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Present Value

1. Present Value (PV) estimates how much a future cash flow is worth today by discounting it using an appropriate discount rate. 2. The PV formula divides the future value by 1 plus the discount rate raised to a power reflecting the number of periods until receipt. 3. Calculating the PV of a company's expected future free cash flows estimates the company's intrinsic value today.

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55 views6 pages

Present Value

1. Present Value (PV) estimates how much a future cash flow is worth today by discounting it using an appropriate discount rate. 2. The PV formula divides the future value by 1 plus the discount rate raised to a power reflecting the number of periods until receipt. 3. Calculating the PV of a company's expected future free cash flows estimates the company's intrinsic value today.

Uploaded by

celso
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Present Value (PV)

What is Present Value?


The Present Value (PV) is an estimation of how much a future cash flow (or stream of cash
flows) is worth right now. All future cash flows must be discounted to the present using an
appropriate rate that reflects the expected rate of return (and risk profile) because of the
“time value of money.”

How to Calculate Present Value (PV)?


The present value (PV) concept is fundamental to corporate finance and valuation.

The premise of the present value theory is based on the “time value of money”, which states
that a dollar today is worth more than a dollar received in the future.
Therefore, receiving cash today is preferable (and more valuable) than receiving the same
amount at some point in the future.

There are two primary reasons that support this theory:

1. Opportunity Cost of Capital: If the cash is currently in your possession, those


funds could be invested into other projects to earn a higher return over time.
2. Inflation: Another risk to consider is the effects of inflation, which can erode the
actual return on an investment (and thereby future cash flows lose value due to
uncertainty).

Present Value (PV) vs. Discount Rate


Since money received on the present date carries more value than the equivalent amount in
the future, future cash flows must be discounted to the current date when thought about in
“present terms.”

Moreover, the size of the discount applied is contingent on the opportunity cost of capital (i.e.
comparison to other investments with similar risk/return profiles).
All future receipts of cash (and payments) are adjusted by a discount rate, with the post-
reduction amount representing the present value (PV).
Given a higher discount rate, the implied present value will be lower (and vice versa).

•Lower Discount Rate → Higher Valuation

•Higher Discount Rate → Lower Valuation

When estimating the intrinsic value of an asset, namely via the discounted cash flow (DCF)
method, how much a company is worth is equal to the sum of the present value of all the
future free cash flows (FCFs) the company is expected to generate in the future.
More specifically, the intrinsic value of a company is a function of its ability to generate future
cash flows and the risk profile of the cash flows, i.e. the company’s value is equal to the sum
of the discounted values of its future free cash flows (FCFs).
Present Value Formula (PV)
The present value (PV) formula discounts the future value (FV) of a cash flow received in the
future to the estimated amount it would be worth today given its specific risk profile.
The formula used to calculate the present value (PV) divides the future value of a future cash
flow by one plus the discount rate raised to the number of periods, as shown below.

Present Value (PV) = FV / (1 + r) ^ n


Where:

•FV = Future Value

•r = Rate of Return

•n = Number of Periods

•Future Value (FV): The future value (FV) is the projected cash flow expected to be

received in the future, i.e. the cash flow amount we are discounting to the present
date.
•Discount Rate (r): The “r” is the discount rate – the expected rate of return

(interest) – which is a function of the riskiness of the cash flow (i.e. greater risk →
higher discount rate).
•Number of Periods (n): The final input is the number of periods (“n”), which is the

duration between the date the cash flow occurs and the present date – and is equal
to the number of years multiplied by the compounding frequency.

Quick Present Value (PV) Calculation Example


Let’s say you loaned a friend $10,000 and are attempting to determine how much to charge
in interest.

If your friend has promised to repay the entire borrowed amount in five years, how much is
the $10,000 worth on the date of the initial borrowing?
Assuming that the discount rate is 5.0% – the expected rate of return on comparable
investments – the $10,000 in five years would be worth $7,835 today.

•PV = $10,000 /(1 + 5%)^5 = $7,835

What is the Difference Between Present Value vs. Future


Value?
The present value (PV) calculates how much a future cash flow is worth today, whereas the
future value is how much a current cash flow will be worth on a future date based on
a growth rate assumption.
While the present value is used to determine how much interest (i.e. the rate of return) is
needed to earn a sufficient return in the future, the future value is usually used to project the
value of an investment in the future.

•Present Value (PV) → How much is the future cash flow worth today?

•Future Value (PV) → How will this current cash flow be worth in the future?

Present Value Calculator (PV)


We’ll now move to a modeling exercise, which you can access by filling out the form below.
(Excel – Present Value)

1. Present Value Exercise Assumptions (PV)


Suppose we are calculating the present value (PV) of a future cash flow (FV) of $10,000.

We’ll assume a discount rate of 12.0%, a time frame of 2 years, and a compounding frequency
of one.
• Future Cash Flow (FV) = $10,000
• Discount Rate (r) = 12.0%
• Number of Period (t) = 2 Years
• Compounding Frequency (n) = 1x

2. PV Formula in Excel
Using those assumptions, we arrive at a PV of $7,972 for the $10,000 future cash flow in two
years.

•PV = $10,000 ÷ (1 + 12%)^(2 × 1) = $7,972

Thus, the $10,000 cash flow in two years is worth $7,972 on the present date, with the
downward adjustment attributable to the time value of money (TVM) concept.
3. Discounted Cash Flow Model Assumptions (DCF)
In the next part, we’ll discount five years of free cash flows (FCFs).

Starting off, the cash flow in Year 1 is $1,000, and the growth rate assumptions are shown
below, along with the forecasted amounts.

• Year 1 = $1,000
• Year 2 = 10% YoY Growth → $1,100
• Year 3 = 8% YoY Growth → $1,188
• Year 4 = 5% YoY Growth → $1,247
• Year 5 = 3% YoY Growth → $1,285

4. DCF Analysis Using PV Function in Excel


If we assume a discount rate of 6.5%, the discounted FCFs can be calculated using the “PV”
Excel function.

• Year 1 = $939
• Year 2 = $970
• Year 3 = $983
• Year 4 = $970
• Year 5 = $938
The sum of all the discounted FCFs amounts to $4,800, which is how much this five-year
stream of cash flows is worth today.

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