This is used rather more in a commercial sense than "net earnings;" the latter being applied in reference to railroads, telephone companies, etc. "Profits" have more the reference to the gain arising from dealing in commodities, and is the gain in any business undertaking of the above nature after taking into consideration the capital invested in such an undertaking, all its expenses incurred in management, and losses sustained, if any.
Again "net profits" and "net earnings" (see that subject) may be used to mean one and the same thing. Or, in some instances, both terms may be used in the same system of bookkeeping, as, for instance, "net profits" to mean the earnings of the business before any losses for bad debts or such like have been deducted, and "net earnings" after such deduction.
Net Return upon the Investment. The proportional rate which the income upon any investment bears to the total cost, interest excepted, of that investment, taking into consideration the time which the investment may be outstanding before being paid off.
Stocks, as a rule, have no definite date of maturity, although there are exceptions to this; therefore, stocks are usually figured as perpetual. Bonds and most other classes of investments have a fixed time to run. In the former case, a simple illustration would be that of a stock selling at $200 per share, and paying dividends at the rate of 8% per annum; in which event the ratio of the dividend, $8, to the total cost, $200, would be 4, or, in other words, the net return to the investor would be 4%. If the stock sold at $100 per share and paid $4 per annum in dividends, the net return would be 4%.
In the case of bonds having a fixed date of maturity, the problem is somewhat more complicated, and special tables are in use to which investors usually turn to ascertain what the net return is upon an investment of that kind. It will do to take as an example a bond bearing 5% interest, and which has exactly ten years to run before maturity. If it is sold at $108.18, that is to say, $1,081.80 for each one thousand dollar bond, the net return to the investor would be 4% per annum, which is 4% for each of the ten years, and is 4% upon the entire sum - $1,081.80 - invested.
This brings up the point that, although - to use the above example - the bond costs $1,081.80, at the end of ten years, when it matures, the holder will only receive $1,000. In the meantime he will have received $50 yearly in interest. All of this $50, therefore, should not be considered as income, for a sufficient amount of it should be set aside each year to liquidate the $81.80 premium paid for the bond.
Some such expression as this is often seen: "Yielding 4% for the first ten years and 5% for all the time thereafter which the bond may run." This means that the municipality or corporation issuing the bond has the right to pay it off any time after ten years, but may not absolutely be obliged to do so until some later date, say twenty years. These are called 10-20 year bonds, or 10-20's, meaning that they are abso lutely due in twenty years, but optional on the part of the issuing party to pay any time between ten and twenty years. It is not safe on the part of the seller of this bond to estimate that it will run longer than ten years. The greater the length of time which any form of indebtedness, with a fixed rate of interest, and selling at a premium, may be outstanding, the greater the percentage in interest return to the holder, at a given price; therefore, in the case of this 10-20 year bond, the seller figures the net return on the basis of its being outstanding ten years only, and, in the case cited, returning 4% to the investor. But should it run twelve years, for instance, before being paid off, the net return to the investor would be 5% per annum for the two additional years; or, in other words, the full rate of interest which the bond bears.
The shorter the length of time which a bond has to run when selling at a discount, the greater the interest return to the investor, prices being equal; just the opposite from a bond selling at a premium.
In the selling of bonds and figuring the interest return, or yield, the following rule must always be observed, if the issue is " optional," so-called, as in the case of the 10-20 year bond just mentioned.
Rule For Computing the Interest Yield Upon Optional Bonds
For bonds selling at a premium, the interest return must be computed upon the shortest possible time which the security may be outstanding. For bonds selling at a discount, the interest return must be computed upon the basis of the greatest possible length of time which they may be outstanding.
In buying an issue of " serial bonds " (see that subject) many bidders make the mistake of averaging the life of the issue, and then, by the use of a table of bond values, basing the bids upon this average maturity; whereas, a separate bid should be computed for each maturity and then an average price taken. If bonds are bought by the first method and retailed by maturities, either a loss will result, or a lesser profit than expected.
How to compute the average life, or maturity, of a lot of bonds falling due at different intervals, is best explained by the following example.
To find, on March 1, 1907, the average maturity of
From March 1, 1907, to July 1, 1910 is 3 1/3 years. Likewise, for the subsequent periods the time is 5 1/3 years, 8 1/3 years, 13 1/3 years.
Three ciphers may be struck out of each of the par value amounts, and we have the following:
Dividing the footing of the right-hand column by the footing of the left-hand, the average maturity is obtained; namely, 7 87-100 years. (See " Bond Values Tables.")