Recently, I was reviewing how many investors evaluate their projects and I realized something: most use two tools but don’t fully understand how they work together. I’m talking about NPV and IRR, two concepts that seem complicated but are actually quite useful if you break them down properly.

Let’s start with the basics. What is NPV in simple terms: it’s the present value of all the money you expect to earn in the future from an investment, minus what you spent at the beginning. It sounds easy, but there’s an important detail: money in the future isn’t worth the same as today, so you need to discount it. The idea is to answer a key question: if I invest X now, will I really earn more than I spent?

To calculate what NPV is, you need three things: the money you will spend at the start, the cash flows you expect in each period, and a discount rate that represents what you could earn in a similar investment. You take each future cash flow, divide it by (1 plus the discount rate) raised to the number of years, and sum everything up. Then subtract your initial investment. If the result is positive, the project generates profit. If it’s negative, you lose money.

Let’s put a practical example. Imagine you invest $10,000 in a project that will give you $4,000 each year for 5 years, and your discount rate is 10%. When you calculate the present value of those $4,000 in the first year, you get approximately $3,636. The second year’s value is $3,306, and so on. Summing all those present values and subtracting the initial $10,000, you get an NPV of about $2,162. That means the investment is profitable.

Now, what are the limitations of NPV? The most obvious is that it depends entirely on the discount rate you choose, and that choice is quite subjective. Also, NPV assumes your cash flow projections are accurate, which rarely happens in reality. It also ignores things like inflation and the possibility of changing strategies halfway through.

That’s where IRR, or Internal Rate of Return, comes in. While NPV tells you how much money you will earn in absolute terms, IRR tells you the percentage of return you expect to get. It’s the discount rate that makes the NPV exactly zero. If the IRR is higher than your reference rate (like the rate of a Treasury bond), then the project is profitable.

The problem is that sometimes NPV and IRR give contradictory answers. A project can have a higher NPV but a lower IRR than another. This especially happens when comparing projects of different sizes or with very different cash flows over time. That’s why serious investors never rely on just one of these tools.

IRR also has its own issues. It assumes you will reinvest positive cash flows at the same rate of return, which isn’t always realistic. Also, in some cases, there can be multiple IRRs for the same project, complicating the evaluation. And if cash flows change signs multiple times (positive, then negative, then positive again), IRR can give misleading results.

When you encounter contradictory results between NPV and IRR, it’s advisable to review your assumptions. Check that the discount rate is realistic, that your cash flow projections are well-founded, and that you’ve considered different scenarios. Sometimes adjusting the discount rate makes the results more sensible.

In practice, the best approach is to use both tools together. NPV provides a real monetary measure of how much value the project generates. IRR gives the percentage of profitability, making it easier to compare investments of different sizes. Together, they offer a more complete view than either alone.

But here’s the important part: neither NPV nor IRR are the only metrics you should consider. Others like ROI, payback period, profitability index, and weighted average cost of capital also matter. Plus, you should think about your personal goals, risk tolerance, available funds, and how this investment fits into your overall portfolio.

The reality is that both tools are based on future projections, and the future always involves uncertainty. That’s why, before committing your money, do a detailed assessment. Analyze different scenarios, consider what would happen if things don’t go as planned, and make sure the investment makes sense in the context of your complete financial situation. Math is important, but good judgment is even more so.