Saturday, 18 February 2012

NPV and IRR - place more importance to the Assumptions than to the Output. "Garbage in, garbage out"

Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

Anyone wi th a simple, hand-held calculator can perform net present va lue (NPV) and internal rate of return (IRR) calculations.  The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present.  IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts.  Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.  "Garbage in, garbage out" is an apt description of the process.

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