What is Net Present Value?

The net present value (NPV) is very important for business owners and investors to consider. It takes into consideration the future value of a dollar.

For example if a company is expecting to be making $2 million dollars in sales in the future how does that compare with today when you consider inflation. That $2 million dollars in the future may only be worth $1.5 million in today’s dollars.

In order to figure out how much money a company has to make in order to have the same buying power in the future you have to use this formula.

(Current Income) x (1 +Yearly Inflation)^N

In the formula below N = the number of years in the future. So if a company is making $1,000,000 a year today and we expect inflation to be 3% we can use this formula to measure how much money a company has to make in 20 years to be making the same money as they are today.

Using the formula above $1,000,000 x (1+.03)^20 = 1,806,111. That means if the company is making less than 1.8 million in 20 years it is actually shrinking. If it is making more than 1.8 million it is expanding.

This allows companies to plan ahead and it allows investors to get some sense of whether or not a company is growing.

Most individual investors would do well to pay attention to net present value. I often see people putting their money into the bank where they make 2% interest on their money while inflation is at 3%. That means they are losing money value in the long run yet thinking that they are making money.

Other Financial Ratios

Here are some other financial ratios to look into.

Inventory Turnover Ratio - This looks at a company’s inventory and sales.

Debt to Equity Ratio – This looks at a company’s debt.

Solvency Ratio - This gives you an idea of how prepared a company is to pay off its debts