### Core Financial Modeling

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Learn moreThe Present Value (PV) of an investment is what that investment’s future cash flows are worth TODAY based on the annualized rate of return you could potentially earn on other, similar investments (called the “Discount Rate”).

Present Value Definition:The Present Value (PV) of an investment is what that investment’s future cash flows are worthTODAYbased on the annualized rate of return you could potentially earn on other, similar investments (called the “Discount Rate”).

This concept of **Present Value** is critical in valuation because it determines what assets and companies are worth.

The foundation here is the **time value of money**, i.e., that $100 today is worth MORE than $100 in 1-2 years from now because you could invest that $100 today and earn more by then.

Yes, there’s also inflation, but that’s **not** the key factor; in an environment with 0% inflation, $100 today would also be worth more than $100 in 1-2 years because you could still invest it and end up with *more than* $100 in 1-2 years.

Suppose that you received $100 today, and you could invest it and earn 5% per year on it.

That means that in 5 years, its **future value** will be $100 * (1 + 5%) ^ 5 = $127.63.

In other words, you multiply the $100 by (1 + 5%) to get $105, and then you multiply the $105 by (1 + 5%), and so on, until you get its value at the end of Year 5.

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Learn moreIf you know this **future value** of $127.63 and your annualized rate of return – the Discount Rate, or 5% here – you can use this information to calculate the **Present Value**, or what it’s worth today:

You can download our Present Value template here to try different assumptions and see how the PV changes.

All company valuation, such as the Discounted Cash Flow (DCF) model, is based on this concept of forecasting a company’s cash flows into the future and then discounting them to today’s values based on how much you could earn on them today.

But rather than just discounting one cash flow to Present Value, you project the company’s financials over a 5, 10, or 20-year period and discount every single cash flow to Present Value.

Also, you normally estimate a “Terminal Value” for the company to represent what it’s worth after that period, and you discount that to Present Value and add it to the PV of all the cash flows to determine the entire company’s estimated value.

Here’s what it looks like when we take the Present Value of a company’s cash flows over a 10 year period and also take the Present Value of its “Terminal Value” and add that:

Confusingly, the **NPV function in Excel** calculates the *Present Value*, **not** the Net Present Value – *if you enter all positive cash flows* over the forecast period:

To calculate the Net Present Value instead, you must enter a negative cash flow in the beginning to represent the upfront purchase price or subtract the upfront price manually in the formula.

To calculate Present Value in real life, you need to know the future cash flows of an investment and the **Discount Rate**, which represents your opportunity cost or expected annualized return.

For real companies, you calculate the Discount Rate using the Weighted Average Cost of Capital (WACC) formula, which we describe in separate articles (how to calculate the Discount Rate and the WACC formula).

You normally measure the company’s annual stock returns/volatility, interest expense, and other factors to estimate how much an investment in the company might return, on average, over the long term.

As an approximation in this simple example, you could just say that the Discount Rate represents **what you expect to earn** on other, similar investments.

So, let’s say you expect a cash inflow of $10,000 five years from now and use a Discount Rate of 8% to represent the risk and opportunity cost.

Plugging these values into the calculator, you get:

The **Present Value** here is approximately $6,806. You could interpret this in the following ways:

**1) Future Value** – If you invest this $6,806 today and earned 8% per year on it, compounded, you would end up with $10,000 after 5 years.

**2) Ability to Pay** – If you earn $10,000 from an investment in 5 years (and nothing in between now and then), you would be *willing to pay* $6,806 for it today because you could earn 8% per year on this $6,806 starting today.

Outside of company valuation, Present Value is widely used in fields such as real estate and fixed-income (bond) analysis.

For example, you could estimate a property’s value based on the Present Value of rental income and other cash flows from it, and you could determine a bond’s price based on its future cash flows and the appropriate Discount Rate.

The whole idea of bond yields is closely linked to the Discount Rate and the time value of money, so a bond’s “price” is closely related to the Present Value of cash flows from that bond.

For more, please see our series on the current yield, yield to call, yield to maturity, and yield to worst.

Present Value always puts future cash flows in *today’s context*, which lets you make better investment decisions.

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.