Investments that produce income can be valued based on their future incomes. The standard way to measure this is 'yield' - the ratio of (annual) income divided by price. There are different types of 'yield':
- 'running', 'income' or 'historical' yield - the most familiar type of yield, based on the latest known information
- forecast yield, usually relating to shares, based on forecasts of both share price and dividend payments
- 'yield-to-maturity', typically used for fixed-interest securities that mature and return the 'face value' - the yield-to-maturity is the average annual return that you would receive if you hold the security to maturity
- income (e.g. from dividends or interest payments)
- capital gains (e.g. from price changes or maturity of a security).
An important basic concept to grasp is that for any future stream of income (in the form of dividends, interest or bond coupon payments, the higher the price you pay now, the lower the average annual rate of return or yield that you will earn over the period you hold that security. So, in other words, there is an inverse relationship between the future long-term return on a security and the current price.
Take an (unusual) example of a 30-year zero-coupon bond (i.e. with no income) with a 'nominal' or 'face' value of £100. If the bond is priced at a yield-to-maturity of 10%, it will cost you only £5.73 today - mainly because there is no income for 30 years but then you will be paid £100. However, because you paid so little for it initially your annualized return will be 10%.
- if the increase in capital value is equivalent to 5 years' income
- if the current yield is less than 3.5%
I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.