Net Present Value (NPV)

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Suppose you want to open a lemonade stand. Building the stand and buying your first batch of lemons and cups costs 50 dollars today. Over the next few summers, you expect the stand to bring in a stream of cash. Using discounted cash flow math to shrink all of that future money down to what it is worth right now, suppose it adds up to 70 dollars in today's dollars.

Is the lemonade stand worth it? You spent 50 dollars to get something worth 70 dollars today. Net present value, usually shortened to NPV, is exactly that comparison: it takes the discounted value of everything you expect to receive and subtracts what it costs you today to get it. Here, NPV is 70 minus 50, or positive 20 dollars.

Reading the sign of NPV

The word "net" just means "after subtracting the cost," and that subtraction is what makes NPV so easy to read at a glance:

• A positive NPV means the future money is worth more than what you are paying for it today. That looks like a good deal.
• A negative NPV means you would be paying more than the future money is worth. If the lemonade stand had cost 90 dollars to set up instead of 50, the NPV would be 70 minus 90, or negative 20 dollars, a bad deal.
• An NPV of exactly zero means the deal is a perfect break even. You get back exactly what you put in, no more and no less, once everything is measured in today's dollars.

Why it is useful

NPV turns any deal, no matter how different it looks on the outside, into one simple dollar amount that already accounts for cost, time, and risk. That makes it easy to compare completely different choices side by side, like a company deciding whether to build a new factory, buy new machines, or launch a new product. Whichever choice has the biggest positive NPV is generally the one adding the most real value.

Fun facts

• NPV depends heavily on the discount rate used to shrink future money down to today, the same rate discussed in discounted cash flow. Pick a different rate, and the very same lemonade stand can look like a great deal or a mediocre one.
• Plain "present value" just means future money shrunk down to today's value, with nothing subtracted. NPV is that same idea with one extra step: subtracting what it costs to get started, which is exactly what turns it from a value into a verdict.
• Big companies often calculate the NPV of many possible projects at once and rank them from most positive to most negative, then work down the list spending money on the best ones first.