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Present Value (PV) |
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WIKI ANALYSIS| This article is part of WikiProject Definitions. Consider editing to improve it. View articles referencing this definition. |
Present Value (PV) refers to the today's value of a set of cash flows that will occur in the future. It is calculated by dividing future cash flows by an appropriate discount rate.
Present value calculations are widely used to assign values to corporations, bonds, or financial securities. It also helps investors make comparisons between investment decisions that have different cash flows coming in at different times. Present value calculations account for the time value of money as well as inherent investment risks.
Present value is used to determine how much a set of future cash flows are worth today. To put it simply, an investor you would be indifferent between holding $100 in cash (present value of $100 today is $100) and a bond that pays off next year but has a present value of $100.
Present Value Terminology
- Time Value of Money is a fundamental concept in which money today is worth more than the same amount of money tomorrow. In other words, being given a $100 bill today is not the same as being given a $100 bill tomorrow, because you can deposit or invest that $100 today. By tomorrow, you will have the same $100 bill, plus any interest earned, making that same bill more valuable today than tomorrow. In this sense, money has a "time value" where money received today is worth more than money received in the future.
- Discount Rate is the rate at which you divide future cash flows by in order to reach a present value. For risk free investments such as U.S. Treasure Bills, the discount rate used is the risk free rate. For investments such as stocks, the discount rate will be much larger due to uncertainties as well as increased risk. The discount rate typically has the greatest impact on one's present value calculation, making the use of an accurate discount rate extremely important.
- Stream of future cash flows is the future cash flow, or future value you will be discounting to find its present value. It can be known with certainty, such as with coupon payments from U.S. Treasury Bonds, or it can be extremely uncertain, such as a small company's estimated future earnings.
Calculating Present Value
Calculating the present value of a set of cash flows is rather straightforward. The present value is equal to the sum each future cash flow divided by the appropriate discount rate.
An example will help clarify this. Assume you have a cash flow that will pay you $100 in exactly one year with 100% certainty. Since there is no uncertainty about the payments or cash flows, and thus no risk involved, the appropriate discount rate is simply the risk free rate. For this example assume it is 10%. The present value is then simply $100 / (1+0.1) = $90.91
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