Using the NPV function
NPV (Net Present Value) gives us the value of a business based on a set of projected cash flows. This is used in the income approach of valuation.
Because these cash flows occur in the future, there is an element of uncertainty, quantified by the discount rate and the year in which they are being generated. The further out these cash flows occur, the greater the discounting effect i.e. the lower the present value of those cash flows.
In the below example, we take a series of future cash flows ($100 annually for up to 6 years) and apply a discount rate of 10%. The values in the 'discount factor' row is applied to each year of cash flows to arrive at the "present value of cash flows".
It can be seen that similar cash flows in the later years have a significantly lower value than those in the earlier years.
To calculate the value of those cash flows, we add up all the present value of cash flows from year 1 to year 6 to arrive at 435.53. This is equivalent to the NPV of those cash flows.
But what does the NPV of 435.53 mean?
"If I invest $435.53 in this project and expect to receive $100 every year for six years, my investment return on this project will be 10%"
Or, another way to look at this is:
"If my expected return is 10% and I can expected to receive $100 from this project for the next 6 years, I should invest no more than $435.53"
The NPV gives you an indication of how much you should be paying for the business based on the discount rate. Loosely speaking, the discount rate is sort of an expected return on investment. Assuming the estimated cash flows are fairly consistent and fixed, in order to get a return that is higher than 10%, one has to invest less than $435 in order to achieve this.
This is obviously more hairy in reality because:
Every investor has a different required rate of return (i.e. the discount rate) and;
Future cash flows can be vastly different, which makes it more complicated because this ultimately also drives the rate of return.
If we plug $435.53 into the series of cash flows per below in row 12, we can calculate the Internal Rate of Return (IRR) based on the:
(i) initial capital outlay in cell C12; and
(ii) the future cash flows as shown in row 12 from column D to I
The IRR based on this series of cash flows yields a value of 10%, which is equivalent to the discount rate of the project.
If you have held an investment for a few years now i.e. you know the acquisition price and the set of cash flows over the period, you can also calculate the minimum exit value based on a specific desired IRR (see this post).
Not happy with a 10% IRR on your investment? This post talks about cost of capital and how to increase investor returns with leverage.