One of the main drawbacks to valuing investments using the previously discussed calculations is that none of those methods factor in the time value of money. Time value of money is important because money today is worth more than money tomorrow.
The value of money decreases over time as a result of inflation, risk, and opportunity cost (money that is invested today is risked because it cannot be invested tomorrow in a higher yielding investment if the opportunity presented itself). As you can probably understand, items that cost $100 ten years ago, might cost closer to $118 today.
It is possible to determine the future value of an invested dollar by considering how today’s dollar earns interest and how that interest over time will earn additional interest, the idea of compounding interest. To find the future value of a dollar considering the compounding of interest, we can use the following formula:
FV = PV(1 + r)n
In this equation,
FV = future value
PV = present value
r = interest rate
n = number of compounding periods
It is important to realize that the value of a dollar will change over time so that when you evaluate a potential investment, you can compare future income dollars at an equal value to the initially invested dollars. There are two investment valuation methods that will take the time value of money into consideration. These methods are the Net Present Value (NPV) and the Internal Rate of Return (IRR), which are closely linked to one another.
NPV is a calculation that will consider the time value of money to tell investors the present value of the potential net income throughout the course of the investment. By reversing the above equation, NPV finds the present value of all future income and expenses, adds those together to find the present value of the investment’s total future cash flow, and then subtracts the initial investment amount to determine the present value of the total expected gain or loss on the investment.
For example, if a property was purchased for $500,000 and earned $50,000 net income every year for three years and then had a net income of $550,000 after selling the property in the fourth year, using an 8% discount rate, the investment would have a NPV of $33,136.
The IRR, in contrast, is the discount rate that would bring a series of cash flows to an NPV of 0, or equal to the amount of cash invested. It is finding the value of “r” in the above equation when NPV = 0. The use of Excel is helpful in completing that equation. In the above example, the IRR is 10% since a 10% discount rate brings the NPV as close as possible to 0.
While NPV can tell an investor how much they will potentially earn from an investment, the IRR can tell an investor when they will potentially receive the gains on their investment.
Negatives to IRR and NPV: When using these valuation tools investors must be careful how they compare the results to other investment opportunities. A 10% IRR or a $33,136 NPV in this example would not necessarily be worse than an investment with a 19% IRR or a $50,000 NPV over a 10-year period. Furthermore, though IRR may be more accurate than other calculation tools because it accounts for the time value of money, IRR is not a fool-proof method. Among other downfalls, IRR doesn’t recognize that reinvestment rates can change over time and does not account for unplanned future costs.
We have a saying in the business; you can’t eat IRR. You could have a high IRR and still have a low actual return on your investment. These are complex calculations and depending upon your specific circumstances, you should always consult with an expert as it relates to a given investment.