Saturday, September 10, 2011

Poor, Poor NPV

It is common knowledge in the financial world that the Net Present Value method, or NPV, is the only appropriate valuation procedure with which to analyze projects, investments, securities, our companies, etc.
Yet, over the course of a year, it is still more likely than not we will hear someone say “this is a great project, it pays for itself within a year” or “this investment is better because it has a higher rate of return”.
NPV might be the better method, but…
Here is the NPV formula:
Just by looking at this formula we can begin to see the problem. Who would want to use this? There are n number of division problems (n representing the number of periods, so if we are valuing something 10 years long n equals 10 if annual, or 120 if monthly) that need to be done, one for each period. These then need to be added up.
Furthermore, there are exponents in the denominator of each division problem. These are not easy to calculate – quick what is 1.3 to the 4th power? It’s also not easy to divide by these numbers.
All these factors conspire to make NPV not very friendly to all but your typical finance guy or rocket scientist.
Other Methods are People Friendly
In contrast, the payback method is a lot simpler. Add up a year’s worth (or whatever period you are using, months, days, etc.) of investment returns or project savings and compare to the investment or project outlay. Is it larger? No, then add the next period. Now is it larger? Once you hit the period where the inflows become greater than the outflows, that’s your payback period. At least there are no exponents!
The internal rate of return method (or IRR) is intuitive. It gives us a percentage. This investment will earn 12%. This project will save 20%.
NPV, in contrast to this, gives us a dollar amount (or euro, renminbi, whatever currency we are working in). If we estimate our cost of capital is 15%, and the project just hits that, the NPV is 0. Which would you rather do – the project that earns us 15% or the one with an NPV of 0? Yes they are both the same, but doesn’t the one sound a whole lot better?
What Can We Do?
The problem here, of course, is that the NPV method always works, where the IRR method and the payback method do not. They can lead to erroneous conclusions.
The finance purist will always want to do NPV, and roll over the folks calculating payback on the back of a napkin or discussing rates of return. This just causes needless friction.
Given that NPV will be calculated in a spreadsheet or other technology-enhanced system, it is really little extra effort to calculate all the measures. That way, people can gravitate to any metric they want, and NPV, lonely and unloved, will still be there to make sure we do not go down a road that will destroy value.
I would love to hear your thoughts about net present value or your stories on this topic if you have them.
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  1. Hi David!

    You're right. Too many people use IRR to make decisions instead of NPV. IRR tends to be used in the most optimistic sense and can be very costly to organizations. Running projections through finance would save and provide a reality check. Great post!

  2. Maddie,

    That's a great point about focusing on the optimistic case only. Another problem with IRR is that it does not tell us the dollar impact if we run a not-so-rosy scenario. Thanks for the comments!

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