Stock investors are trying to hit a moving target. Inflation, profit growth and other factors will change the value of the stock over time. Not only do investors want to pick a stock that will increase in value, but they want to pick one that will increase faster than other stocks. There is no magic formula that will unerringly identify these sought-after stocks. However, investors will have a better chance to hit their elusive target by examining a stock's net present value, or NPV.
Usually if a stock's net present value, or NPV, is positive, the stock stands a better chance of producing significant earnings.
What Is NPV?
Net present value helps reveal what future profit growth is worth now, which is when you will make a decision on a stock purchase. A simple example focuses on inflation. If inflation is 2 percent a year, $100 today will buy $98 worth of goods or services the next year. You would have to make a profit of more than 2 percent to end up with more money.
With a 3 percent profit, the NPV today equals $103 divided by one plus the amount of inflation, or one plus 0.02; 103 divided by 1.02 yields a positive NPV of $100.98. NPV can be calculated for any number of years. A common period used by analysts is 30 years.
Understanding the Discount Rate
In the previous simple example, the inflation rate was the “discount rate” in the NPV calculation. But inflation is not the only factor that reduces the value of future profits. Stocks face built-in risks from bad news or lower-than-expected earnings. One common practice is to add the inflation rate to an “equity premium” of 6 percent to figure the discount rate.
But there is no hard-and-fast rule. Investors and analysts sometimes use a higher “equity premium” to account for more risk, including the risk that estimates of future profit growth are overoptimistic.
To Buy or Not
After all the calculations, a positive NPV is not an automatic signal to buy. First, investors must divide the NPV by the number of shares available in a company to get the NPV per share. If that number is significantly higher than the current market price, the stock is a good buy. A lower number indicates an investor would lose money by purchasing the stock.
To simplify, say a company over 30 years has a total NPV of $10,000 and has 1,000 shares. That equates to $10 per share. If the market price is $5, you may want to jump in; If it’s $15, you would not.
Limits of NPV
NPV calculations can help investors pick winners in the stock market, but they have limits. For one thing, setting discount rates is tricky. And, predicting a company’s rate of profit growth over a long period is not exact science.
Companies sometimes take new strategic directions or adopt new business models that substantially affect risks and profits. Some experts advise investors to start with NPV analysis and then examine components of the analysis such as growth rate.