What is net present value (NPV)?
Net present value is when you take the sum of the discounted net cash flows over the future forecasted years, minus any one-off capital costs.
As the name suggests, it represents:
- the net (after ALL reasonable deductions)
- present value (minus comparative gains)
- of the monies, you would invest today in your poultry farm idea
Understanding net present value (NPV)
This is an indicator which tells you how much your net profit would be from setting up this poultry business (after reductions for a comparative rate of investment and one-off capital costs).
It basically tells you how healthy a cash flow your new business could have…
…above and beyond an alternative rate of gain.
NPV is an outright measure of return (ROI) for your poultry farming business because it also includes upfront capital costs.
It singlehandedly gives qualification to this question,
“How much money do I stand to personally gain after running this business for (x) years?”
Also, take a look at this example poultry farm valuation.
Cash flow (and therefore, net present value – NPV) is one of the primary factors, if not THE MOST important for business valuation.
In fact, cash flow (or rather, discounted cash flow) is such a strong indicator for business value,
That Warren Buffet, American investment billionaire, calls it an all-important concept:
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
– Warren Buffet (from Berkshire Hathaway, Owner’s Manual)
As you can see, when it comes to the world’s most successful financial investors –
Discounted cash flow is what they use to determine if a business holds value, or not.
But why is DCF & NPV (net present value) so important?
I think about it like plumbing.
In a house, people need water.
You need it to:
- wash your hands
- prepare food
- heat radiators
- water the lawn
- wash the car
…and just as important, you need it NOW.
The outlet (e.g. tap, or sprinkler) is only trusted and valued if it works by letting out water when you need it.
(Otherwise, it’s called ‘broken’, becomes a disappointment and you need to find the budget to fix it.)
So, in short –
- A working outlet (e.g. tap) is an asset (profits you)
- A broken tap is a liability (costs you)
With business, it works the same.
As an investor, you are willing to buy shares in businesses which are assets (profit you with ‘flow’).
What you don’t want as an investor is a share in a business that is a liability (cost you with ‘drain’).
Think about your poultry farm in the same way, and you’ll be on to a winning plan.