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.

Net Present Value and Internal Rate of Return Summarize the Returns for a Given Series of Cash Flows

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows.

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, IRR provides the precise rate of return to the investor while NPV describes the value of the investment at a given discount rate.

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due.

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.