Definition: Present value, also known as discounted value, is a financial calculation that measures the worth of a future amount of money or stream of payments in today’s dollars adjusted for interest and inflation. In other words, it compares the buying power of one future dollar to purchasing power of one today.
What Does Present Value Mean?
What is the definition of present value? It’s an indication of whether the money an investor receives today can earn a return in the future. PV is widely used in finance in the stock valuation, bond pricing, and financial modeling.
Investors calculate the present value of a firm’s expected cash flows to decide if the stock is worth investing in today. The firm’s expected cash flows are discounted at a discount rate that is actually the expected return. The discount rate is inversely correlated to the future cash flows. The higher the discount rate, the lower the present value of the expected cash flows.
Let’s look at an example.
Karen wants to buy a flower shop near her home. First, she needs to estimate the future cash flows of the shop and then discount them to calculate their present value.
The flower shop costs $85,000 and Karen estimates that she will be able to earn $85,000 over the next 4 years. This sounds like a good deal right? Karen will make her money back in four years, right?
Well, technically she won’t. The future streams of income are not equal to $85,000 in today’s money. They are worth less. In order to find their real value, Karen should discount the earnings using a discount rate to calculate the PV.
Let’s assume Karen’s present value calculation shows that the $85,000 of future earnings actually equals $65,554 today. The PV of the future cash flows is $19,446 less than Karen’s original investment, which means Karen might not want buy the flower shop.
Karen should buy the flower shop if the present value was positive, which means that the future cash flows of the shop should be higher than $85,000. However, as the flower shop has a value that is less than $85,000, Karen should step out of the deal.