Fundamental Analysis

Reinvestment is the retention of interest, dividends, or earnings within the investment in order to accumulate capital value or enhance future earnings. For securities, reinvestment is the use of dividends due to the investor to purchase further shares of the same investment. Perhaps the most commonly recognized type of reinvestment is the compounding of interest; by allowing the interest earned to remain rather than withdrawing the interest when it is due, the resulting principal and retained interest will earn still more interest, increasing the total amount earned on the investment.

Most companies engage in dividend reinvestment in order to maintain or replace aging equipment, acquire new properties or securities, or to pay down existing debt. These activities do not produce immediate results, but add to the long-term potential for earnings of the company. Paying down corporate debt is especially useful for most companies since it reduces the amount of outstanding liability on the balance sheet, eliminates a portion of the interest payments due on that debt, and typically improves the company’s credit rating and stock value.

Capital Reinvestment

Capital reinvestment is especially important in the corporate world, since it provides the needed influx of operating capital for continued production and expansion. A company that returned 100% of its earnings to its shareholders would soon lag behind in production capacity and see its facilities and equipment fall into disrepair. Sustaining capital reinvestment is the amount of profit that a company must retain in order to maintain its capital assets; this reduces the amount returned to shareholders in the form of dividends, but is essential for the continued existence and earnings potential of the company. Investors typically expect a certain amount of reinvestment in order to maintain the quality of their principal investment and ensure the company’s overall operating health.

Dividend Reinvestment Plans

Some companies offer direct dividend reinvestment plans to their investors; these plans allow shareholders to build equity within the company more rapidly than would otherwise be possible. Because these plans automatically apply earned dividends to the purchase of additional shares of stock rather than distributing them to the shareholder, the investor’s equity in the company grows with every dividend distribution. Typically, these plans require direct ownership of the stocks in question, rather than proxy ownership through an investment brokerage. Dividend reinvestment plans typically feature very low minimums required for participation and relatively high annual maximum investment limits. Since shareholders do not need to use a broker to purchase additional shares, the fees associated with these services are significantly reduced.

Diversified Reinvestment Funds

Reinvestment funds are specialized mutual funds that allow their members to roll scheduled dividends back into the funds rather than receiving them as earned income. These funds combine the convenience of a managed plan with the quick equity building power of individual dividend reinvestment plans. This allows the shareholders of reinvestment funds to quickly amass a sizable equity stake and provides them with a diversified position in the market. By packaging the dividend reinvestment plan of numerous companies into one reinvestment fund, the risk to investors is significantly mitigated.

Funds from Operations Definition

The accepted funds from operations definition is the measurement of cash flow derived from certain types of real estate investment trusts. These real estate investment funds, or REITs, are generally exempt from corporate income taxes; consequently, they are required to distribute 90% percent of profits to investors. REITs share the same general investment structure as mutual funds, but are composed of real estate investments rather than stock market shares.

Funds from Operations Calculation

In order to determine the potential for earnings of a REIT, it’s necessary to calculate its likely funds from operations figure. This is accomplished by determining its net income including depreciation and amortization but excluding gains on real estate sold during the period. The typical formula for funds from operations calculation is as follows:

• Funds from operations = (Net income + depreciation + amortization) – gains on sales of real estate

The funds from operations figure offers a more accurate picture of the performance of REITs than typical accounting methods, since it takes into consideration the depreciation (or appreciation) of real estate investments and excludes one-time gains on sales that generally do not have a long-term effect on earnings potential.

Adjusted Funds from Operations

For an even more accurate depiction of the current financial performance of a REIT, analysts use a number of formulas to calculate the adjusted funds from operations figure. Simply put, the adjusted funds from operations for a REIT is derived by adding rent increases and subtracting capital expenditures and routine maintenance expenses from the funds from operations figure. The resultant figure provides shareholders and analysts with a more accurate basis for assessment of the probable earnings potential of the REIT and a better measure of its financial security.

Other Financial Indicators

Other important figures to consider when investing in REITs include net asset value and cash available for distribution. Net asset value is, as its name indicates, the total value of assets less any outstanding liabilities, and is usually divided by the number of outstanding shares in order to derive the net asset value per share. Because 90% of all profits are distributed to investors, the cash available for distribution figure is used to derive the likely short-term return on investment for REIT investors. Combined with the figures for funds from operations or adjusted funds from operations, these are the primary indicators of financial condition for REITs.

REITs have suffered hits to both their funds from operations and adjusted funds from operations figures in recent years due to recent housing industry downturns. Some REITs have lost as much as 60% of their previous value; prospects are uncertain for full recovery, although some recent indicators offer hope for the future. In order to ensure a reasonable return on investment, potential investors are advised to carefully examine management policies and historic data for any REIT they are considering; conservatively managed REITs typically have performed better in recent years than more risk-oriented investment offerings.

Future value is a measurement of the value of an investment at a specific point in the future; it assumes a predictable rate of return on the investment, such as a consistent interest rate. It does not incorporate the fluctuation in value created by factors like inflation, and thus is not as accurate a measure of investment return as indicators which include an estimate of the time value of money. Basically, the future value is determined by multiplying the present value by a rate of interest or growth over time; this rate is known as the accumulation rate.

Future value formula

For simple interest, the future value formula of an investment is derived by multiplying the present value by the sum of one plus the annual interest rate multiplied by the number of years, as in:

• Future value = Present value * (1 + (annual interest rate * years))

Compound interest rates are more complex, and typically require the use of a future value calculator or computer program in order to derive the figures. Essentially, future value on investments that include compounded interest are calculated by multiplying the present value by the sum of the interest rate plus one to the exponential power of the number of years, as in:

• Future value = Present value * (1 + annual interest rate)number of years

Thus, we can see that compound interest investments increase at an exponential rate, making them far more desirable for investors than simple interest transactions. Most future value calculations take into account the compounding of interest which adds to the future value money accrues over time. For variable rate interest calculations, actuaries normally use the risk-free interest rate; this is the lowest guaranteed rate for the investment, and is the most conservative method of calculation.

The process of calculating future value from a known present value is referred to as capitalization; it estimates the value of an investment at a present date, allowing analysts and investors to determine the profitability and advisability of a specific financial transaction. For instance, if a high-risk investment and a low-risk interest-bearing account both share the same future value on initial investment, it’s obviously better to invest money in the lower-risk alternative. The same criteria apply to other investments, including annuities, bonds, and preferred stocks.

Future value annuity calculations

An annuity is a series of payments made over time; fixed annuities are made in equal payments and generally are paid either at the beginning or end of the payment interval. Because an annuity has no set present value, it cannot be calculated using a simple or compound interest future value calculator. Future value annuity calculations often involve the compounding of interest multiple times during the same year; this results in extremely complex formulas that vary from annuity to annuity, and cannot be reduced to a single method of calculation.