What Is Net Present Value (NPV)?

Want to make smart investment decisions regularly? Then you need a good understanding of net present value (NPV). Just look at Warren Buffett.

Buffett is an investor, business magnate, and philanthropist. He's known as one of the most successful investors of all time. In fact, he bought his first stock when he was 11 years old and filed for taxes at 13. But guess what? He uses NPV to evaluate investment opportunities.

In this post, you’ll learn about net present value and the NPV formula. Then we’ll cover how to interpret NPV and calculate NPV using Excel.

Table of Contents

• What is net present value?
• Net Present Value Formula
• How to Find Net Present Value
• How to Interpret NPV
• How to Calculate NPV Using Excel

What is net present value (NPV)?

Net present value (NPV) is the value of projected cash flows, discounted to the present. It's a financial modeling method used by accountants for capital budgeting and analysts to evaluate the profitability of proposed investments.

You can use the NPV method to evaluate current or potential investments and calculate your expected return on investment (ROI).

Net Present Value Formula

NPV is calculated with this formula:

Net Present Value (NPV) = Cash flow / (1 + discount rate) ^ number of time periods

When you have multiple periods of projected cash flows, use this formula to calculate the present value for each time period. Then sum up the values and subtract the initial investment from the sum to get the net present value.

The discount rate depends on the company and how it gets its funding. For example, if shareholders expect a 10% return on investment, a business will often use that percentage as the discount rate.

How to Find Net Present Value

Now, let’s put our net present value formula to the test and dive into an example.

Suppose Pet Supply Company is looking at two research and development projects. One involves creating a line of new dog food. The other focuses on improving an existing grooming kit for cats. Stakeholders expect a 10% return on investment.

The R&D team wants to pick one of the projects to invest in.

Let’s use the net present value formula above to calculate the NVP for both projects.

Dog Food R&D

• Initial investment: $10,000
• Discount rate: 10%
• Year 1: $5,000
• Year 2: $15,000
• Year 3: $9,000
• Year 4: $18,000

Now, calculate the present values for each year of the project:

• Year 1: 5,000/(1 + .10)^1 = $4,545
• Year 2: 15,000/(1 + .10)^2 = $12,397
• Year 3: 9,000/(1 + .10)^3 = $6,762
• Year 4: 18,000/(1 + .10)^4 = $12,294

Next, find the summation of these present values and subtract the initial investment amount to find the net present value.

NPV = ($4,545 + $12,397 + $6,762 + $12,294) - $10,000

NPV = $25,998

Cat Grooming Kit R&D

• Initial investment: $5,000
• Discount rate: 10%
• Year 1: $8,000
• Year 2: $16,000

Here’s the present value for each year of the project:

• Year 1: 8,000/(1 + .10)^1 = $7,273
• Year 2: 16,000/(1 + .10)^2 = $13,223

And here’s the result after the present value is calculated for each cash flow and time period:

NPV = ($7,273 + $13,223) - $5,000

NPV = $15,496

How to Interpret Net Present Value

You now know how to calculate a net present value. But what does the result actually mean? In this section, we’ll discuss how you can interpret your NPV. Then, we’ll interpret the NVPs in our Pet Supply Company example.

When the NPV is Positive

A positive net present value (NPV) indicates that the expected cash inflows from an investment or project will be greater than the costs it will incur.

In other words, your project is expected to be profitable. By investing in positive NPV projects, a company can increase its profitability and shareholder value. This can also help the company secure additional funding in the future, as investors are often more willing to work with companies with a proven track record of profitable investments.

When the NPV is Negative

If seeking investment externally, a negative NPV likely means the company will not receive funding or investment for the project. A negative NPV may also impact the company's credit score and debt obligations if the project is financed through borrowing.

If seeking investment externally, a negative NPV likely means that the company will not receive funding or investment for the project. A negative NPV may also impact the company's credit score and debt obligations if the project is financed through borrowing.

Choosing Between Projects

Finding NPV can provide valuable insights into a project or investment’s viability. Results from this calculation can help investors compare different options and determine which one is most financially beneficial. Often, they choose which project yields the greatest ROI.

So let’s dive back into our Pet Supply Company example. Which of the two projects should we invest in?

Let’s review:

• Dog Food R&D NPV: $25,998
• Cat Grooming Kit R&D NPV: $15,496.

The dog food project has a higher NPV value and potential ROI. Pet Supply Company should focus its research effort on this product.

How to Calculate NPV Using Excel

You can also calculate NPV in Excel. But to get an accurate final result, you need to calculate the inputs properly.

How to Calculate NPV with Excel

Net present value (NPV) can be calculated in Excel by entering the discount rate, the number of time periods (in consecutive order), and entering the expected cash flows for each time period. Then, enter the following formula in a new cell: =NPV(select the discount rate cell, select first cash flow cell:last cash flow cell.

Here’s a step-by-step guide you can follow to calculate NPV using Excel:

1. Determine the discount rate and add it to a cell.
2. Add the number of time periods in consecutive order.
3. Enter the expected cash flows for each time period.
4. Calculate NPV by typing this Excel formula in a new cell: =NPV(select the discount rate cell, select first cash flow cell:last cash flow cell)

Download the Excel template below and try it out.

Image Source

This is a quick method of calculating NPV, but more advanced financial modeling is often used to see each calculation and input that goes into the formula. Investors and analysts can see all the formulas used for the calculations, which makes it easier to audit.

Getting Started

NPV translates the money you expect to make from an investment into today's dollars. With NPV, you can effectively evaluate projects and investments to determine whether they’ll be profitable.

Now, pull out your calculator, and get started!