Net present value can be a useful metric in investment planning, helping you to evaluate the profitability of an investment. This is why we've compiled this short guide to net present value and how to calculate it.
Net present value (NPV) - explained
Net present value refers to the difference between present cash in- and outflows within a specified period. Put simply, to arrive at the net present value, you look at all the capital expected to be made through an investment, then translate the amount into its value of the present day. This can help you decide whether an investment or project is worth it or not. Net present value considers the time value of money (ie translating future cash flows into their value today). This helps account for inflation and gives you a better idea of future cash flow. Also, you can then use this metric to compare with the actual result of the investment.
Calculating the net present value
The formula for calculating the net present value of an investment is as follows: NPV = Cash flow / (1 + i)t – initial investment. "i" stands for the required return or discount rate and "t" stands for the number of periods.
However, if a project has more than one cash flow, you need to adapt the formula you are using. While this can get complicated, it is easy to think of the formula as basically the following: NPV = Today’s value of the expected cash flows − Today’s value of invested cash.
Interpreting your results
If your result is a positive net present value, the earnings from an investment or project are likely to exceed anticipated costs, which makes the investment profitable. If your net present value figure comes out negative, on the other hand, the potential investment is likely to result in a loss.
If you don't feel like you want to calculate NPV, there is several online calculators for identifying the net present value of an investment or project based on cash inflows and cash outflows.
Return on investment (ROI)
Another method of calculating the profitability of an investment is the return on investment. It refers to the net future value you are likely to receive from an investment over a given period. The formula for return on investment is as follows: ROI = (Total benefits – total costs) / total costs. Because the return on investment does not take into consideration the time value of money and is, therefore, less exact in predicting the profitability of an investment than NPV. However, the latter is a more complex equation.