Stock investors who apply fundamental analysis to the positions taken in the market will often encounter net present value calculations when they review financial statements and reports. Net present value, often shortened to NPV, is used by accountants and analysts to get a reasonably accurate idea of how much their investments or capital expenditures will be worth.
In essence, NPV calculations are similar to return on investment; however, whereas ROI provides a ratio, NPV provides monetary information in today’s dollars. Financial analysts use NPV to present the actual value of an investment in real money terms.
One of the most important aspects of NPV calculations is that they take into consideration the time value of money. For companies such as Berkshire Hathaway, NPV calculations are crucial because they are holding entities that do not usually take on management or operational roles.
Let’s say a major investor like Warren Buffett considers taking a large position on a personal transportation service such as ZipCar or Uber; after reviewing financial statements and meeting with analysts, Buffett may estimate that he can make a seven percent profit over the next three years, but he would first run NVP calculations to determine if this investment would actually make sense. A seven percent may sound reasonable on paper, but someone like Buffett will know that money in the future is expected to be less than money today; this is when the aforementioned time value of money comes into play.
NPV is not something that can be easily calculated by hand; the most common method involves using a special function found within Microsoft Excel. This function takes into account discount rates, payments that will need to be made in the future, and income that will be received. The discount rate is annualized, the payments are negative and the income received is positive. The Excel syntax will look like this:
NPV (annual discount rate, investment cost at the end of the year, [expected annual return]…)
In most cases, the annual discount rate will be the projected inflation rate set by the Federal Reserve or by foreign central banks for international investments. In addition to Excel, NPV functions can also be found in financial calculators.
Many investors tend to give NVP calculations too much credit. Even with the time value of money consideration and the real dollar amounts, it is important to note that NPV is still a projection that makes assumptions about future returns. NPV tends to work out better when the investments are sovereign bonds since the annual returns are contractually set; nonetheless, there is still a certain degree of speculation at play.
NPV calculations are routinely made by publicly traded company that are serious about their commitment to increasing value for shareholders. Whenever a company reports that it has made a major investment or capital expenditure, the NPV of the financial operation should be included in the quarterly report. If a couple of quarters go by without NPV calculations, investors should be concerned about the viability of the project.