Net present value, or NPV, is a method that investors use frequently when they are examining current or potential investments. These strategies will help assess if a return on investment is low or high for a new product or service.
Net Present Value and Why It's Important
The net present value is just one of the many ways to determine the return on investment (ROI). This method focuses on the present value of cash compared to the ultimate return of the cash outcome. The reason that NPV is often chosen as the model for financial analysts is because it evaluates the time value of money and delivers a specific comparison between initial cash outlay versus the present rate of return. Some financial experts prefer this method since there are more known factors, such as the present value of cash.
How to Calculate Net Present Value
To calculate the NPV, the first thing to do is determine the current value for each year's return and then use the expected cash flow and divide by the discounted rate.
Net Present Value (NPV) = Cash Flow / (1+rate of return) ^ number of time periods
The outcomes for NPV can be positive or negative, which correlates to whether a project is ideal (a positive outcome) or should be abandoned (negative NPV). The higher the positive NPV number outcome, the more advantageous the investment or project. With regard to the discounted rate, this factor is based on how the project or company obtains funding. Funding through expensive, high-interest loans should be considered when determining the NPV.
Net Present Value vs. Internal Rate of Return
The use of NPV can be applied to predict whether money will compound in the future. The reason that current or potential investors and management use NPV is to help them decide whether to make expensive purchases, assess the value of mergers and acquisitions and conduct an overall corporate evaluation in some instances.
Calculating the internal rate of return (IRR) is conducted by examining the cash flow of a potential project against the company's hurdle rate. One drawback of using the IRR is that the same discount rate is applied to all investments. This method could affect long-term projects that could take an extended period of time such as five or 10 years when many variables could change.
Since the discount rate is the interest rate used in analyzing the discounted cash flow to produce the present value of future cash flows, it is likely the interest rate will fluctuate from year to year.
Many experts use both net present value and the internal rate of return to determine if an expenditure is a worthwhile investment.
Drawbacks of Net Present Value
Although NPV is used often by many financial professionals as a metric for determining ROI, the model also has many drawbacks. The reason that many errors can occur is because the calculations are based on educated estimations and knowing the past and current expenditures.
One important question to consider is whether the valuation of the project or business is accurate, depending on the current market conditions, potential for price increases, the possibility of tariffs and the potential for cost overruns.
When purchasing static or material items with a definite price, you can have confidence with this figure. However, when upgrading systems that may involve other aspects or areas of your business (staffing, overhead, etc.), the hard cost may not be as apparent.
Additionally, when working with the discounted rate, you are prognosticating rates, which may not be truly what happens in the future. These changes in the market, depending on supply and demand, could hinder or be an advantage to the bottom line, which can not always be accurately determined months or years prior.
What Is ROI?
There are many methods to determine the return on investment, commonly know as ROI, which measures how profitable an investment is. Companies typically use the ROI to make decisions about where to invest its profits. An investment of the same magnitude that generates more profits is likely to win out over one with less profit.
The formula for ROI is: gain from investment - cost investment/cost of investment. The ROI shows how much profit an investment generates as a percentage of the investment cost. Companies use ROI to gauge the profitability of separate business segments or of individual assets such as a single machine in a factory line.
Investors also can use ROI to determine returns from their investments in company shares. This is not the same as a company's return on equity or ROE but it is a measure of the investment gains relative to cost. For instance, as an investor you decide to purchase a share in company for $1,500, but later on you decide to sell the share for $2,000. Your ROI would be $500 divided by $1,500 or 33%. Suppose you paid $1,500 for shares in another company and sold that one for $1,700. Your ROI would be just 13%. The first investment appears to be the better choice, assuming both investments were held for the same period of time.
The scenario changes if you kept the first investment for three years and the second for just one year. In that case, you would have to divide your returns by the number of years it was held. In this instance, 33% divided by three years is 11% while 13% divided by one year is still 13%. The second investment appears to be the better choice under this scenario.
By calculating the ROI on various investments, it helps you make better, informed and objective decisions on where to allocate your money.