MBA in 2 minutes | Lesson 25: Valuations and NPV Drama
We will be solving practical challenges through MBA concepts. No theory only applications!
So far, we have covered MBA in 2 minutes concepts in accounting. In this lesson, for the 1st time, we set foundations for real finance.
As a non-finance professional, there is a fundamental law of finance that struck with me when I attended my ISB MBA classes. This lesson will be extremely helpful once again for non-finance professionals who aim to enhance their fundamentals because finance touches everyone if you are working in the corporate world.
With that said, let's directly jump into the lesson.
One of the common (and most important) decisions that CEOs, finance, and retail investors decide on a regular basis is which projects to pick and which opportunities to miss from an investment point of view. Because there is always an opportunity cost (refer to previous Economics Lessons if this opportunity cost is a new concept) to the time and money invested by the professionals.
While of course, the regular readers of my blog will argue that in Shatakshi there are certain statistical tools at our disposal that can help us decide a go/no-go. But then, still, the argument prevails if we have 2/3 such projects then which one should we pick.
Enters the concept of NPV- Net Present Value.
Now, what is NPV?
Net present value (NPV) = PV(cash in Flows) - PV(cash out Flows)
Now, let's understand what is PV (or present value)
Intuitively, Rs 100 today and Rs 100 one year later are not equal. We need to transport money across time. Typically, equivalent money today is always better than receiving in later. Or in other words, how much would you be willing to accept today instead of receiving 110 rupees one year later?
Mathematically, the interest rate= 5%. To calculate the present value of 110 one year later, we need to discount it by the interest rate (had we deposited this money in an FD, etc.)
PV (present value)= 110/(1+5%)= 104
Hence, in this case, you may accept 110 later because the NPV of it is more than equivalent Rs. 100 today.
From a definition standpoint, Going from 100 to 110 (forward) is called compounding. Going from 110 to 100 (backward) is called discounting.
If you stack things up, then you have projected multiple cash flows for the next 10 years of an opportunity (identified via market size, share, competition, etc).
In such a scenario, we add PVs to find NPV= PV
Now, the decision rule is that A positive NPV (>0) project indicates a wealth increase, hence must be accepted; a negative NPV project destroys wealth or value, hence must be rejected.
Intuitively, a positive NPV project means you increase shareholder wealth by an amount equal to the NPV of the project - do for shareholders what they cannot do for themselves!
In the case of multiple such opportunities, we choose the project with a higher NPV.
Now of course as startup founders, share over valuated excel sheets to investors, the VC professionals independently conduct a diagnosis on what the real cash flows can and should be. Hope this basic fundamental lesson was helpful. Such types of valuation calculations frankly exist for large projects, in many small startup deals, a lot of the time investors don't even value the venture.
However, if you are a recent retail stock trader then of course you may want to pick stocks by using this lever :)
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