Before you buy or sell stock in a company, you should have a sense of the market value of each share. The same goes for shares of mutual funds and exchange-traded funds, whose market value is represented by a metric known as net asset value, or NAV.
Let's go over how to calculate NAV and how this metric can help fund investors make smart buying and selling decisions.
Calculating net asset value
Calculating a fund's NAV is simple: Simply subtract the value of the fund's liabilities from the value of its assets, and then divide the result by the number of shares outstanding. To figure out a fund's total assets, we add the market value of all securities held by that fund to its total cash and cash equivalents.
Let's say a mutual fund has $10 million in securities, $2 million in cash, and $1 million in liabilities. Let's also assume that it has 1 million shares outstanding. In this case, its net asset value would be $11 per share:
($10 million + $2 million - $1 million) / 1 million = $11
A mutual or exchange-traded fund's NAV will typically change on a daily basis, because its assets and liabilities are in constant flux. Similarly, the number of shares outstanding might change from day to day as investors buy or redeem shares. A fund's net asset value might therefore be $15 per share one day and $18 per share the next day.
Mutual funds and exchange-traded funds must generally calculate their net asset value on a daily basis, typically after the close of the major U.S. exchanges. All subsequent buy and sell orders are then processed using the net asset value as of the trade date.
Importance of net asset value
Net asset value has a similar function to looking up a company's stock price, as it's an indication of how much one share of a mutual fund or exchange-traded fund is worth. Net asset value can help investors compare different funds or compare the performance of a single fund to other market or industry benchmarks (such as the S&P 500 Index).
Limitations of net asset value
While net asset value is a helpful calculation, it's not necessarily the best way to gauge a mutual fund's performance. Because mutual funds pay out almost all of their income and capital gains to shareholders, looking at a fund's total annual return is a better way to measure its potential than looking at changes in its net asset value.
Net asset value vs. market price
Investors buy and sell mutual fund shares at prices based on net asset value. With exchange-traded funds, however, a fund's net asset value can differ from its market price (the price at which shares can be bought or sold). The reason is that exchange-traded funds are subject to supply and demand, which can drive share prices above or below a fund's net asset value. That said, the market price per share of an exchange-traded fund is usually reasonably close to its net asset value per share.
Evaluating a fund's net asset value can help you determine whether it's an investment worth pursuing. Keep in mind, however, that it's just one of many factors you should take into consideration. Fees, management strategy, and the specific needs of your portfolio are equally important, if not more so.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!