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5 Investment Valuation Methods Every Investor Should Understand
5 Investment Valuation Methods Every Investor Should Understand

5 Investment Valuation Methods Every Investor Should Understand

When going to make an investment, an investor needs to consider and estimate the level of profit and risk that will be obtained. An investment is said to be feasible if the investment is profitable for investors. To assess the feasibility of an investment requires an assessment called the investment appraisal method.

Investment appraisal method is a form of analysis to assess the attractiveness or feasibility of an investment that includes capital factors, cash flow, long-term profitability, and investment period. There are 5 methods of investment appraisal that can be done. Here is the explanation.

Investment Valuation Method

There are at least 5 investment appraisal methods that can be considered in investing. These methods have different calculation formulas. The five methods are as follows.

1. Net Present Value (NPV)

NPV is an investment appraisal method by measuring the difference in the current investment value  (present value)  of cash inflows with the value of future cash outflows during a certain period. In other words, NPV is a calculation of the profit that an investment will get in the future if it invests at the current value of money.

NPV is related to the  time value of money  because there is a difference in the value of money in different time periods. In NPV, there are two important things to calculate, namely estimating cash flows and determining the relevant interest rate. If the NPV is positive, an investment is acceptable or feasible.

A positive NPV value means that the difference in the value of the investment is greater than the cash outflow so that the income is greater than the value invested. While a negative NPV value means that the level of income from the investment is smaller than the expenditure. In theory, the value of NPV = 0 is possible, that is, there is no profit or loss, only a return on investment.

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Rumus NPV = (C1/1+r) + (C2/(1+r)2) + … + (Ct/1+r)t) – C0

NPV = Net Present Value

Ct = cash flow per year in period t

C0 = initial investment value in year 0

R = interest rate in %

2. Payback Period (PP)

Payback Period or PP is a simple investment appraisal method. PP is a method for calculating the time required to return the initial investment capital. The calculation results are expressed in units of time (years or months).

The formula PP = investment value: net cash in. 

The shorter the payback period  , the better the investment is. Investors will be attracted to short  payback times compared  to long paybacks even though the profits are quite large.

3. Average Rate of Return (ARR)

ARR is also known as  financial statement  or  accounting rate of return . ARR is an investment valuation method to measure the average annual net profit of an investment. This is to provide an overview to investors about the potential income received during the investment period.

ARR formula = (average profit after tax: average investment) x 100%

The ARR value expresses the percentage of annual net profit to the amount of initial investment capital. The higher the ARR value, the more profitable the investment.

4. Internal Rate 0f Return (IRR)

In addition to the Average Rate of Return (ARR), there is also the Internal Rate of Return (IRR). IRR is an investment valuation method that calculates the interest rate of an investment by equating the current NPV of cash flows with the NPV of future cash flows.

Rumus IRR = rk + (NPV rk/(TPV rk – TPV rb)) x (rb – rk)

rk = lower interest rate

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rb = higher interest rate

NPV rk = NPV at low interest rate

TPV rk = Total Present Value of Proceeds at a small interest rate

TVP rb = Total Present Value of Proceeds at high interest rate

The higher the IRR value, the investment is very feasible. This means that the IRR value is greater than the capital issued. However, if the IRR is less than the capital, the investment is not feasible.

5. Profitability Index (PI)

Profitability Index is an investment assessment method that is carried out by comparing the value of future cash flows with the value of current investment expenditures. In other words, PI is the comparison of the  present value  (PV) of cash inflows with PV of cash outflows.

PI formula = present value of future cash flows : initial investment

A PI value greater than 1 means the investment is profitable. If it is less than 1, the investment is not worth it.

Advantages and Disadvantages of Investment Valuation Method

Of the five methods, NPV is referred to as the investment valuation method that can provide the best results. With the NPV method, the future value of an investment can be measured in the present. This makes it easier to make decisions regarding these investments. However, this assessment method requires very careful calculations.

The PI and IRR methods are also good methods. But unfortunately it has many shortcomings. For example, the IRR does not consider investment funds with different values ​​and the calculation takes time if the cash flows are not the same.

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Meanwhile, the ARR and PP methods may not be good investment valuation methods. This is because they both ignore the time value of money. In fact, money has an important time value in investing.

Each investment appraisal method has its advantages and disadvantages, whether it is a  mutual fund investment  or a mixed mutual fund. Therefore, it is necessary to consider wisely in terms of choosing the best method. Plan your investment carefully in order to provide maximum results.