A Beginners Guide to NPV and How it Affects Investments

The US Stock Exchange, however, dwarfs all the others in the world. According to Statista, the US Stock Exchange accounts for around 56% of all the world’s stocks. After the US, come Japan and China, although India is no slouch.

The National Stock Exchange of India was the world’s largest derivatives exchange during 2021. It has a total market capitalization of $3.4 trillion.

Every single day, billions of shares and stocks trade hands. Some investors make decisions that earn them a fortune, while others make unwise trades.

How can you evaluate whether an investment is a worthwhile one, and what does it mean when NPV is mentioned?

How do you evaluate if an investment is a wise choice?

When it comes to evaluating a business as an investment it may not be as difficult or complex as it appears. However, many investors do get this wrong.

There are several areas that should be looked at when considering an investment, and these include balance sheets, cash flows, and what sort of return on assets can be expected.

You need to see that a business is liquid, and you also need to see what income is being made. Indeed though, you will need to look at the investment in terms of future profitability.

One area that you may hear when investments are considered is NPV. This refers to the term, net present value.

What is the net present value?

Investopedia defines NPV as the present set of cash inflows against the present set of cash outflows. This is set against a period of time and is used to test the profitability of a business.

A negative net present value would indicate the investment would be a poor one, and should therefore be discarded. NPV is there so that investors can look to see whether a business is worth investing in, and would it be profitable or more likely to fail.

What NPV does is show you how the present value will translate into future value. Will the NPV grow, or will inflation, for instance, outstrip it?

How do you calculate net present value?

There is a formula for calculating net present value, and this can be found on many investment websites.

However, a simplified version exists as the following:

Net present value equals today’s values of expected cash flows minus today’s values of invested cash

A far simpler way to calculate NPV online is to use a net present value calculator. What this does is to take the initial investment, any discount rate, and the length of time the investment is over.

NPV can be calculated over a number of years, and many analysts will look at decades rather than short periods.

For instance, if inflation was 5% and your investment was $100, then you need to make a profit of more than 5% (the inflation rate) to make a profit. This is how NPV works. It looks at what the value will be in the future against its value now.

An online NPV calculator can simplify this process, especially for any investment considerations.

Is NPV the same as NAV?

Sometimes NAV and NPV can become confused. NAV refers to the net asset value.

Where NPV refers to the present value and is used to calculate future valuations, NAV is used differently. Net asset value refers to a company’s total assets minus any liabilities they have.

When you need to understand your company’s true worth, and how to value your business, is where NAV and NPV can become confused.

Why is NPV important?

The phrase “time value of money” is one you should understand when talking about NPV.

It refers to the fact that money is worth more in the present than it will be in the future.

NPV provides accurate information to the people that decide whether to make large purchases in businesses. Or the people that want to invest further in a company.

Without NPV, mergers and acquisitions would be harder to evaluate. If an NPV is negative, then the deal should be avoided. It means simply that cash will continue to pour out. However, the opposite is true. If there is a high NPV then you can be more assured of a profitable future.

How does NPV affect investments including stocks?

When wondering how to calculate the future value of your financial goals, it would be wise to understand NPV.

Previously you have read about how inflation affects NPV. Also, when the formula and online NPV calculator was mentioned, there was talk of a discount rate. These two are the same thing.

Inflation is talked about as the discount rate when it comes to NPV. And this can affect investments such as stocks and shares. You only need to look at the UK’s headline inflation rate to see how it can affect things.

When pondering on whether to invest in stocks, net present value is a powerful tool. But stocks are subject to many other aspects other than just inflation.

Anything from war, to data breaches, to poor publicity, can affect the valuation of a stock. This is something that NPV calculations and formulas just cannot predict.

All manner of things can affect investments including elections, as was seen when gold rallied as Joe Biden neared the White House.

There is an easy way to mitigate this, although it is not foolproof. When NPV is applied to a potential investment in stocks, the discount rate is set much higher than normal.

It would be standard to add an inflation, or discount rate at six percent say. This would then cover any surprise eventualities, and if the NPV is still positive then the investment should, or could, be a good one.

Are there any advantages or disadvantages to NPV?

NPV is not a perfect solution to determining the value of any future profits an investment may make. In the case of stocks, there are far too many factors for NPV to be wholly accurate as you have seen.

Nevertheless, NPV has a number of advantages, and some disadvantages too.

Advantages of NPV

The main advantage of using net present value calculations is that it provides something of an unambiguous answer.

It uses the very real idea that money held today will be worth less in the future. It is able to help then to predict whether an investment holds any value for the future.

Because it uses inflation as its discount rate, it takes away some of the uncertainty of an investment. It can help to show an investment with a heavily positive NPV.

It takes into consideration the cost of capital along with inherent risks, which some other formulas and metrics don’t.

Disadvantages of NPV

There are some disadvantages to NPV also though, and these include being able to compare different sized projects.

A smaller project may have higher returns than a larger one, but the formula will show the larger project has a higher NPV.

NPV can also be somewhat flawed when it comes to the cost of capital. This is because a certain amount of guesswork has to go into it, and this can make the NPV less accurate.

NPV also doesn’t consider any hidden costs, and cannot predict possible future opportunities within a business.

Summary

Despite its flaws, NPV is a widely used tool when it comes to investments. Its biggest strength lies in understanding that today’s money will be worth less in the future and thus looks to present profitability in a simple manner.

It can be used for any investment, and this includes stocks. However, other aspects need to be considered, and a higher discount rate must be incorporated.

When working out the NPV of any investment, it is simple to use an online calculator. Many spreadsheets will also have an NPV function built-in. Far easier than trying to calculate it out with a pencil.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes