What does net present value (NPV) assess?

Net present value (NPV) is a financial metric used to evaluate the profitability of an investment. It assesses the value of all future cash flows that an investment is expected to generate, discounted back to their present value using a specific discount rate. By calculating the difference between the present value of cash inflows and outflows associated with the investment, NPV provides a clear picture of the potential profitability.

When the NPV is positive, it indicates that the projected earnings (adjusted for time and risk) exceed the anticipated costs, suggesting that the investment is expected to be profitable and can enhance shareholder value. Conversely, a negative NPV suggests that the costs outweigh the expected benefits, making it a less attractive investment. This focus on future cash flows and the time value of money fundamentally ties NPV to assessing profitability rather than growth potential, financial health, or liquidity.

Growth potential typically examines future revenue increases rather than cash flow timing, while financial health relates to overall assets and liabilities rather than just specific investment returns. Liquidity is concerned with the ease of converting assets into cash, which does not directly relate to the cash flow profitability assessment that NPV provides.