The NPV method is based on the idea that the value created by a business comes from the cashflow after investment that this business generates, which can be used for distribution to entity holders and the rest kept on the Balance Sheet as cash. Future cashflows are discounted to the present to take the time-value of money and risk into account: a Euro next year is not worth the same as a Euro this year, and a risky Euro is not the same as a risk-free Euro. As the cashflow considered is an entity cashflow, the valuation result is an entity value as well. From the entity value, the value of net debt can be deducted to derive the equity value. The latter can be compared to the stock-market value if the business is quoted on a stock market.
The NPV takes the point of view that other non-cash assets in the business such as fixed assets and operating current assets are necessary to pursue ongoing operations to perpetuity, so they are resources required to generate cashflows, and adding the value of these resources to the NPV calculation would be double counting. If the company has cash on its balance sheet that is not necessary to support future operation, the excess cash on the asset side can be deducted from the interest-bearing debt on the liability side to calculate the net value of debt. If the company has no debt, but current short-term liquidities beyond the normal cash level necessary for operation, then net debt is actually negative, so that the equity value becomes the sum of the NPV and the (positive) excess cash.
The Present Value in the NPV is said to be ‘Net’ because the cashflows are net of initial investment necessary to start the project like start-up costs and other investment costs required in the early phase, and net of any continuing investment required beyond the initial phase.
The beauty of using the entity cashflow rather than a cashflow to shareholders (an equity cashflow) is that the investment decision can be separated from the financing decision, and operating managers do not need to get concerned with the mechanism and alternatives available to raise capital and debt – these issues can be delegated to the financial officer. In principle, using an NPV based on cashflow to shareholders is also possible, but then an equity cost of capital should be used to discount future cashflows, and the NPV result is the value of shareholders’ equity, not the value of the whole entity. However, the entity approach is usually preferred as it is less prone to error.
Another way to think about the value of a business is to say that from an entity point of view, the value of the business today is equal to the cashflow that is generated during the year (the cash remaining after operating and investment costs are covered, including tax but before financing) plus the value of the business at the end of the year. If one repeats this approach for the following year, the value now is the sum of the cashflows discounted to reflect the time value of money and risk, plus the value of the business in n years from now. Now the value n years from now is certainly a high number, but when extrapolated to infinity, this value won’t be necessarily be growing as fast as the cost of capital WACC, so the business value in year n discounted by the factor WACC will tend toward zero in the long term.