what net present value means in finance
Net present value, or NPV for short, is simply the difference between the present value of a business’s cash outflows and inflows. It is often used to measure an investment’s profitability compared to its initial cost. NPV can help determine if an investment will be worth it by discounting future values to their worth at the time of interest.
The concept of NPV is widely applied in business and economic analysis, with the concept dating back to the early 1700s.
According to Jordan Sudberg, net present value is simple: It’s a way to determine if a cash-generating activity will be more profitable than it costs to perform. While most people learn about NPV regarding investments, it is applied to almost any other type of future financial undertaking. In accounting, for example, NPV is used when calculating the liquidation value of a company.
Sudberg says that the first thing to know about net present value is that it’s a discounted cash flow. That means that the future value of money is treated as less valuable than money presently. The fact that money in the future is worth less than today is due to inflation; over time, the dollar’s value decreases. So, for example, even though a business may receive $1 million 10 years from now if inflation over that 10 years averages 3 percent, that million dollars has the purchasing power of only $690 in today’s dollars.
When calculating net present value, a person needs a cash flow projection over several years. Most startup businesses would have no more than a few years’ cash flow; a company that has been around for longer can provide a 10-year or longer projection. Sudberg says that the present value of all future inflows is typically calculated and then subtracted from the present value of all outflows to see if there is any net value.
When considering investing in stocks, bonds, or other securities, market participants may look at the net present value of a security. The analysis works the same way when considering an investment in any other product.
For example, suppose a company sells 10 percent of its stock for $10 per share. So, if a market participant buys 1,000 shares, she will receive $10,000 cash upfront.
The other side of the trade sees 10 percent of the company going to another investor for $10 per share. The market participant who sold the stock to the first investor must buy it back to keep ownership. So, to buy back the 1,000 shares from the company, the trader must come up with $10,000 of his own in addition to the $10 per share he receives.
The market participant owns 11 percent of the company after buying back all of his shares. As long as he receives at least $11 per share for his original shares, he’s made a profit. If the company’s stock price increases, the market participant who sold the stock to the first investor must pay more for his shares. If the price falls, he will receive less per share than he originally paid. The market participant can either hold or sell shares and take their loss in that transaction.
If a venture capitalist invests in a business as an angel or seed stage investor, NPV is part of her due diligence process. Angel investors typically require an NPV of at least 25 percent or more to make a deal. A seed-stage venture capitalist also looks for at least a 15 percent return on investment.
Jordan Sudberg says NPV is good for business and economic development because it provides a sequence of cash flows. In the first year, for example, the cash flow is negative. But next year, it’s positive. After that point, the series of cash flows becomes positive.