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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Finance: What are Time-Weighted Rate Of ...1 Views
Finance allah shmoop what are time and risk waited rates
of return a dollar today is worth more than a
dollar tomorrow Like that's the central prayer of the financial
force Here's the gist You've double your money in an
investment Is that good Bad ugly mon We need a
whole lot more information here Tto answer Did you buy
thirty eight million and two dollars worth of lottery tickets
and that last two dollar ticket got you seventy six
million in winnings Was that like a good investment Or
how about this You took thirty six years to double
your money Was that good I answer to both No
not at all The lottery ticket example is a risk
waited return The lottery famously takes advantage of ignorant people
spending their hard earned money on tickets representing dreams but
which have horrible odds of any kind of decent pay
back But the lottery makes go into a vegas casino
look like actually a good deal so you may win
but it's a bad risk no matter how you look
at it And hey somebody has to pay those teacher
pension bill So why shouldn't it be people who didn't
graduate high school Right Well the time waiting is a
big deal to in a world where the stock market
broadly speaking doubles on its own About every eight nine
ten twelve years Something like that This calculation is done
over very long periods of time and it's held true
for about a century and change in america So if
he took thirty six years to double your money well
it implies you only made two percent a year as
your rate of return Remember that rule of seventy two
thing Yeah that right there Seventy two divided by thirty
six and you get a whopping two percent return Well
in that same period of time the market might have
doubled in four times So the ten grand that double
to be twenty grand in thirty six freakin years under
your watch we'll have you just put it into an
index fund of the s and p five hundred over
that same time period Well it would have doubled once
along the timeline here to be twenty grand then doubled
again here to be forty grand and then doubled again
here to be a tigre rine and then ah forthe
doubling right here after thirty six years maybe one hundred
sixty grand And that's just an index fund Nothing fancy
Not warren buffett Just a basic vanilla index fund that
anyone with two hundred fifty bucks in their pocket can
buy And it's worth noting dividends which often get ignored
in the financial press actually matter a ton when it
comes to the calculation of long term investment results Generally
speaking that continued payment of dividends is a low risk
adventure Very few companies ever cut or fully do away
with their dividends And if they do well it means
a pretty much everything is rotten in denmark so you
can count on dividends The bolster overall returns that historically
dividends have had a wide range of somewhere between two
and seven or eight percent for the mid range of
the s and p five hundred But if you pegged
them around and three ish percent today and changed to
reflect the modern era well then the overall market need
only compounded about five percent To deliver that five plus
three percent and change eight ish percent total returns That
will allow the stock market to double about every nine
years or so right so we're ignoring taxes here but
we're ignoring the use of dividends proceeds to buy more
shares every quarter as well when those dividends air paid
So when you think about time and risk think about
them like they're a kind of financial stone soup which
when mixed together with the right spices of tax hedges
leverage and a bull market well make a really nice
retirement meal and you don't even need your teeth on 00:03:22.773 --> [endTime] a bonus