Present Value

What Is Present Value?

Present value (PV) is the amount that a future sum of money is worth today. Money available now is generally worth more than the same amount received later, because it can be invested to earn a return, a principle known as the time value of money. Future payments also carry the risk of not arriving as promised. Present value expresses a future payment in today's terms so that amounts received at different times can be compared fairly.

How It Works

Present value is found by reversing the growth that would occur if money were invested. Instead of asking what an amount will grow to, it asks what amount today would grow to the future figure. This process is called discounting, and the rate used is the discount rate, which reflects the return an investor could reasonably expect elsewhere for similar risk.

The basic formula for a single future payment is:

PV = FV / (1 + r)^n

Here FV is the future value, r is the discount rate per period, and n is the number of periods. The higher the discount rate or the longer the wait, the lower the present value.

Example

Suppose someone is due to receive 1,000 dollars in five years, and the appropriate discount rate is 5 percent a year. Dividing 1,000 by 1.05 raised to the fifth power gives about 784 dollars. Under these assumptions, the promised payment is worth roughly 784 dollars today. Changing the rate changes the result, which is why the choice of discount rate matters so much.

Why It Matters to Investors

Present value is the foundation of discounted cash flow analysis, in which expected future cash flows from an investment are discounted to estimate what it is worth now. It is also used in net present value calculations for comparing projects, and in valuing bonds, whose future coupon and principal payments are discounted to a price. Because the result depends heavily on assumed rates and cash flows, estimates can differ widely between analysts.