Net Present Value - NPV

Categories: Company Valuation

As a concept, the net present value seeks to assign a total value for an asset that is expected to provide cash flow over a period of time. You have an asset that pays off a little at a time. What's that worth right now? What amount would be a fair price for it, if you were to try to sell it now? Net present value effectively answers those types of questions.

Calculating the net present value involves a good deal of expectation and assumption. It's a rigorous mathematical operation, but, since it involves the future, many of the variables are based on probabilities and educated guesses.

You loan your brother $1,000. He promises to pay you back over the next year, plus a good amount of interest. Under the deal, he'll give you $100 a month for each of the next 12 months. So, by the time the year is up, you'll have $1,200 back...your original $1,000 plus a $200 profit...a 20% return. The day after making the deal with your brother, your dog gets sick and needs an operation. Suddenly, you need that cash you handed over to your brother...except he's already spent it. Your sister steps in, offering to buy your brother's debt from you. She asks you to name a fair price.

Your sister is basically asking you to provide the net present value for that cash flow you expect from your brother. The deal promises to pay off $100 a month for the next 12 months...meaning it is theoretically worth $1,200.

But net present value gets more complicated than that. There are a bunch of factors at play. For one, your brother might not pay off the full amount. He may pay on time for five months, then give $50 in the sixth month, and finally stop answering texts in month number seven...by next year, he might be living under an assumed name, only sending coded messages to your mom via carrier pigeon. Also, you have to account for inflation. A 20% return in a year is pretty good. But if inflation eats away that return by three percentage points, suddenly the net return becomes 17%. Basically, a dollar right now is worth more than that same dollar in 12 months. $100 now might have the equivalent buying power of $97 by the end of the term.

Your brother is pretty reliable, but something could happen to him (for instance, he could catch the same thing your dog has and become incapacitated). You put the chance of default at 10%. Meanwhile, you project inflation will eat away about 3% of the value of cash flow as well. So $1,200 nominal value for the deal becomes $1,164 after inflation. Then the chance of default knocks another 10% off. That leaves you with a net present value for that loan to your brother of $1,047.60.

Real-life net present value equations can get even more complex. A lot of variables go into the calculations and, as we noted, it can involve some guesswork. That guesswork should be based on data and reasonable assumptions...but there is an element of the unknown inherent in the process.

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your money Was that good I answer to both No

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which have horrible odds of any kind of decent pay

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pension bill So why shouldn't it be people who didn't

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graduate high school Right Well the time waiting is a

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big deal to in a world where the stock market

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broadly speaking doubles on its own About every eight nine

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ten twelve years Something like that This calculation is done

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over very long periods of time and it's held true

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for about a century and change in america So if

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he took thirty six years to double your money well

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it implies you only made two percent a year as

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your rate of return Remember that rule of seventy two

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thing Yeah that right there Seventy two divided by thirty

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six and you get a whopping two percent return Well

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in that same period of time the market might have

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to be twenty grand in thirty six freakin years under

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your watch we'll have you just put it into an

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again here to be forty grand and then doubled again

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doubling right here after thirty six years maybe one hundred

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sixty grand And that's just an index fund Nothing fancy

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with their dividends And if they do well it means

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the s and p five hundred But if you pegged

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three percent and change eight ish percent total returns That

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we're ignoring the use of dividends proceeds to buy more

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