
the advantage to plan adequately for cash expectations from their securities. It should
be noted that not all investments have maturity period. There are certain exceptions
to rule of timing for securities. Perpetual investments like perpetual bonds,
irredeemable preference stock or debenture do not have maturity period. (This will
be discussed later).
5. Safety. Safety refers to the protection of the principal amount invested and the
expected rate of return. Some selected investments should be under regulatory
framework, for instance, Investment on government securities are generally safer
than investments on private securities. This is so because government as a prime
mover of economic activities of a given country would ensure that the investments
of its citizens are well protected.
6. Liquidity. If a proportion of the investment can be converted to cash without loss
of time, it will help the investor to meet financial emergencies. Stock or shares are
said to be liquid if and only if they can be converted to cash immediately to meet the
investor’s needs. Liquidity means that investment is easily realizable, or saleable.
An investor generally prefers liquidity for his investments, safety of funds through
a minimum risk and maximization of return from such Investment.
7. Marketability. Marketability means transferability or saleability of the stiock.
Securities that are listed on the stock exchange are more easily marketable than those
not listed on the exchange. The shares of Public Liability Companies(PLC) are more
easily marketable and transferable than those of private limited companies.
8. Concealability. This is another attribute of investment. Concealability means that
investment should be free from all forms of government confiscation or interference,
and or any form of social disorder. Investments should be kept intact under strict
confidentiality.
9. Capital Growth. The desire for investment is mostly for the invested amount to
grow and multiply in the future. Capital Growth therefore refers to appreciation of
investment. Capital growth has today become an important attribute of investment.
Investors and their analysts are constantly seeking for ‘growth stock’ in the right
industry to buy at the right time.
10. Stability of Purchasing Power . It refers to the buying capacity of investment
in market. Purchasing power stability has become one of the import traits of
investment.Investment always involves the commitment of current funds with the
objective of receiving greater amounts of future funds.
11. Stability of Income.It refers to constant return from an investment. Another
major characteristic feature of the Investment is the stability of income. Stability of
income must look for different path just as security of principal. Every investor
always considers stability of monetary income and stability of purchasing power of
income.
12.Tax Benefits.Tax benefits is the last characteristic feature of the investment. Tax
benefits refer to plan an investment programme without regard to one’s status may
be costly to the investor. There are actually two problems:
• One concerned with the amount of income paid by the investment.
• Another is the burden of income tax upon that income.
Investment has two basic characteristics, viz.:
SPECULATION vs. INVESTMENT:
Sometimes, people tend to confuse 'making an investment' with 'speculation'.
Investment usually involves the creation of wealth through a thorough analysis and
careful consideration of the investment alternatives, whereas speculation is more like
a zero-sum game. It is simply putting money into a venture with the expectation of
getting higher but short term returns. More specifically, speculation involves buying
and selling activities with the expectation of having profit arising from price
increases within a short period of time. Example of speculation includes buying of
stock from the capital market in anticipation of price rise in the near future, betting
on a Horse-race, a football match, or any other form of gambling that requires one
to put money for making quick money.
In general, the dividing line between the activities of a speculator and that of an
investor can be looked at from the table below:
A TABLE OF COMPARISON BETWEEN INVESTMENT AND SPECULATION
SPECULATION INVESTMENT
A Speculator mostly plans for short term An investor plans for medium and long
Time investments. His holding period may be for term investments. His holding period of
Horizon hours, days, weeks or few months. the investment may range from one year
up to ten years or more.
A speculator takes higher risks because of his An investor takes moderate risks because
Risk desire for higher returns. Higher returns go with his investments are mostly on medium
higher risks and vice-versa. and long term bases. An investor makes a
thorough analysis of investment
proposals in order to have adequate
safety or security for his investment.
Returns tend to be higher with speculation In the case of investment, returns are
Returns because of the high level of risks shouldered by moderate
a speculator. The higher the risks, the higher the due to moderate level of risks shouldered.
returns.
An investor carefully analyses the
Decision A speculator relies mostly on informal source of investment proposals, obtains all relevant
To Invest information such as hearsays, insider information on the companies he intends
information, imaginary expectations, etc, in to invest; he also analyses the market, the
making investment decisions. competitors and any other external
factors in order to make investment
decision.
The speculator may not rely on his personal An investor relies on internal source of
Source finance for investment; he could borrow or funds (his own personal funds) generated
Of collect funds on behalf of someone with the through savings or any other source in
Finance hope of magnifying returns from the money. A order to finance investments.
Speculator could sell his property or any asset
for the sake of investment with anticipation of
getting huge returns
Classification of Investment:
Investment can be classified into various categories, even though the
classification may vary according to context, purpose or area of application of
the term investment. The following are some of the common classifications
of investment:
1. On the basis of the objective for making an Investment, we can categorise
investment into:
a. Financial investment: This refers to investment in financial products like
stocks, bonds, real estate, debentures, etc. These investments are made by
generally with a view to having returns from the investments.
b. Economic investment: This refers to investment in the production of
goods or services which are not consumed immediately but instead used in
future production. Examples of this include building of a factory, rail road,
raw material importation, commercial transportation, expenditure in one’s
education at college or university, etc.
2. On the basis of general classification, investment can be categorised as:
a. Traditional Investments: Traditional investments refer to investment in
securities like stocks, bonds, debentures, treasury bills, real estate, etc. This
category forms a group of investment products that are commonl traded in the
capital market.
b. Alternative Investments: These are investments in products other than the
traditional or conventional investments of stocks, bonds, debentures, and so
on. They are investments in tangible assets like gold, precious stones, metals,
commodities, antiques, etc. These products are normally purchased by
investors for speculative reasons, i.e. buy and keep and sell later when prices
appreciate.
3. On the basis of duration or tenor of Investment, we can categorise investments
into short-term, medium term or long term. Although this classification may
be subjective because what constitutes short, medium or long term
investments depends on the investment productsts or the organisation where
the investment is being made. In Nigeria, there is no clear cut classification
on the basis of time frame for short, medium or long term investments. For
the purpose of this book, we may classify short, medium and long term
investments as follows:
a. Short term Investments: Short term investments are investments with
duration mostly of one year or less. Examples of these investments are fixed
deposits, treasury bills, savings deposit, etc.
b. Medium term Investment: Medium term investments are those investments
with duration between one year and five years. This, as said earlier, will
depend on the way and manner the investment products are classified by the
issuing organisation; or how the investor personally prefers to classify his
investments. Any investment that falls within the stipulated period can be
regarded as medium term investment. In our example, investments with
duration of between one and five years can be considered as medium term
investments
c. . Long term investments: Long term investments are investments with
holding period or duration ranging above five years. These may include real
estate investment, mortgages, development stocks, bonds, debentures, etc.
4. We can also categorise Investment on the basis of marketability of the
investment instruments. Marketability means the ability of the investments to
be traded at the secondary market. That is, the investor can sell off his
investment at anytime in the secondary market, and can buy again at anytime
he wishes. We have in this category:
a. Marketable investments: The marketable investments are those investment
instruments which can be traded in the secondary market. The investor can, at
any time, buy or sell his investment at the security market. This category
includes stocks, debentures, bonds, commercial-paper, etc.
b. Non Marketable investments: The non marketable investments are the
investments that cannot be traded at the secondary market, or cannot be sold
to a third party. Examples of these include fixed deposits, savings deposit,
treasury bills,
OBJECTIVES OF INVESTMENT
There are several reasons why individuals, groups, organisations, associations, or
the government undertake investments. Notable among these reasons, which
are common to most investment decisions, include:
1. Returns.
2. For liquidity reasons.
3. To hedge against inflation.
4. For safety reasons.
RETURNS
A return is defined as the total income that an investor receives during the holding
of his investment. Return is the extra income to be received for making an
investment in a particular venture. It is the major attraction why investors put
their money into different investment products for the purpose of magnifying
the amount invested. Investors generally prefer higher returns from their
investments.
. Arithmetically, returns can be calculated as follows:
Return=
100
Example: If someone has made an investment in the shares of a companyin 2005
which were selling for N50 per unit and decided to sell the shares at the rate of
N60 per unit in 2006. Assuming he received a dividend of N5 per unit, what is
his rate of return?
Return= EPp - BPp X 100
BPp
Return= N60 - N50 x 100= 20% 30%
N50
LIQUIDITY REASON
If a proportion of the investment can be converted to cash without loss of time,
it will help the investor to meet financial emergencies. Stocks or shares are
said to be liquid if and only if they can be converted to cash immediately to
meet the investor’s needs. Investors generally use investments as fall back
option for cash whenever the need arises.; therefore investments should be
liquid enough to allow realization into cash immediately the needs arise.
HEDGE AGAINST INFLATION
As a result of inflation in the economy, the investor will always want to plan
his investment in such a manner in order to protect himself against the rising
prices of goods and services. By this we mean the investor will seek for a rate
of return on his investment over and above the inflationary rate in the
economy. Generally, the rate of return that investors should desire in an
inflationary situation should be a rate higher than the current rate of inflation;
this helps them hedge against the inflationary effects.
SAFETY REASONS
Investors do make investments for reason of safety of their funds. Safety refers
to the protection of the principal amount invested and the expected rate of
return. Some investments are under regulatory framework, i.e. having the
cover or backing of the government. For such investments, there is usually a
cushion provided to the investor which guarantees his investments. For
instance, Investment done with government are safer than investments done
with private organisations, this is so because government as a prime mover of
economic activities of the country would ensure that the investments of its
citizenry are well protected. From a safety point of view, investment can be
ranked as following order:
i. Bank deposits.
ii. Government treasury bills.
iii. Government bonds.
iv. Debentures.
v. Preference shares.
vi. Equity shares.
