Present value

What is present value

Present value is financial calculation that measures the buying power of a dollar today that we expect to get at some point in the future. The main principle behind it is that money available today are more valuable than the same amount available at some point in the future. Why? Because money have interest earning potential or in other words: you can use money to make money. This is also known as the time value of money.

How to calculate present value

Present value in essence is compound interest in reverse. The easiest and the most accurate way to calculate present value of future amounts is to use financial calculator or spreadsheet software. If you want to use a formula to calculate the present value of future cash there are few different options. Present value = future amount/ (1+i)^n were the i is the discounted rate we are going to use and the n is the number of periods.

Why is present value important

The concept of present value is fundamental in determining real rate of return on investment. One of the most common stocks valuation methods DCF (Discounted cash flow) is based on the assumption of present value of money. It is the basis of determining pricing on stocks, bonds, annuities etc. Calculating present value of return in stocks can be a very complex task as it includes varieties of assumptions about the business future.

What number to use as a discount rate

There are may different numbers that one can use as a discount rate when determining the present value of money. The general idea is to use as a discount rate a expected return from alternative investments with similar risk. The most common one is to use the risk free rate or the current interest rates. This is the interest rate that the Federal Reserve charges banks for short term loans. This is under the assumption that you can simply put the money in a government bonds (or saving account) and earn the interest in that money. The