We’ve seen the term “Present Value” pop up in previous blogs, but what exactly does it mean, and how does it impact us? In this blog we’ll present you with some value with a deep dive on this subject, explaining what it is, why it matters, how we calculate it and more.
What is Present Value?
In layman’s terms, Present Value is where we calculate how much a future sum of money is worth today, which is important due to something we have already seen several times, the concept of the Time Value of Money, namely that the value of a dollar today is not worth the same as a dollar in the future. Present Value is a key part of calculating and understanding this, and we calculate it by taking the future sum of money (or stream of cash flows), then applying a discount rate to them.
Why does Present Value matter?
Put bluntly, if you can’t determine how much a future sum of money is worth today, then you can’t assess any investment opportunity, so that’s how key Present Value is, however, let’s look at some specific examples:
Investment Decisions
PV allows us to compare the value of money received at different points in time, making it easier to evaluate investment options with varying payouts and timeframes. By comparing the PV of expected cash flows across different investment opportunities, we can identify which option offers the highest return relative to its cost. This analysis ensures resources are allocated to projects with the greatest potential for profitability and we can therefore assess profitability by comparing the PV of expected cash flows to the initial investment.
Aids in financial planning
PV helps us determine how much to save today to reach future financial goals like retirement, buying a house, or funding a child's education. For example, if someone plans to have $500,000 in savings 20 years from now and expects an annual return of 5%, they can calculate how much they need to invest today by discounting the future amount using the PV formula.
Facilitates better budgeting
PV helps individuals understand the true cost of long-term financial commitments, such as loans or mortgages, by calculating the present value of all future payments, while companies can use PV to evaluate the profitability of potential projects by comparing the present value of their expected cash inflows to the present value of their outflows.
Enables more effective risk assessment
PV allows individuals and businesses to account for uncertainties in future cash flows. By using appropriate discount rates that reflect the level of risk, decision-makers can better understand the potential impact of various scenarios and make more informed choices.
Useful in business valuations
Companies use PV to determine the value of future cash flows, which is essential for mergers, acquisitions, and financial planning. For example, when a company considers acquiring another business, it can use PV to estimate the value of the target’s future revenue streams. By discounting these cash flows to their present value, the acquiring company can make a well-informed decision about how much to offer.
How do we calculate Present Value?
To calculate the present value we use the following formula:
PV = FV / [ 1 + r / n ] ^ ( n * t )
where:
PV = present value
FV = future value
dr = discount rate
t = the number of years
n = the number of compounding periods per year
Example
As we saw in the Time Value of Money blog, if we received $10,617.84 in 3 years time with a discount rate of 2% and discounting monthly, by solving for the Present Value:
$10,617.84 / [ 1 + ( 2% / 12 ) ] ^ [ 12 * 3 ]
= $10,000 (Present Value)
we can see that in today’s money that is worth $10,000.
What are the limitations of Present Value?
Assumptions Dependence
PV calculations rely on assumptions about future interest rates and cash flows, which can be uncertain and may change over time.
Subjectivity of Discount Rates
The choice of discount rate can significantly impact the PV calculation. Different investors may use different discount rates based on their risk tolerance and investment goals.
Ignoring non-financial factors
PV calculations focus solely on monetary factors and may not consider other important factors, such as environmental or social impact.
Static Nature
PV does not account for changes in market conditions, inflation, or unforeseen events over time.
Short-Term Focus
PV analysis tends to favor short-term gains, which may not align with long-term strategic goals.
Summary
Although not without its limitations, Present Value is a key financial tool that can help both individuals and companies make informed decisions around investments, and it underpins the calculations that KangaROI performs when calculating Net Present Value.
