Net present value or NPV represents the difference between the present value of cash inflows and outflows over a set period of time. Knowing how to calculate NPV can be useful when trying to determine whether an investment — either business or personal — will eventually pay off.
In capital budgeting, calculating the net present value can help with estimating the profitability of an investment or expansion project. Meanwhile, investors use the net present value calculation to gauge an investment’s potential rate of return based on the present value of its future cash flows and a discount rate, based on the cost of borrowing or financing.
What Is Net Present Value (NPV)?
Net present value is a measure of the value of all future cash flows over the life of an investment, discounted to the present after factoring in inflows, outflows, and inflation, which can erode the value of money over time.
When applying the net present value formula, you’re looking at whether revenues are greater than costs or vice versa to determine whether an investment or project is likely to yield a gain or a loss.
As mentioned, net present value is often used in capital budgeting. Businesses and governments can use capital budgeting methods to determine how much of a return they’re likely to see on a project before funding it. The NPV formula takes into account the time value of money, a concept which suggests that a sum of money received now is worth more than that same sum received at a future date.
NPV vs Present Value
NPV and present value may sound similar but they measure different things. Present value or PV is the present value of all future cash inflows over a set period of time. Companies use this calculation to estimate values for future revenues or liabilities. When you calculate present value, you’re trying to measure the value of future cash flows today.
Net present value, on the other hand, is the sum of the present values for both cash inflows and cash outflows. With the NPV formula, you’re trying to determine how profitable an investment might be, based on the initial investment required and expected rate of return.
NPV vs IRR
Analysts use IRR or internal rate of return to evaluate proposed capital expenditures. The IRR calculation determines the percentage rate of return at which a project’s cash flows result in a net present value of zero. Like NPV, internal rate of return is also a part of capital budgeting.
Both NPV and IRR measure potential profitability but in different ways. When calculating the net present value of an investment, you’re estimating returns in dollars. With internal rate of return, you’re estimating the percentage return an investment or project should generate.
Depending on whether you’re trying to target a specific dollar amount or percentage amount for returns, you may apply one or both formulas when evaluating an investment.
NPV vs ROI
Net present value measures expected cash flows for potential investments. You’re looking at future discounted cash flows to determine whether an investment makes sense financially.
Return on investment, or ROI, measures the efficiency of an investment, in terms of the rate of return that the investment is likely to produce. With ROI, you’re looking at the cash flows you’re likely to gain from an investment. To find ROI, you’d add up the total revenues less the total costs involved, then divide that figure by the total costs.
NPV vs Payback Period
The payback period is the period of time required for a return on investment to equal the initial investment. Payback period calculations don’t account for the time value of money. Instead, they look at how long it will take for you to realize a return from an investment that’s equal to the dollar amount that you invested.
Calculating the payback period helps determine how long to hold onto an investment. You might use this method if you’re trying to compare multiple investments to see which one is a better fit for your personal investing timeline. But if you want to get a sense of the total return you’re likely to realize, then you’d still want to apply the net present value formula.
Net present value calculations follow a distinct formula. A positive NPV means earnings from the investment should outpace the cost. Negative NPV, on the other hand, means you’re more likely to lose money on the investment.
The application of the formula depends on the number of expected cash flows for an investment or project.
NPV with a Single Cash Flow Investment
If you’re evaluating potential investments with a single cash flow, then you could use this formula to calculate NPV:
NPV = Cash flow / (1 + i)t – initial investment
In this formula, i represents the required return or discount rate for the investment while t equals the number of time periods involved. The discount rate is an interest rate used to discount future cash flows for a financial instrument.
Weighted average cost of capital (WACC) usually serves as the discount rate for calculating NPV. The WACC measures a company’s cost of borrowing or financing.
NPV with Multiple Cash Flows
If you’re evaluating projects or potential investments with multiple cash flows, you’ll use a different net present value formula. Here’s what the NPV formula looks like in that scenario:
NPV = Today’s value of expected cash flows – Today’s value of invested cash
How to Calculate NPV
If you want to calculate net present value using the NPV formula, you’d first need to know the expected positive and negative cash flows for an investment or project. You’d also need to know the discount rate. From there, you could complete your calculations in this order:
• List future cash flows for each year you expect to receive them.
• Calculate the present value for each cash flow.
• Add all present values for future cash flows together.
• Subtract cash outflows from the present value sum of future cash flows.
You’ll need to know the present value calculation to complete the second step. Here’s what that formula looks like:
PV = FV/(1 + k)N
In this formula, k is the discount rate and n is the number of time periods.
If you want to simplify your calculations you could look for an online net present value calculator. Or you could use the NPV function in Microsoft Excel. The NPV function helps calculate net present value for an investment based on the discount rate and a series of future cash flows, both positive and negative.
To use this function, you’d simply create a new Excel spreadsheet, then navigate to the “Formulas” tab. Here, you’d choose “Financial”, then from the dropdown menu select “NPV”. This will bring up the function where you can enter the rate and each value you want to calculate.
What Does NPV Show You?
The NPV formula should tell you at a glance whether you’re likely to make money from an investment, lose money or break-even. This can help when comparing multiple investments to decide where to put your money when you have a limited amount of capital to work with.
It works the same way in capital budgeting. Say a fast-food chain is trying to decide whether to expand into a new market which entails opening up 10 more locations. They could calculate the net present value for each location, based on expected cash flows, to determine whether moving ahead with the project is a financially sound business decision.
What Is a Good NPV?
Generally speaking, a net present value greater than zero is good. This means that the investment or expansion project is likely to yield a gain. When the net present value is below zero, you have negative NPV which means the project or investment is likely to result in a loss.
The higher the number produced by a net present value calculation, the better. But it’s important to remember that the results produced by applying the NPV formula are only as reliable as the data points used in the calculation.
Inaccurate cash flow projections could result in skewed numbers which may produce a net present value estimate that’s above or below the actual returns you’re likely to realize.
Example of Using NPV
Here’s an example of what the NPV formula looks like in action. Say that you own a food truck business and you want to invest $100,000 in buying new vehicles and upgrading your equipment. You plan to take out a small business loan for that amount at a 10% interest rate.
You expect to see these future cash flows from the investment:
• Year 1: $10,000
• Year 2: $25,000
• Year 3: $41,500
• Year 4: $62,500
• Year 5: $81,000
Based on these numbers, your net present value works out to $53,914.60. Since this is a positive number, you could assume that taking out the loan to buy the food truck could be a good investment.
Now, say you’re a large company that’s planning a $10 million expansion project. Your discount rate is 5% and your projected future cash flows look like this:
• Year 1: $50,000
• Year 2: $125,000
• Year 3: $275,000
• Year 4: $310,000
• Year 5: $430,000
If you apply the net present value formula, you get a result of -$9,492.91. Since you’re getting a negative NPV, you may need to take a second look at the investment to decide if it’s going to be worth it in the long term.
Advantages and Disadvantages of NPV
Net present value can help analyze and evaluate business projects or personal investments. You can easily see at a glance what you could stand to gain — or lose — from making a particular investment. But the NPV formula does have some limitations that are important to be aware of.
Advantages of NPV
Net present value’s main advantage is that it takes the time value of money into consideration. By looking at discounted cash flows you can get a better understanding of the viability of an investment, based on what you’ll get out of it versus what you’ll put in.
This can help with decision-making when choosing investments for your portfolio or making strategic capital investments in a business. Net present value calculations can also help companies with projecting future value based on the investments they make today.
Disadvantages of NPV
The biggest disadvantage or flow associated with net present value is that results depend on the quality of the information that’s being used. If your projections for future cash flows are off, that can produce inaccurate results when using the net present value formula.
NPV can also overlook some hidden costs involved in an investment or project which may detract from total returns. It also doesn’t take into account the margin of safety, or the difference between an investment’s price and its value.
Finally, it’s difficult to use net present value to evaluate projects or investments that are different in size or nature, as the input values are likely to be very different.
How Investors Can Use NPV
You can use NPV to evaluate stocks and other securities, including alternative investments, based on your time frame and projected profits. With stocks, for example, net present value can give you an idea of whether a company is a good buy or not by calculating NPV per share.
To do that, you’d divide the company’s net present value by the number of outstanding shares in the company to get this number. If the net value per share is higher than the stock’s current market price, then the stock could be considered a good buy. On the other hand, if the net value per share is below the stock’s current market price that suggests you might lose money if you decide to buy in.
Understanding the net present value formula can help with making smarter investment decisions. As with any tool, most investors use NPV along with other financial ratios and forms of analysis before deciding whether to purchase any asset.
Whether you’re using the NPV formula or not, SoFi Invest is ready to help when you start investing in stocks, exchange-traded funds, cryptocurrency and IPOs. Opening an account on the SoFi Invest® investment app is a great way to begin building a portfolio.
Photo credit: iStock/Sanja Radin
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