How it works
NPV rests on the time value of money: cash today is worth more than the same cash later. Each future cash flow is divided by (1 + discount rate) raised to the number of years. The pieces are then added up and the initial cost is subtracted.
The discount rate should reflect the risk of the cash flows. A riskier project needs a higher discount rate. NPV is expressed in money, so it shows how much value is created.
NPV = Sum of [Cash flow in year t ÷ (1 + r)^t] − Initial investment
A simple example
How it is used
- Deciding whether to go ahead with a project or an acquisition.
- Ranking projects by the value they create.
- The core of every DCF valuation.
Common mistakes
- Using a discount rate that does not match the risk.
- Ignoring the timing of cash flows.
- Leaving out the cash cost of working capital.
- Comparing projects of different lengths without adjusting.
Questions
What does a negative NPV mean?
It means the investment is expected to earn less than the return you required, so it would destroy value at that discount rate.
What is the difference between NPV and IRR?
NPV gives the value created in money. IRR gives the percentage return. They usually agree on whether to accept a project, but NPV is better for comparing projects of different sizes.
Keep learning
- What is IRR (internal rate of return)?
- What is a DCF (discounted cash flow)?
- What is WACC (weighted average cost of capital)?
- Guide: Business valuation
- Glossary: Net present value (NPV)
- Glossary: Internal rate of return (IRR)
- Glossary: Discount rate
- Glossary: Discounted cash flow (DCF)