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What is Present Value?

Definition: Present value (PV) is the idea that money is worth more today than in the future.

What is present value?

Present value (PV) is the value of the future cash amount in today’s dollars, calculated using a predetermined rate of return (discount rate). In other words, if you get $500 today, it costs more than getting the same $500 after five years. Investors and businesses typically use PVs when assessing the rate of return on investments or projects.

Investments with a higher discount rate will have a lower present value, while investments with a lower discount rate will have a higher PV. Understanding the discount rate is crucial when trying to determine the current or future value of a cash amount or potential cash flow.

Why do I need a PV?

The current value is vital for several different reasons. First, it will help you understand how much the future amount of money in today’s dollars will cost, based on the discount rate chosen. This is important when you calculate how much you may need to invest today to reach the target amount in the future given the expected rate of return – financial advisers often make similar calculations when planning for retirement.

You can also use PV to calculate the future value of your cash flows. If you know what you have today and you have a reasonable idea of the expected rate of return, then you can calculate the future value of your money. For example, if you have $ 10,000 that you invest over five years with an annual return of 5%, you can calculate the expected future value of $ 12,762,82. (Future returns are never guaranteed; all investments involve risk.)

In addition, companies and investors often use present value as a basis for calculating net present value, which is an estimate of the present value of all future cash flows (both inbound and outbound). This gives them the opportunity to evaluate and compare different investment opportunities.

PV vs. FV

Present value and future value are different sides of one coin, and you need each to calculate the other – in addition to the discount rate.

The present value tells us that $1 today will be worth more than $1 tomorrow. Why? In general, inflation will lead to a decrease in the value of your money over time. This means that all the money you have today will decrease by the amount of inflation annually, so that in the future it will cost less than today.

You also need to consider the temporary value of the money. This is another way to say that money is worth more today than the same amount of money in the future because of the potential return on it. For example, suppose that today you have $10,000, and you invest it for five years with a return of 5%. In five years, you’ll have $12,763. Thus, the temporary value of money makes $10,000 more valuable today than $10,000 in the future.

Future value is the value of an asset in the future based on a certain rate of return (discount rate). Again, it’s just the downside of PV. For example, suppose today you have $1,000 (present value) and invest it over five years (number of periods) at 5% APR (discount rate). This gives you a future value of $1.276.

There are four main elements to the equation: present value, future value, number of periods, and discount rate. You always need the discount rate and the number of periods, and then use the PV to determine the FV or vice versa.

How to calculate PV?

The formula for PV is as follows:

PV = FV/(1+r)^n

Each character means the following:

PV = present value in today’s money, FV = projected future value of money, r = expected rate of return, interest rate or inflation rate (aka discount rate), n = number of periods.

Let’s say in 5 years you want to get $15,000 for a trip to Hawaii. This is the future cash flow you want to have. You assume you could get a rate of return of 5%. How much money do you need to invest in today’s (PV) to reach a future value of $15,000?

PV = $15,000/( 1 + 5%) ^5 or $11.753

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