What Is Net Present Value?

Net present value (NPV) is the current value of discounted future cash flows expected to be earned by an investment, this is after accounting for the net cost of the investment. NPV analysis is thought to be one of the most precise investment valuation methods. However, NPV relies heavily on accurate forecasts discounted back to present value using an intelligently selected discount rate.

Why Use Net Present Value?

The utility for net present value analysis is exploited by companies or individuals who are looking to determine whether or not an investment will create value. Net present value is one of the most popular tools used to gauge the attractiveness of an investment. This is because, unlike some other valuation methods, net present value accounts for the relationship between the value of money and time. By discounting forecasted cash flows, net present value shows investors the current value of all future cash flows, net of the cost of the investment. If analysis shows that net present value is greater than zero, the investment will create value.

How To Calculate Net Present Value

Unfortunately, the calculation of net present value is not so simple. Before beginning this calculation, it is necessary to thoroughly analyze the investment and to be able to forecast the most accurate future cash flow predictions possible. It is also necessary to utilize a proper discount rate which will also require thorough research and perhaps calculation; one popular discount rate for valuing companies is the weighted average cost of capital (WACC). Once this information is gathered NPV can be calculated using the formula below.

NPV - Net Present Value

Where:

Rt = net cashflows during a period

i = selected discount rate

t = number of periods

Understanding The NPV Formula

While this equation itself may seem complex, understanding the underlying concept is what is important. By discounting expected cash flows via the discount rate into present value, this equation accounts for the time value of money. This equation then reveals the net present value of a prospective investment by accounting for the investment’s cost. A negative NPV would reveal an investment that will not provide sufficient enough cash flow to create value.

Alternative Ways To Calculate NPV

As stated before, understanding the underlying concept of NPV analysis is more important than memorizing the equation. This is because, fortunately, investors can preform NPV simply building an Excel model or using other similar software. There is also a function on excel to calculate NPV, simply type “=NPV” on an excel sheet and follow the given directions.

The image below shows an example of Net present value being calculated via excel.

NPV - Net Present Value Excel

In this image, we see net present value being calculate. The first inputs are the carefully selected discount rate and future cash flow projections. Next, the future cash flow projections are discounted to present value via the discount rate. After the present value of future cash flows are added, the expected cost of the investment is subtracted, leaving us with the net present value of the investment. In this particular example, the prospective investment is attractive on the basis of discounted future cash flows exceeding the investment cost, thus creating value.

Limitations To Net Present Value

One glaring limitation to this valuation method is its heavy reliance on inputs. Please note that, unlike what is shown in the example, forecasting future cash flows is a very in depth and complex process. Investors may be overly-optimistic when forecasting future cash flows and ignorantly mislead themselves into believing there is a value opportunity. Unfortunately, NPV analysis is only as accurate as the inputs are and for some investments, it is near impossible to precisely forecast cashflow. It is also necessary to predict future cash outflows which, like cash inflows, are subject to both internal and external instability and thus are very difficult to precisely forecast. It also must be mentioned that the selected discount rate will likely be affected by factors such as interest rates which are subject to periodically change. Overall, it is absolutely vital that investors be as thorough and unbiased as possible when forecasting the NPV inputs.

Net Present Value (NPV)