A Net Present Value Calculator
Allows the intrinsic value of a company to be estimated
The net present value calculator (NPV calculator) is a tool that can assist in estimating the intrinsic value
of a company (its true worth) when considering whether to purchase its stock.
The calculation is based on forecast earnings for a number of years in the future. The investor can then compare the calculated intrinsic value to the current stock price to determine its value as an investment.
More generally, a net present value calculator enables an investor to determine the difference between the present value (PV) of the future cash flows from an investment and the amount to be initially invested.
This present value of the expected cash flows is computed by discounting the expected cash flows at the individual investor's required rate of return (also referred to as the discount rate).
For example, an investment of $2,000 today at 10 per cent will yield $2,200 at the end of the year. So the present value of $2,200 at the required rate of return (10 per cent) is $2,000.
The initial investment ($2,000 in this example) is deducted from this figure to arrive at NPV which here is zero ($2,000-$2,000).
A zero NPV means the initial investment is repaid plus the required rate of return. A positive NPV means a better return than a zero NPV. A negative NPV means a worse return than the return from a zero NPV.
Estimating the Intrinsic Value
I use a net present value calculator (either a net present value table, a financial calculator or a spreadsheet) to determine the fair value of a stock so I can compare it with the current stock price.
Investors may follow the steps I outline below using their net present value calculator of choice.
The steps involved are as follows ...
Net Present Value Analysis
- Calculate an average annual earnings per share (EPS) growth figure for the company in question for (say) the last five years. Do this by subtracting the EPS five years ago from the latest EPS figure, then dividing by the EPS five years ago and then expressing the result as a percentage by multiplying the result by 100.
Keep in mind that companies can have one-off expenses in particular years that may not re-occur in the future, so in these cases it may be reasonable to adjust for these when calculating historical EPS growth.
- Calculate the future value (FV) of the EPS, say five years hence, knowing the current EPS and the EPS growth and assuming the earnings growth for the next five years is the same as the previous five years.
Earnings stability measures how consistent the earnings per share growth of a company is. The more stable the earnings per share growth of a company, the more accurately one can forecast future earnings.
So the NPV formula works best for companies with high earnings stability (>70%). I obtain the earnings stability figure for companies from my online broker's website.
- Adopt a conservative guesstimate for the company's price earnings (P/E) ratio five years hence by looking at the average annual P/E ratio values for the last five years.
If the historical average annual P/E ratios have a high variability then the guesstimate will be harder to make. This may raise questions about the quality of the company as an investment.
- Multiply this estimated P/E ratio by the future value of the EPS calculated above to obtain the estimated share price five years hence. The reason for doing this is that as ...
P/E ratio = Share price divided by EPS, then Share price = P/E ratio X EPS.
- Then calculate a present estimated share price (PV) knowing the future estimated value (FV) of the share price, the number of years (N = 5) and your required rate of return on your investment. A required rate of return somewhere between 10% and 15% is considered reasonable.
- Finally, subtract this present estimated share price (calculated fair value price) from the actual current share price to determine if the calculated fair value price is sufficiently below the actual share price to make the stock a candidate for purchase.
A positive result from the subtraction above would indicate a better return on the investment than the required return. This is what is meant by a margin of safety. This would suggest that the stock is undervalued at the current share price
A zero result from the subtraction carried out above would indicate a return on investment equal to the required return set by the investor. This would suggest that the stock represents fair value at the current share price.
A negative result would indicate a poorer return than that set be the investor. This would then suggest that the stock is overvalued at the current share price.
The return required by the investor has an important influence on the determination of calculated fair value. The greater the return required by the investor, the lower the current share price needs to be to achieve a positive result from the subtraction carried out above.
Other important company considerations to take into account in order not to become too fixated on numbers include ...
- the quality of management (look for high quality)
- the level of the company's debt (low or zero)
- the ongoing capital requirements of the company (the lower the better)
- the potential for future growth (the greater the potential the better, and
- the return on equity (ROE) for the past five years or so (look for high (>12%) and stable or increasing ROE).
The NPV calculations should be used in conjunction with these considerations as the strength of some of these factors may determine the size of the margin of safety required - the greater the strength the less the margin of safety.
To Conclude ..
A net present value calculator is a useful tool to calculate the intrinsic or fair value of a company when value investing.
The formula for net present value does not need to be known if using a calculator or spreadsheet as the net present value calculator does the job for you.
The above net present value method is a relative measure as it relies on an estimated future price earnings ratio, the determination of which is reliant on share price.
The calculated fair value is an estimated measure. However, as Warren E. Buffett has noted in relation to stock value... "it is better to be approximately right than to be precisely wrong".
Other important considerations need to be taken into account as well as calculating NPV with a net present value calculator.
The related articles below provide additional background on this topic.
- helps the investor to have confidence in forecasting a company's future earnings!
A margin of safety - reduces the downside risk!
Return from Net Present Value Calculator to Calculating Stock Values
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