Present value is a financial concept that reflects the prevailing “time is money” wisdom. In its simplest form, calculation of a present value for an investment allows an investor to compare one alternative for investing to another. While net present value (NPV) can be calculated by hand, the process of calculating NPV is likely to be simplified by using a financial calculator or an online website. Perhaps the major benefit of NPV for investors is to serve as a constant reminder that the risk and timing of future cash flow can change everything.
A concise definition of present value provided by Expectations Investing is the following: “The value today of tomorrow’s cash flows.” If an investor is considering three investment opportunities such as common stocks, gold bullion and commercial real estate, it can be difficult to compare them. However, the concept of present value is one solution to this dilemma.
The Primary Components of Net Present Value
The three basic present value elements that an investor needs to consider are timing, risks and future cash flow amount. Using an investment example of an apartment building purchased by a commercial real estate investor, income projections should be made prior to the acquisition. Monthly and annual income after expenses can be estimated, but there is always some uncertainty because of changing vacancy rates and rental income.
Whether receiving income from apartment rentals or dividends from a common stock, money will frequently be received in the future by an investor rather than immediately. A dollar received next year is worth less than a dollar received today because current cash can be reinvested at a rate of return that produces additional income. In comparison, a dollar received in five years is worth even less. Each investor should decide what their own reinvestment return is in order to calculate net present value. Some investors use the interest rate available with conservative choices such as bank savings accounts. However, in recent years this rate has been extremely low (often less than 1 percent annualized). An alternative approach is to estimate the annual rate of return that you would want from an investment similar to the one under consideration. Many investors will choose a rate between 5 and 10 percent.
Few investments can be considered risk-free because of the various possibilities of something going wrong due to unexpected events. This is one reason why savings accounts pay only 1 percent or less while a common stock dividend might be 6 percent. There is no guarantee that the dividend will stay the same. As a result, investors expect higher returns in exchange for assuming some risk.
Here is a basic example of net present value. Let’s assume that the apartment cash flow will be a one-time amount of $1,000 received in five years and that your expected reinvestment rate is 10 percent based on other choices for investing at a similar risk. In this case, the NPV is $620. With this information, the most that you should pay today for this investment is $620. The calculations become more involved with annual or monthly cash receipts rather than the lump-sum example, but the investment principles are identical.
The Critical Importance of Investment Income
Some investments such as gold bullion do not produce any income at all. The expected return or profit is based entirely on capital appreciation when the gold is sold. For example, if an investor expects to sell their gold in five years, there will not be any income other than the selling price and that will not be received for several years. With an investment that produces regular income, the net present value calculations include the cash flow received each year in addition to the eventual selling price. The income received can help investors offset the delay and uncertainty about the value of their investment when it is sold.
– Research Optimus