Photo Credit: pixelmama
Welcome to Redundantland where financial terms overlap, things seemindistinguishable, and everything makes perfect relatable sense. Right?
In two of our previous resource pages, Time Value of Money and Discount Rates, Present Value plays a significant role, and itâ€™s about time it received its own post.
Letâ€™s recap two very important conceptsâ€¦
But first download the sample Excel file here!
1)Â Money today is worth more than money tomorrow. If you were offered â€˜$100 in the futureâ€™ or â€˜$100 todayâ€™, you would prefer the money today. Why? Because at that specified moment in the future, the offer would be â€˜$100â€™ or â€˜$100 and all the money earnedâ€™ respectively.
2) When you purchase an investment, youâ€™re essentially purchasing the right to collect the future cash flows the investment produces (I didnâ€™t know money took part in autogamy!). In order to quantify how much that future cash flow is worth today (risk), we must discount the Future Values.
What exactly does Present Value (PV) mean?
Present Value is the current worth of a future sum of money or stream of cash flows given a specified discount rate. The higher the discount rate, the lower the Present Value and vice versa.
The formula for present value looks like this: PV = FV / (1+R) ^ t, where FV = Future Value, R = Discount Rate, t = Time from now.
This formula is the fundamental driver of investment purchases.
But thereâ€™s a catch when purchasing investments. The discount rate must account not only for inflation, but risk, which is variable from investment to investment. Projecting future cash flows is easy, but valuing the possibility of a major tenant vacating a shopping center, or lease rates taking a 50% dive (both very realistic scenarios circa 2007-2011) is a little trickier.
The point is that we donâ€™t know whatâ€™s going to happen, and because we donâ€™t know, we cannot assume future cash flows are guaranteed, they must be discounted to account for our risk!
So what discount rate should we use? The first place to start is inflation, and while inflation can range greatly, history suggests 3% will do you just fine. Once youâ€™ve established your base discount through inflation youâ€™ll want to add your risk, in other words, whatâ€™s taking this investment risk work to you?!? Will you require 5% or 15% for your time and money? Once youâ€™ve established your risk, youâ€™ll have your discount rate.
Check it. The summary below includes a series of cash flows discounted at various rates. Youâ€™ll find that the face value of these future cash flows is $420,000, however by simply discounting for inflation, the value of those cash flows is reduced by almost $40,000! Furthermore should you discount to include both risk and inflation, say 15%, the total value of the future cash flows is reduced by almost $150,000! Dang, that time is expensive!
It is utmost important to understand the concept of present value, as weâ€™ve described earlier here in Redundantland, youâ€™ll find present value in any real analysis.
As a supplement weâ€™ve included aÂ great spreadsheet detailing PV and its practical application!