There are many ways to analyze and compare the fundamentals, returns, and risk of publicly traded investments such as stocks, bonds, and mutual funds. If you have an investment opportunity for a franchise, rental property, or your business, though, you may have to rely on other resources and metrics. Net present value (NPV) and internal rate of return (IRR) are two standard financial measures that can be used to evaluate and compare investments based on their potential for cash flow.
Understanding NPV and IRR can help you make sound financial decisions about an investment opportunity or project. Learn how the measures work and when to use them.
Evaluating Net Present Value
A basic principle of investing is that the value of one dollar today is worth more than one dollar in the future. That's because the dollar today can be invested and earn a return over time. NPV translates future cash flow generated by an investment into what those dollars are worth today, assuming a rate of return called the “discount rate.” For example, the value today of $10,500 one year in the future, discounted at 5%, is $10,000.
The discount rate you select is key because it represents how you want to evaluate the potential investment.
As an individual investor, for example, you might decide between investing your money in the market or a rental property. The 10-year returns of the S&P 500 can be used as a discount rate, because that represents the benchmark for your investment decisions.
If the projected rental property income over the next 10 years doesn't outperform the S&P benchmark, you may decide that your money is better invested elsewhere. Let's look a little deeper:
- Potential rental property investment: $135,000
- Ten-year average annual return of the S&P 500: 14%
- Rental property income: $19,000 per year for 10 years
So with these numbers, you would have a present value of $19,000 in cash flow for 10 years at a discount rate of 14%. The NPV is $99,106. In turn, this is not a good investment because you are paying $135,000 for a cash flow that is only worth $99,106 at 14%.
How To Calculate NPV
The easiest way to calculate NPV is to use the excel NPV function or a financial calculator. Another simple way is to use a present value table. Present value tables have factors for interest rates and a number of years, and are also easily found on the internet. They look like this:
In our example above we can calculate the NPV by multiplying $19,000 by the 14% factor for each year and then totaling the result like this:
|Year||Cash Flow||14% Factor||Present Value|
Evaluating Internal Rate of Return
Internal rate of return looks at the present value of cash flow from a different perspective. Instead of assigning a discount rate, IRR calculates the discount rate you’d need to earn to make the cash flow you earn each year to break even, or make back what you invested the first year (in this case, $135,000).
In our example above, the IRR of a $19,000 cash flow for 10 years of investing $135,000 is 6.75%. IRR is a way to look at the investment from a risk perspective. How does the 6.75% return compare to the risk and return of other investments?
How To Calculate IRR
Like NPV, the simplest way to calculate IRR is to use Excel, which has an “IRR” function that takes the data you put into your sheet and calculates the IRR you’d need to break even.
Here’s how our example of a $135,000 investment and $19,000 returns for a 10-year investment would look using an IRR table (“K” is used in place of zeros in this example to save space):
|After-tax cash flows||19K||19K||19K||19K||19K||19K||19K||19K||19K||19K|
To use the IRR function, click the cell in which you want IRR to appear. Then type “=IRR(”. After that, highlight all the cells that include your initial investment or cash flow. Then type “)”” and hit enter. Your IRR should appear automatically.
Make sure your initial investment is a negative number, or the formula won’t work.
NPV vs. IRR: Which Should Investors Use?
NPV and IRR are both used extensively by financial managers and investors to value the future cash flow or returns of an investment. The difference is in the approach. NPV is an actual amount, using a rate of return (the discount rate) that is assigned based on the investor's criteria. If the net present value is higher than the initial investment based on the assigned discount rate, the investment is worth pursuing.
An investor’s criteria for the NPV could be a benchmark like the S&P, a minimum acceptable rate of return, a company's cost of capital, or anything else.
Financial managers use NPV to compare the value of projects as part of capital budgeting. Financial managers generally prefer to use NPV as a tool because it evaluates projects based on a discount rate specific to the company. For the average investor, NPV is useful to evaluate a franchise, rental property, business, or another opportunity.
IRR is used to establish the actual rate of return of the cash flow based on the initial investment. It can be used to compare the investment relative to the returns and risk of other investments. IRR is commonly used by private equity/hedge funds to evaluate potential opportunities.
For the average investor, IRR or yield to maturity is used to value a bond. Using yield to maturity to value a bond shows the investor the bond's actual rate of return accounting for the premium or discount that the bond sells for in the market.
The Bottom Line
NPV and IRR both measure the cash flows of a business, investment, or project, but from different perspectives. NPV compares an investment relative to an assigned discount rate, which is often the company's cost of capital. Financial managers prefer this method because the cost of capital is a more relevant measure than market rates of interest. IRR, on the other hand, compares an investment relative to its breakeven rate of return.