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How to use DCF, NPV and ROI

Someone asked on Jun 27, 2017 - 2 answers

Hi all,

I have a few questions about NPV and DCF:

1- Where would you use one or the other? Investment cases / Valuation cases
2- When you use ROI in lets say an investment case, would you use the result of DCF, NPV, or neither?

Thanks a lot

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Olu replied on Jun 27, 2017

NPV= Net Present Value- [-investment +( Summation of FCF/(1+wacc)^t from 1 to t)].This is a basic formula, it is way more involved than the substituting numbers in the formula, typical you would need to create a DCF model based on a pro forma to get the FCF and terminal value. We could spend hours discussing adjustments, discount rate calculation (WAAC or APV), growth rates, and terminal valve assumptions etc. but for a case situation, the intuition and application of the formula rather than the development of the model would be required.

In short, NPV of a deal is today's value of all future streaming of free cash flow generated from the deal in question. If it’s above 0 or positive then you should do the project, if below 0 or negative, then you shouldn't do the project.

So all you need in essences is FCF and the Discount rate or WACC and the time horizon to evaluate.

P.S- Clarify with the interview the approach and formula you plan to use, as well as the assumptions.

On the other hand, ROI is simply (N.I/Investment) this doesn't take discount rate or WACC into account, which makes it inferior to NPV, You could call ROI a payback estimator (inverse of ROI= Payback) that doesn't take risk, inflation and opportunity cost into account. ROI is a quick and dirty estimate to sniff test the deal.

For instance, If payback time requested by your client is 2 years and your ROI/payback analysis yields 20% or 5years then you can almost be certain its not a +NPV project and should be cautious about making the deal, else other strategic reasons support doing so. For example, accepting the deal because it’s serves as a structural barrier to deter entry by competition etc.

Kamaraju updated his answer on Jun 27, 2017

NPV and ROI can be used interchangeably. But when standard or industry standard interest rate is given, ROI is calculated and compared with standard interest. Otherwise, in general NPV is calculated and compared between two options.

(edited)

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