What is Net Present Value (NPV)?

Net present value is like a pair of corrective glasses while evaluating a potential investment…

Time — like distance — can make things look bigger or smaller than they really are. Returns or expenses five years from now may look big, but will look different when adjusted for the inflation that will happen in the coming years. Net present value helps companies and investors bring things into focus.

The net present value helps estimate the current value of future cash flows. This is a useful tool for investors considering different investment options. It’s also a valuable tool for companies that are considering investing in different growth options, whether it be a new piece of equipment or renovations in their stores.

Money today generally is worth more than the same amount of money in the future. We know that, in most cases, inflation erodes the buying power of money. This means that $1,000 in 10 years will not buy you as much as $1,000 does today. We refer to this as the time value of money.

Net present value is a calculation that allows us to consider future money and decide what the value of it is when you take into account the passage of time.

To demonstrate, imagine someone offered to give you $100,000 either today or five years from now. First, we know that money won’t be worth as much in five years due to inflation. The Federal Reserve has a target inflation rate of 2%, so let’s use that for comparison’s sake. Adjusting for 2% inflation per year, that $100,000 has lost roughly 10% of its value after five years –- Since inflation is compounding, it’s not exactly 10%, more like 9.4%. This means that $100,000 in five years is only worth $90,573 today.

Next, consider what else you could have done with that money. You could have invested it in an investment that follows the overall stock market. Let’s say hypothetically that it returned 9.3% annually over the past five years. Assuming again hypothetically that its performance remains relatively stable, your $100,000 would increase by more than $50,000, thanks to the power of compound growth. No one can predict the future movements of markets; all investments carry risk.

You can see how much more $100,000 is worth to you today versus what it will be worth five years from now. The same goes for investors and businesses. They want to make sure the investments they make will grow the value of their money over the years instead of just staying the same, or worse, decreasing.

Net present value is one of the best ways that investors and businesses have found to calculate the return on investments and capital projects when analyzing if they’re putting their money to work in the best way possible.

The formula for determining the net present value looks like this:

Net present value = (Net cash flow / (1+ discount rate) ^ number of time periods) - initial investment

For multiple cash flows (such as annual payouts over the life of the investment), you repeat this formula based on the number of periods you have. So if you have a venture that lasts for five years, with five annual cash flow values, then you repeat the equation five times and add the five results. In this formula, the net cash flow represents the sum of incoming and outgoing cash flows.

The discount rate is how you adjust the value of the investment. First, you can modify the value based on the risk of an investment. If you’re comparing two potential investments, one might seem like a clear winner based on the potential profits. But that investment might be a lot riskier than say, a US Treasury bill. In this case, you would increase the discount rate for the riskier investment to account for that added risk.

The discount rate also helps you to adjust for the time value of money. The value of a dollar today will change over time. The more time passes, the greater the difference in the worth of a dollar bill today and the worth of a dollar bill in the future. First of all, inflation will erode the value of money over the years. Additionally, you could have been putting that money to better use elsewhere, perhaps at an even higher rate of return.

Therefore, you can use the discount rate to take into account the return you believe you could have been getting from a different investment during the period in question to compare the two better.

Let’s say there is an investment opportunity that will cost $50,000 and provide an expected return of $20,000 per year for the next five years. However, you think you could invest that same amount in the stock market and see an 8% return annually. The discount rate to use to figure out your net present value would then be 8% or .08.

You’ve got your cash flow, and you’ve got your discount rate, so we can plug those into the formula, while also taking into account your initial investment:

Net present value = [($20,000 / (1 + .08) ^ 1) + ($20,000 / (1 + .08) ^ 2) +($20,000 / (1 + .08) ^ 3) +($20,000 / (1 + .08) ^ 4) +($20,000 / (1 + .08) ^ 5)] - $50,000

As you can see, we need to make sure to take the initial investment into account, which, in this case, was $50,000. The resulting net present value is $29,854.20. A positive net present value assumes that an investment will be profitable. A negative value anticipates that an investment will not be beneficial — You will ultimately lose money at the given discount rate (or not make as much as you could have in an alternate vehicle). So by seeing a positive net present value from our formula, we could conclude that this is a good investment.

You could also use net present value to compare different investment options. For instance, we used the discount rate of 8% to compare this investment with our hypothetical stock market returns. So, by getting a positive result, we’re showing that this is the more profitable of the two options. (Of course, this relies on all of our assumptions on rates and return values being accurate.)

You can also compare options by calculating the net present value of different potential investments. Theoretically, the investment with the higher net present value would be a better investment.

Net present value can be an excellent way for investors to figure out if an investment opportunity is worth their time and money. It can help them weigh the opportunity cost of an investment, and whether a different investment might have a better return.

At the same time, net present value requires a lot of guesswork. You can’t know with certainty the discount rate, the rate of return, and whether the cost will be higher than anticipated (especially with companies taking on new capital projects).

An alternative that investors can use to compare investments is the payback method. The payback method represents how long it will take for the investment to be repaid. This method only considers the time it will take to make your money back for an investment. It doesn’t take into account the projected rate of return after you’ve made back your money.

Another alternative to net present value is the internal rate of return. The internal rate of return estimates how profitable a potential investment might be. The calculation sets the net present worth at zero and solves for the internal rate of return. The investment with the highest internal rate of return would thereby probably have the highest profit. A company might use IRR to compare the profitability of different capital projects.