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Calculating the Net Present Value (NPV) Or Negative Edge - Which Is Better

If you are in your mid-thirties or older, chances are good that your career has been defined by some form of investing. Your investment may have started with mutual funds and matured to options, stocks, or maybe even Forex trade, but in the end, it has always been about the risk-reward payoff and some form of the stock market.

One of the most popular methods to measure the risk and rewards in investments has been the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) calculation. The formula for this is as follows.

EBITDA = (Purchasing Power X Expense Ratio X Debt / Equity) / Earnings

Purchasing Power is simply the price of the stock divided by the value of the investment. Expense ratio is simply the share of the purchase price that is used as an offset to reduce the EBITDA. Debt/Earnings is the negative aspect of the equation as it shows how much you're actually losing compared to your purchase price. In the case of a mutual fund, this would be the net amount of what you've paid for the stock multiplied by the total earnings you've made since purchasing it.

So in the case of the last example, if you had purchased a $5,000 mutual fund that is currently trading at a price of 50 cents and that fund had an expense ratio of 2:1, you would have a Negative EBITDA (-$5,000/$2,000) as you are losing ($2,000 - $5,000) times 2:1 which equals $500.

Another calculation that some prefer is the Net P/L (profit/loss). This is usually the most useful one and is calculated by subtracting profit from expense. So in the case of the last example, if you have made $2,000 but have also spent $4,000 on the purchase and $400 on commissions, then your Net P/L would be -$800 ($4,000-$2,000 - $400/$400). In some circles this is often used to determine the minimum investment required to get a good return on your money. This is often taken as the first step in the investment process by many investors.

One of the hardest things to calculate in the above examples is the time value of account. If you had purchased an investment when it was trading at 50 cents and the current price is still trading at that price, your value for the day would be 50 cents. If that investment were to close at $1.50 dollars at the end of the day, your value for the day would be $1.50 * 1.50 = $2.00. If you were to hold onto that investment overnight, the P/L would be zero and the value would be infinite (which could be confusing for some).

It is the P/L and value that are calculated at the time of the initial investment and are only adjusted as the investment changes in value and as commissions, expense ratios, time value of account change.

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