Profitability is one of the key concepts in investment theory. The general principle of evaluating the effectiveness of any investment can be formulated as follows: "The higher the risk, the higher the return." At the same time, the investor seeks to maximize the profitability of the portfolio of securities in his possession, while minimizing the risks associated with such ownership. Accordingly, in order to be able to use this statement in practice, an investor must have effective tools for numerically assessing both terms - both risk and investment return. And if the risk, being a category of qualitative, is very difficult for formalization and quantitative assessment, then profitability, including the profitability of securities of various types, can be estimated even by a person who does not have a lot of special knowledge.
The yield of securities inherently reflects the percentage change in the value of securities for a certain period of time. As a rule, the calculation period for determining profitability is one calendar year, even if the time remaining until the end of the circulation of the paper is less than a year.
The theory of investment identifies several types of profitability. Previously, such a notion as current yield of securities was commonly used. It is defined as the ratio of the sum of all payments received by the owner during the year due to ownership of a package of securities to the market value of the asset. Obviously, such an approach could only be applied to stocks on which dividends can be paid (i.e., first of all, preferred stocks) and to interest-bearing bonds involving a coupon. Despite the apparent simplicity, this approach has one significant drawback: it does not take into account the cash flow that is generated (or can be formed) due to the sale of the underlying asset on the secondary market or repayment by the issuer. It is obvious that, as a rule, the face value of even a long-term bond is much larger than the sum of all coupon payments made on it during the entire period of its circulation. In addition, this approach does not apply to such a common financial instrument as discount bonds.
All these deficiencies lack another indicator of profitability - yield to maturity. By the way, I must say that this indicator is fixed in IAS 39 for calculating the fair value of debt securities. Following international standards, the majority of national accounting systems of developed countries have adopted a similar approach.
This indicator is good in that it takes into account not only the annual income in the form of income from ownership of the asset, but also the profitability of securities that the investor receives or loses due to the discount or paid premium when purchasing a financial asset. Moreover, when it comes to long-term investments, such a discount or premium is amortized over the entire period remaining until the maturity of the security. This approach is convenient if you need to calculate, say, the yield of government bonds, which in most cases are long-term.
When calculating the yield to maturity, the investor must determine for himself such an important parameter as the required rate of return. The required rate of return is the rate on invested capital, which, from the point of view of the investor, is able to compensate him for all the risks associated with investing in such assets. Accordingly, it is this indicator that determines whether an interest-bearing bond is traded on the market at a price below or above par. So, for example, if the required rate of return is higher than the annual coupon rate, the investor will seek to compensate for this difference by discounting it at the face value of the bond. And vice versa, if the required rate of return is lower than the annual coupon rate, the investor will be ready to pay the seller or issuer of bonds an amount in excess of the face value of the security.