I read many posts and articles a week discussing various investments. That being said I also frequently see mistakes made on determining the return of said investments. Today’s post will highlight the importance of looking at all cash flows when calculating your investment return.

### What is Usually Missing from Return Calculations

So lets start this discussion with dividends. Often times you will hear that a dividend yields a 1% return. The problem is many people typically only look at the dividend payout instead of factoring in the capital gain or loss. Think of it this way, suppose I held a stock for 3 years. It had a dividend of 1% a year and after 3 years I sold it for 3% less. Did I make any money? The answer is obviously no, in fact thanks to inflation I lost some. Yet we often forget this. White Coat Investor had a good post on this a few months ago.

You see the same thing with bonds. So if you have a bond with a coupon of 4%, but you receive a discount of 2% and you hold it for one year, ignoring inflation your bond has a yield of 6% not 4%. Alternately had it been bought at a premium of 2% your same return would only be 2%.

Finally you see the same thing with a depreciating asset. Recently I commented on a post over at the Green Swan on ROI of depreciating assets. The common view of any assets you might invest in to improve your house or life is related to the savings it brings you. However again you have to account for its initial upfront investment cost. To make matters even more interesting you might also sell the item at the end or it may outlive it’s useful life and break essentially going to 0 value. So the return without inflation has to account for your yearly return minus any depreciation for that specific year.

### Calculating Actual Investment return

The key lynch pin here for your returns is they are always an estimate up front. You make assumptions about your holding period and how much you can sell them at the end of the period. You use these assumptions when estimating returns. In some cases, like bonds, the ending has a finite set of possibilities (you can’t hold beyond the bonds maturity and if held to maturity it will be worth face value). In other cases like a depreciating asset you have to take a best guess based on the depreciation or appreciation of like objects (for example if you put a new heater/air conditioner into your house it will increase the value of the home in the near term, but what will it be worth in 10? 15? At some point the age actually becomes a drag on the price of your home due to buyer fear of replacement). But in either case the analysis has to start with estimating your expected cash flows and when they occur. Let’s explore three models for doing so.

### Return on Investments Cash Flow model

Return on Investments (ROI) is a powerful simple tool for evaluating an investments. The equation for ROI is simply your (total return minus initial investment) divided by initial investment. The only special scenario is if you sell the asset for a value at the end, say a stock/bond or even something that has not depreciated to 0, then there will also be a cash flow at maturity for the sale of the investment. So the ROI is really the Sum of all the money paid to you by the investment minus sum of all the money taken from you by the investment divided by the money originally invested. This equation is great for comparing investments of like maturities, but when evaluating a single investment it can be misleading. ROI does not take into account the impact of inflation or risk. So for longer term investments it can give the wrong answer and is not the best alternative. That being said, if the criteria above are met ROI is the easiest to understand. As such I would recommend it in many cases as an option to Keep it Simple Stupid (KISS).

ROI=(sum all years return- initial investment)/initial investment

### Net Present Value Cash Flow Model

If you want to control for inflation you need to adjust your cash flows to the same time period. You see due to inflation 3 dollars you earn today is actually greater than 3 dollars you earn next year. This is because that 3 dollars buys less next year then it did today. As such you need to account for this. Moreover, not all investments are risk free. As such you also need to account for any risk you take in the investment. So the easiest way is to take the Net Present Value (NPV) of the cash flows. You can do this in excel via the Net Present Value function (NPV)

So enter all of the yearly returns in dollars you expect going forward. Then create a cell with the net present value function. Highlight the cash flows and select your discount rate. The discount rate should be your inflation rate plus your expectations of the impacts of any risk. This should pop out the present value of all your returns.

What this is doing in the background is simply converting all those cash flows into todays terms and then subtracting the initial investment from them.

NPV = ∑ {Net Period Cash Flow/(1+R)^T} – Initial Investment

The resulting number is your return in present dollars today. IE what you will make as payback on your initial investment. If it were negative walk away. However if it is positive you should consider it. However given it is just a raw number it is difficult to compare this to other potential investments with differing investments amounts and holding periods. Furthermore, calculating the discount rate attributable for your risk is not something that is easily done. For these reasons I do not recommend NPV for a investment comparison unless used in combination with other metrics.

### Internal Rate of Return Cash Flow Model

Which brings us to the hardest to calculate but potentially best option. Internal Rate of Return (IRR) is essentially taking your cash flows and solving backward for NPV to determine what type of return you will get on a given investment over time to make NPV=0. It can be a very complicated equation so I again suggest you consider excel. The result is a number that is comparable to other investments of similar length and inflation. If the value is less than inflation walk away. If the number is less than other options, also consider choosing another option. There is one significant risk/issue with IRR. It assumes you reinvest any cash flow at the same return. Needless to say this is unlikely to hold true as coupon rates, stock returns, and everything in between are in constant motion. The implication here is investments of different maturities are not comparable using IRR. IF you can’t reinvest the cash flow at the same rate, which is a likely outcome, then the dates which the cash flow occur can have a huge impact on which investment is optimal. Still since length of investment brings its own distinct set of interest rate risk, I don’t often see the need to compare different lengths of investments solely on return. As such this is the option I utilize when making investing decisions.

Do you use any of these cash flow models to calculate your return?

## Be First to Comment