What Is Present Value?

What Is Present Value?

Present value, an estimate of the current value of a future sum of money, is something you calculate as an investor to compare the probable benefits of various investment choices.

When you calculate present value, you're allowing yourself to compare the potential performance of various investments by determining the current worth of the dollars each will return by a future date.

Present value (PV) is based on the concept that a sum of money you have today is probably worth more than the same sum in the future because you can invest it and earn a return in the meantime.

You calculate present value by discounting the future value by the estimated rate of return that the money could earn if invested.

Key Takeaways

You use present value calculations to make investing decisions and to inform strategic planning in businesses.

A present value calculation requires you to estimate the potential rate of return, known as the discount rate.

Since the discount rate can only be estimated, if it's inaccurate, your present value calculation will be off as well.

Understanding Present Value

Present value is based on the concept that a particular sum of money today is likely worth more than the same amount in the future—this is the time value of money. Based on the same logic, a sum you'll receive later won't be worth as much as that sum today.

For example, if you have $1,000 today, it should be worth more than $1,000 five years from now because you can invest it and earn a return. Say it earns 5% a year, compounded annually—it'll be worth about $1,276 in five years.

Present value reverses this. If you're due $1,000 in five years—the future value—what's that worth today? Using 5% compounded annually, it's about $784.

In this setup, the rate of return is the discount rate, which discounts future value back to present value.

Present Value Formula and Calculation

Here's how you calculate the present value of a future sum: Present Value = FV / (1 + r)^n, where FV is Future Value, r is Rate of return, and n is Number of periods.

Use the future amount you expect as the numerator. Estimate the interest rate you might earn if invested today, plug it in as a decimal for r in the denominator. Indicate the time period as the exponent n—so for three years, use 3.

For a stream of future cash flows, repeat the formula for each and total them. It's easier to use an online calculator than do it by hand.

Determining the Discount Rate

The discount rate is the rate of return you use in the calculation—it represents the forgone return if you accept money later instead of now.

This rate is highly subjective because it's what you might expect if you invested today's dollars, which you can only estimate.

Most investors use a risk-free rate like U.S. Treasury bonds, backed by the government. The higher your discount rate, the lower the present value, assuming you'd earn more on the money.

Benefits of Present Value

Present value clarifies if an investment's estimated return is worth pursuing. You or businesses might set a hurdle rate as the minimum return needed.

It helps you decide among competing investments.

Limitations of Present Value

Present value requires assumptions about the discount rate, which may not be accurate. These assumptions allow manipulation, like by managers pushing a project.

Fast Fact

You can incorporate inflation effects into the formula by using the real interest rate instead of nominal.

Example of Present Value

Say you choose between $2,000 today or $2,200 in one year, and you expect to earn 3% on the $2,000. Which is better?

Here, $2,200 is FV, so PV = $2,200 / (1 + 0.03)^1 = $2,135.92. You'd need at least $2,135.92 now to match, so $2,000 isn't enough.

Calculating Future Value vs. Present Value

In the PV formula, you know FV and solve for PV. To solve for FV when you know PV: FV = PV x (1 + r)^n.

Using the example: FV = $2,000 x 1.03 = $2,060. Both show you'd be better waiting for $2,200. But wrong rate estimates can prove this incorrect.

How Do You Calculate Present Value?

You calculate PV using expected FV, the interest rate if invested, and number of periods. Use the formula: PV = FV / (1 + r)^n.

What Is an Example of Present Value?

If you expect $5,000 in five years at 8.25% discount: PV = $5,000 / (1 + 0.0825)^5 = $3,363.80.

Why Is Present Value Important?

It lets you judge if a future outcome is worth investing today and helps choose among investments paying off at different times.

The Bottom Line

Present value represents the current value of future money or cash flows. While useful, it relies on good assumptions about returns, which get trickier over longer periods.