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Net present value

Net Present Value is the current value of all future cash streams from an investment.

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Expanded Definition

The present value of a future cash payment is the value to you today of that payment in the future. Adding "net" onto that means that you're adding up all the future cash payments, all at different times, and creating an estimate of what those future payments are worth in terms of today's money. How does this work and why is it important?

Let's say you want to buy common stock of company XYZ. You know that last year, they paid $1 in dividends, and the stock costs $25. Should you buy this today, you will have spent $25 cash to gain a $25 assett. So far so good. You predict that the dividend will remain consistent at $1 (for the sake of our example, let's keep things simple) for every year going forward.

So if you think you're going to get $1 a year in perpetuity, that is worth something to you, but not nearly as much as having that money in your hot little hands today. There is risk to consider. There is also inflation, and opportunity cost. To account for that what-if scenario, NPV uses a discount rate to reduce the value of each future payment. The discount rate is your best guess of what a dollar will be worth in the future. You might use your favorite rate of inflation for this, or you might use the rate of return on a safer investment, depending on what you are valuing.

For our example, we will use a discount rate of 5% annually. This means that a dollar next year will be worth $0.95 today. Compounding the discount rate each year, a dollar earned in year 3 would be worth $0.857 today, and so on, approaching but never reaching zero.

Since the discount rate is a guess, and since future cash flows are speculative for many types of investments, in practice, NPVs are often calculated with only a few years worth of cash flows, hopefully underestimating the investment's value. Mortgages and loan payments have more certainty, but can be calculated in a similar manner.

Microsoft Excel has an NPV function that uses a summation formula to calculate the values of your cash flows based on a fixed time schedule, to use it, type =NPV() and the wizard will walk you through preparing the cash flow list.

Remember to be conservative when applying your discount rate.

A $1 dividend over 8 years with a discount rate of 5% yields an NPV of $6.46 for the dividends. If I feel that this is a decent estimation then I can help use it when deciding whether to buy my stock for $25. If the dividends alone are worth about $6.46 today, then I'm getting a deal if the rest of the company is worth more than $25 - $6.46, or more than $18.54.

Cash flows can be more complex than $1 each time period, in fact you can have positive and negative flows, and even use NPV to calculate the value to you of anything from periodic sales of comic books to finding the total value of your credit card payments. Have fun!

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