Beyond the Stock Market: Measuring Profitability of Alternative Investments

Historically, investors have relied on more traditional investments such as stocks, bonds, mutual funds, and cash equivalents to build wealth. However, alternative investments have earned a place in many high-net-worth investors’ portfolios in recent years.

What are Alternative Investments?

Alternative investments include financial assets like hedge funds, real estate investment trusts (REITs), venture capital, and private equity holdings. They also include physical and virtual investments like precious metals and oil, cryptocurrencies, collectibles, and other items.

There are a few notable differences between traditional and alternative investments. Traditional stock market assets are relatively reliable and regulated with high liquidity, making them quick and easy to purchase or sell. Alternative investments are more complex on which to place a monetary value. They’re also less liquid than traditional investments and have an elevated risk. However, they can result in higher profits than commodities on the stock exchange.

One of the main lures of alternative investments is they function outside of entrenched financial markets. They can also diversify portfolios, a common goal for most investors, and they serve as hedges in times of economic distress on the traditional stock market.

How Are Alternative Investments Valued?

Traditional investments are straightforward to value, as the market determines share prices and provides information on capitalization and assets. In contrast, alternative investments are more complex. Since these assets are illiquid and not traded on public stock markets, their value depends on industry conditions, market demand, location, size, and the current regulatory framework. The private nature of alternative investments can also make it difficult for investors to find reliable data. However, if you can access relevant data for analysis, here are five standard metrics and techniques to help you assess their value.

1. Internal Rate of Return (IRR)

Internal rate of return (IRR) is one of the metrics that alternative investors frequently consult. It reflects the expected compound return rate an investment can earn over a certain period of time. IRR is particularly useful because many alternative investments are held over the long term, and profits can take a while to develop.

2. Multiples of Invested Capital (MOIC)

Multiples of Invested Capital (MOIC) measure the returns investors receive on their initial investments. It is calculated by dividing the total income and capital gains by the total amount of invested capital. MOIC is an important metric because it indicates how much profit an investor has made from a specific investment.

3. Net Asset Value (NAV)

Net asset value calculates how much underlying asset value an investment carries minus expenses, liability, and management costs. Divide the total asset value by the investment’s outstanding shares to determine this metric.

4. Cash Flow Analysis (CFA)

Cash flow analysis estimates how much income an asset will produce in the future. This income can come from rental fees, business revenue, interest, royalties, and other sources. CFA is particularly useful for real estate, infrastructure, and private equity funds.

5. Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is similar to regular cash flow analysis but with more considerations. DCF estimates an investment's future income by evaluating its risk level, setting an expected discount rate, and adjusting the value to reflect its current “discounted” total.

Other Valuation Strategies for Alternative Assets

Various metrics can assist you in assessing the profitability of alternative assets. Investors should also consider market conditions, external appraisals, risk assessments, and other pertinent factors. Regardless of the strategies and metrics employed, investors must closely monitor all alternative investment commodities. This diligent tracking will help them discover new opportunities, identify potential risks, maintain accurate data, and decide when to hold or exit a particular investment.

Looking Ahead: The Future of Alternative Investments

The alternative investment market may appear confusing to most investors. Those who explore this area need to track the movements of various commodities and employ different metrics to assess their value. However, by closely monitoring and refining these strategies, alternative investments can transform your portfolio and provide significant long-term returns.