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Problems with the net present value methodology for investment appraisal

Net present value is a strong tool of the investment analyst

It is widely acknowledged that the net present value investment appraisal methodology is one the best tools an investment analyst has at their disposal. It fully considers the time value of money. Additionally, the metric makes for easy comparability between alternative investments.

The time value of money element is important. Over time money depreciates in value, wheather from inflation, whether due to a next best alternative or whether due to risk. The point is that money is worth more today than it is in the future. Hence, the need to discount future earnings when appraising an investment opportunity.

Difficulties with a discount rate

A key question for a user of the net present value tool is at what discount rate should an analyst discount the investment? A lower discount rate could significantly increase the estimated value of the investment versus a higher rate. How do you choose a discount rate?

The technical answer is that the discount rate is a risk free rate of return plus a risk premium. The risk free rate is an interest rate that's charged on an investment with little to no risk - normally government bonds such as US treasury bonds. However, the problem still exists when it comes to the risk premium.

How are you supposed to now what interest rate fully reflects the additional risk inherent within an investment? Hard to say. Mostly this is just a finger in the air exercise, an average industry rate or gut feel. A surprising answer for something that can have such a big influence on value.

Some investors take a prudent approach. They adopt a high discount rate of 15%-20% just to be cautious. If the investment still looks good at this high discount rate (regardless of whether it's accurate) then they'll look to invest. Essentially, this naturally builds a margin of safety into the investment.

What are the future cash flows?

Another difficulty with any investment appraisal involves trying to estimate the future cash flows. Whilst it would be nice to assume that every business grows at a set interest rate each year this is far from true.

Businesses are multi-faceted. There are millions of cogs within the business machine, all turning at different speeds and affective different areas of the company. The life of an analysis is trying to understand in broad terms the general direction of travel of cash generation from the business.

I wish I could tell you that estimating the future cash flows is easy or that there was a nice shortcut. Unfortunately I know for a fact that this isn't the case. Furthermore, most people are probably liable to make a mistake.

I work full time for a team that build forecasting and investment analysis models. Some of these businesses are relatively small with revenue under £100million. However, the  financial models still take a number of weeks to build even though we have the business owners explaining how their business works. 

An external investor without access to the business owner will find it extremely difficult to produce an accurate model. My recommendation is to start with listed businesses, where the financial information exists and it available. 

Without intimate knowledge of how financial statement and financial models are put together I recommend stearing clear of investing in individual stocks. Pick an index fund instead.

However, if you are set on investing in individual stocks then forcash flows in future periods, make a reasonable and prudent estimate based on how the cash flows that have developed to date. How have they grown in the past. Apply that growth in the future. Keep up to date with the news surrounding that company and continue to challenge your assumption.

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