What is Net present value?
Net Present value is simply the difference between the value of incoming cash vs outgoing cash over a given period. It is useful for investors to analyze the profitability of a project or investment.
A positive NPV is when the projected earnings from the project exceed the projected costs in the present dollar or pound value. A project or investment with a positive NPV will be profitable and a project with a negative NPV will incur losses.
NPV is very important for everyday investments, whether you are investing in a startup or real estate. NPV helps mitigate the difficulty in determining what future cash will be worth. At this point, we all know future cash is worthless due to inflation. This means present cash will be worth more than future cash and is the major factor we should consider when making investments.
To account for this future fall in the value of money NPV is used by discounting any expected future incoming cash. This allows us to know what that cash is worth today and if it is a good investment.
A practical example: If you were going to buy a house as an investment and after calculating the future cash flow from the house you discount it to one Net present value sum of £50,000. If the house was listed for anything less than £50,000 you should buy it as this represents a positive NPV. If the owner agreed to sell the house for £30,000 then the investment represents a £20,000(£50,000 - £30,000) net gain during the calculated investment period.
If the house is listed for more than £50,000 then this will represent a negative NPV and not a good investment for the current time period.
NPV isn't a perfect formula, it doesn't account for unforeseen circumstances, takes into account so many assumptions and might have figures which are more than optimal such as cash flow figures.