Did you know the world’s famous stock investor Warren Buffet bought stocks when he was 11 years old? And yes, he filed for taxes at the age of 13 years. Isn’t this pretty amazing? We don’t know about your goals but ours at the age of 11 was to play with friends and eat pizzas all day around.
Buffet is a business tycoon and a philanthropist who is known as one of the most successful stock market investors over the globe. This is not a magic that happened in a year, it took several years and practice to grow his wealth and further sharpen his powerful investing techniques.
He has consciously taken efforts to explain the budding investors with the following quote:
“The techniques and formula to evaluate stocks and businesses are identical. The formula for financial gain for evaluating all assets that are purchased for financial gain has been same since it was first laid out.
So, what do you think was the ancient formula? And how does Warren Buffet come to know about this and investment opportunities?
Well, the simple answer is he uses Net Present Value (NPV).
Well, we cannot promise that you will be the next Warren Buffet; we can provide complete information on Net Present Value and how we can identify great investments. So, let’s dive in with details.
What is Net Present Value?
NPV is the present value of net cash inflows differentiated by cash outflows over time. It is used as a financial tool for cash flow analysis. It is also used in investment planning and capital budgeting.
NPV is widely used for evaluating revenues, expenses, and capital costs compared with investment analysis. Also, the biggest advantage of NPV is that it considers the time value of money that has a major impact on the present value of investment.
Why NPV is important?
You know that NPV is an inevitable evil. It depends upon the magic of time value of money that a rupee spends today won’t be the same in the future. The best example is the hike of petrol prices, which went from 72 to almost 98 in just a year! A massive 28% inflation. This was an example of petrol. Similarly, all the commodities get expensive over time.
NPV Example:
Are you ready to see NPV in action? Let’s understand that a pet supply company is confused in investing between two projects. The discount rate is 10%
The formula for NPV is:
NPV= Cash flow/ (1+ discount rate) ^ no. of time periods
Project 1 details are:
Initial investment: $ 10,000
Discount rate: 10%
Year 1: $ 5,000
Year 2: $ 15,000
Year 3: $ 9,000
Year 4: $ 18,000
Let’s calculate the present values for each year:
Year 1: 5,000/ (1+0.10) ^ 1 = $ 4,545
Year 2: 15,000/ (1+0.10) ^2 = $ 12,397
Year 3: 9,000/ (1+0.10) ^3 = $ 6,762
Year 4: 18,000/ (1+0.10) ^4 = $ 12,294
Now let’s take the sum of these present values and subtract the initial investment from the sum obtained to get the net present value
NPV = ($ 4.545 + $ 12,397 + $ 6,762 + $ 12,294) - $ 10,000
NPV = $ 25,998
Project 2 details are:
Initial investment: $ 5,000
Discount rate: 10%
Year 1: $ 8,000
Year 2: $ 16,000
Let’s calculate the present value for each year:
Year 1: 8,000/ (1+0.10) ^1 = $ 7,273
Year 2: 16,000/ (1+ 0.10) ^2 = $ 13,223
Here are the final results after getting summation of the above figures.
NPV= ($ 7,273 + $ 13,223) - $ 5,000
NPV= $ 15,496
Conclusion: The NPV of project 1 is higher than the NPV of project 2. The pet supply company hence should choose the project 1 for investment in that project.
Drawbacks
Well, you might think that this method of investment decision is free from any defects. However, the drawbacks lie in the core itself.
- Assumptions: discount rate calculations lies on assumptions, which has a huge possibility for arithmetical error.
- Other factors ignored: NPV majorly considers quantitative factors and qualitative factors are ignored.
- Difficult comparison: Every project has different cash flow life span and hence it becomes difficult to compare them.
- Complex: it is impossible to calculate the profitable investment if you do not know how to use the MS-Excel functions or NPV Calculators.
Wrapping up
To sum up, NPV is the difference between net cash inflows and outflows used in many financial decisions. It is essential to consider the time value of money. Moreover, it is the best method for calculation as compared to other capital budgeting techniques.
But, always remember that the best present you have is that you are in the present. So, be wise and also consider the present situation as well as financial position before making any investment decisions.
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