Net present value (NPV) represents the difference between the present value of cash inflows and outflows over a set time period. Knowing how to calculate net present value can be useful when choosing investments. In a nutshell, an investment’s NPV can help you to analyze its potential for profit. In business settings, it can also be used in capital budgeting to decide how to best allocate funds.
Looking for money management advice? Connecting with a financial advisor can help you fine-tune your portfolio.
Understanding Net Present Value (NPV)
The net present value uses the present value of cash inflows and the present value of cash outflows to estimate the profitability of an investment or project. What you’re looking for when calculating NPV is whether the result is positive or negative. A positive number means that you’re likely to make a profit, while a negative number can indicate the opposite.
Why would you want to calculate the net present value of an investment? Simply, to determine whether it’s something that belongs in your portfolio, based on your goals. Net present value considers the time value of money, which is the idea that money you receive now is worth more than money received at a future date.
As mentioned, net present value is not specific to investing in stocks or other securities. Businesses can also use net present value formulas to determine where to allocate their capital. For example, if a retail store is thinking of opening a new location, a net present value analysis can shed some light on whether the project is worth undertaking.
Net Present Value Formula
There are two formulas you might use to calculate net present value. The one that you choose can depend on the number of cash flows the investment has.
If you’re calculating NPV for a project with a single cash flow and the project is short-term in nature, the formula you’d use would look like this:
NPV = [Cash flow / (1+i) ^t] – Initial investment
In this formula, the “i” represents the discount rate. When you’re talking about investments, the discount rate is the rate of interest that’s used to discount all future cash flows. You can also look at it as the percentage of interest an investment may yield over time. The “t” in this formula is the number of time periods in which new cash inflows are invested.
If you’re calculating the NPV of an investment that’s of a longer duration and has multiple cash flows, you’ll take a slightly different approach. To find NPV, you subtract the current value of invested cash from the current value of expected cash flows.
How to Calculate the Net Present Value of an Investment
The easiest way to calculate the net present value of an investment is using an online NPV calculator. You can also make these calculations in Excel. Regardless of whether you’re using a calculator or doing it manually, there are four key pieces of information you’ll need to do the math:
- Expected cash flows from an investment
- Discount rate
- Time period
- Initial investment
Once you have the details you can plug them into the NPV formula. Keep in mind that if you’re calculating NPV for a longer-term investment, you’ll need to discount cash flows for each period of the investment to present value. That’s meant to help you analyze outcomes more accurately by factoring in the time value of money.
For example, say that you plan to invest $100,000 in a single security. The discount rate for the investment is 5% and the time period for the investment is five years. You expect the investment to generate these cash flows for years one through five:
- Year one: $10,000
- Year two: $20,000
- Year three: $30,000
- Year four: $40,000
- Year five: $50,000
If you apply the net present value formula for each time period, you’d end up with $25,663.93. Since that’s a positive number, you could assume that the investment would most likely be profitable.
Now, what if the investment was projected to generate just $10,000 in cash flow each year? In that case, the net present value would be -$56,705.23 when the formula is applied. This is a simplified example of how net present value calculations work but it’s meant to illustrate what the formula can tell you about an investment.
What if you get $0 when calculating NPV? When the net present value of an investment is zero, it means it won’t make you any money, but it won’t cost you any money either. If you’re calculating NPV for a business investment and it’s $0, you’d have to evaluate whether there are intangible gains you stand to make. For example, an investment that raises your brand visibility might be worth it even if there is no positive cash flow to be had.
Advantages and Disadvantages of Using NPV
Net present value makes it easier to compare investments by distinguishing cash inflows and costs. In terms of the advantages or benefits of applying the NPV formula, it’s easy to calculate if you know the key information the formula requires. And because it factors in the time value of money, NPV can make it easier to predict the likelihood of an investment being profitable or not.
Like any other investment formula, however, there are some potential flaws. For one, the accuracy of the calculations you’re doing depends on how accurate your estimates are of future cash flows. NPV also doesn’t consider the actual return on investment (ROI), nor does it consider non-financial metrics that might affect outcomes and profitability.
NPV vs. Return on Investment vs. Internal Rate of Return
Net present value, return on investment and internal rate of return (IRR) can all be used to compare investments, but they don’t tell you the same thing.
Again, the NPV of an investment is a measure of how valuable it has the potential to be. ROI, on the other hand, reflects how much profit an investment is likely to generate for each dollar that’s invested into it. Internal rate of return can give you insight into an investment’s annualized rate of return.
The higher an investment’s ROI and IRR are, the more profitable they’re likely to be. Businesses can also use another metric, the payback period, to determine how quickly they’ll be able to recoup their initial investment in a project.
Knowing how to calculate the net present value of an investment is a useful skill to have if you want to make the best decisions for your portfolio. Keep in mind, however, that NPV shouldn’t be considered an exact predictor of an investment’s outcomes. And again, the accuracy of what comes out of an NPV calculation hinges largely on the accuracy of the numbers you put in.
- Choosing the right asset allocation matters for reaching your financial goals and it’s important to strike the right balance between risk and rewards. Talking to a financial advisor can help you understand how to apply the NPV formula when making investment decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One way to approach asset allocation is to use a percentage-based approach that’s tied to your age. For example, the rule of 110 suggests subtracting your age from 110, with the difference reflecting the percentage of your portfolio that should be held in stocks.
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