No one calculates NPV by hand, Knight says. Any time a company is using today’s dollars for future returns, NPV is a solid choice. In fact, it’s the model that Warren Buffet uses to evaluate companies. It’s also used in mergers and acquisitions (though it’s called the discounted cash flow model in that scenario). Managers also use NPV to decide whether to make large purchases, such as equipment or software. And fortunately, with financial calculators and Excel spreadsheets, NPV is now nearly just as easy to calculate. That’s what makes NPV a superior method, says Knight. The attraction of payback is that it is simple to calculate and simple to understand: when will you make back the money you put in? But it doesn’t take into account that the buying power of money today is greater than the buying power of the same amount of money in the future. “It’s far superior to the payback method, which is the most commonly used,” he says. The boldest innovations are the hardest to measure. Two, it provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return. One, NPV considers the time value of money, translating future cash flows into today’s dollars. Knight says that net present value, often referred to as NPV, is the tool of choice for most financial analysts. When a manager needs to compare projects and decide which ones to pursue, there are generally three options available: internal rate of return, payback method, and net present value. By looking at all of the money you expect to make from the investment and translating those returns into today’s dollars, you can decide whether the project is worthwhile. In practical terms, it’s a method of calculating your return on investment, or ROI, for a project or expenditure. “Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment,” says Knight.
To learn more about how you can use net present value to translate an investment’s value into today’s dollars, I spoke with Joe Knight, co-author of Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Meanand co-founder and owner of What is net present value? But how exactly do you compare the value of money now with the value of money in the future? That is where net present value comes in. Future money is also less valuable because inflation erodes its buying power. That’s because you can use it to make more money by running a business, or buying something now and selling it later for more, or simply putting it in the bank and earning interest. Most people know that money you have in hand now is more valuable than money you collect later on.
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