Online Tutorial #1: How Do You Calculate Present Value?

What Does Present Value Mean?

Present value is today’s value of tomorrow's cash flow. A dollar in the present is worth more than a dollar in the future because you can invest a dollar today and earn a positive rate of return. This process is called compounding. The reverse of compounding is discounting, which converts a future cash flow into a present value.

How Do You Calculate Present Value?

Three factors determine the present value of cash flow:

1. How large is the cash flow? This is how much you expect to receive in the future. The larger the future cash flow, the larger the present value.

2. How risky is the cash flow? Riskiness determines the rate of return that you require from an alternative investment that generates a cash flow with the same level of risk. Certain cash flows have low risk and uncertain cash flows have high risk. For example, the required rate of return for a U.S. Treasury security is low and the required rate of return for a biotechnology startup is high.

3. How long do we have to wait for the cash? The longer you must wait, the less valuable the cash flow. The length of the wait lowers the present value of a cash flow for two reasons. First, you can invest your money in alternative investments that would earn interest during those years. Second, if you are not 100 percent confident that you will get the cash, the more risk you will have to assume as time passes. 

The formula to calculate present value incorporates these three factors:

Here is a simple example:

Let us say you expected to receive a dividend of $200 in 5 years from a stable company. To calculate the present value of that dividend, you would first answer the 3 questions presented above:

1. How large is the cash flow? It is $200.

2. How risky is that cash flow? In this hypothetical case, investors of companies similar to our dividend-paying company require an 8 percent return.

3. How long do we have to wait for the cash? We must wait five years.

Thus, the present value equals:

To put it another way, if you auctioned off the right to receive this $200 dividend in a public market, another investor would pay roughly $136.