A Concise Guide to Present Value
The present value connotes the value at the moment (current value) of a given sum of money or a cash flow stream at a designated rate of return. Cash flows in the future go at a discounted rate. When the rate of discount is higher, the present value of the cash flows is lower. We’ll discuss in this article the diverse aspects of present value. Thus, for example, if you have an asset and are promised to get $120 in one year, the present value of the asset is the current value of that asset ($120) today.
To put it differently, the present value implies that the money of the amount is worth greater than that same amount in the future. That is to say, when you get money in the future, it’s not worth that is an equal amount that you get today.
Present discounted value
Present discounted value is yet another term to denote the present value. It’s important to note that the present value is either equal to or less than the future value. This is because as money earns earning interest, yet another attribute of the asset, namely time value’ of money emerges.
Importance of present value
Each financial asset has a market price. Along with this, it also has a theoretical price. The market price is influenced by sellers and buyers who can affect the price go up or decline on an everyday basis.
The market price is the price on which there is consensus on earning in the future and the cash flows of the company that issues the security (asset).
How to estimate the present value?
You can estimate the conceptual price by estimating the same value that is projected to earn and the cash flows. This, you can do by using diverse financial analytical frameworks. Of course, the conceptual price estimated by different analysts may vary thanks to the different analytical models they use. Occasionally, the conceptual price may be around the market time. It also can vary from the market price.
However, in both cases, the present values depend often on the value of cash flows the investor hopes to receive in the future.
Present value as a concept
Present value is among the most important concepts in financial analysis. You can understand the present value by making a simple question. Would you like to get $1,000 today or get $1,000 one year later?
If you get the $1,000 today, you can invest in good assets. One year later, the mount becomes worth more than $1000.
If your $1000 investment grows to 1,010, in one year, you stand to earn an annual return of one percent. The present value of 1,010 you’re likely to receive one year later from now, discounted at 1 % per year is 1000.
The discount rate in this example is 1%. The present value and discount rate always go together.
When the cash flow in the future is less, the rate of discount is higher. It should be used to determine the present value of the security.
US Treasury bonds, for instance, are said to be immune from the risk of default. And, the return (yield) or discount rate on a 2-year US Treasury bond is 0.559%. This implies that if you discount all the future cash flows involved in 2-year Treasury bonds by 0.559%, the grand total of the discounted cash flows would equal the price. If you’re still not able to reach the concept, you should make additional readings.
Formula to estimate the present value
To estimate the present value, the following mathematical expression is used:
Future value divided by (1 + rate of discount (r)) to the power of n. This can be mathematically expressed as present value equation:
Present Value = FV * PV factor = Fv / (1+r)^n
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An example to illustrate the formula
Investor A plans to decide how much he has to put in the market to earn $100 one year from today with an interest of 5% earned as simple interest is r, and the number of periods would be 1. Period implies time length unit (years).
Rate of return and interest rate
When an investor invests $1,000 today, earns a rate of return over the following five years. The present value is estimated according to the rate of interest an investment can accrue.
Thus, if you get $1,000 today and earn interest at the rate of 5% annually, the $1,000 is definitely more than getting $1,000 five from today. If you wait for five years for $1,000 you reap opportunity cost or you may lose out on the return rate for the five-year period.
How do inflation and purchasing power affect the present value?
Inflation is a situation wherein the prices of goods services increase over time. If you get money today, you can buy goods at today’s prices. Inflation will make the piece of a good increase in the future. This is because, as the value of money falls you need to pay a higher amount for the same quaintly of goods and services, which is in turn because the purchasing power of money has become lower.
Present value vs future value
The present value is the current value of a future money sum or stream of cash at a given rate of return. The present value is determined according to the future value and is determined by a discount re of interest that you can ear if invested.
On the other hand, the future value is the value of the current asset a designated date in the future according to the assumed rate of growth.
Simply put, future value shows how worth the investment in the future is whereas the present value shows how much you need in today’s dollars to get back a specific amount in the future.
Understanding the present value will help better to make sound financial investment decisions. While considering any asset, be aware that each of the securities that you come across has the market price and conceptual price (theoretical price). Often the market price is influenced by sellers and buyers. Likewise, the theoretical price is also influenced by applying different methods resulting in varying values. Therefore, you should be careful while estimating the present value. If you cannot, seek expert advice.