When investing, whether in real estate, stock market or some other asset, it's important to know the common measures used to analyze an investment's performance. These can start to become very complicated so let's break it down and go over the most common and provide a very simple explanation of each. In a later post, we'll go over which ones are most commonly used for Real Estate Investing and go into more depth on this. For now, we'll just focus on some quick and simple definitions.
Due Diligence: The research that an investor performs on a potential deal. This term is used in a number of cases and not just for financial analysis. But it is an important term when it comes to investing. Investors should perform extensive Due Diligence on any investment opportunity to determine if that opportunity is worth pursuing. Therefore, any thorough Due Diligence will take into account any, and potentially all, of the following terms.
Return on Investment (ROI)- The Return on Investment is the percent increase, or decrease, of an investment over a set period of time. It is calculated by taking the difference between current, or expected, value and original value divided by the original value and multiplied by 100. This calculation can be used for any period but it is a poor measurement of an investment over a long period of time.
Internal Rate of Return (IRR): This is one that you'll need a computer to calculate. Or at lease, you should. It’s calculated as the rate that sets the Net Present Value of an investment’s cash flows (positive or negative) equal to zero. IRR is used as a metric to estimate the profitability of potential investments. It becomes handy when you want to compare the potential return of an investment against the potential of another investment.
Net Present Value (NPV): Used are part of the IRR analysis, NPV is the difference between the current value of cash inflows and the current value of cash outflows over a period of time.
Time Value of Money: This is a financial concept that we should all be aware of and take into account. It holds that a dollar available today is worth more than a dollar available in the future. It takes into account the interest a dollar, today, has the potential to earn over time and is the fundamental concept behind IRR.
Holding Period: An investor’s holding period is the amount of time for which an investor plans to hold an investment and can be expressed in either months or years. The holding period is a key consideration when considering any investment.
Equity Multiple (EM): Equity Multiple is a measure of an investment’s absolute return and is calculated as the total cash flows, received from an investment, divided by the total amount invested. For example, an Equity Multiple of 2.0 means that an investor received back the money they originally invested plus that same amount in returns. In other words, if you invested $100,000 and the EM is equal to 2, then you would have received your $100,000 back plus another $100,000.
Cash on Cash Return (CoC): For many this is a key metric for investing. Especially passive investors looking to capitalize on their investments in order to receive regular cash flows. It is a measure of an investment’s return and is applied to income producing assets. CoC is expressed as the ratio of the investment’s before tax cash flow divided by the amount of cash invested. For example if you invest $100,000 in an asset and receive total of $20,000 in a year then the CoC return, for that year, is 20% (CoC= 20,000/100,000).