What Is Present Value in Finance, and How Is It Calculated?

What Is Present Value?

Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or debt obligations.

Key Takeaways

• Present value states that an amount of money today is worth more than the same amount in the future.
• In other words, present value shows that money received in the future is not worth as much as an equal amount received today.
• Unspent money today could lose value in the future by an implied annual rate due to inflation or the rate of return if the money were invested.
• Calculating present value involves assuming that a rate of return could be earned on the funds over the period.
• Present value is calculated by taking the expected cash flows of an investment and discounting them to the present day.

Understanding Present Value

Present value is the concept that states that an amount of money today is worth more than that same amount in the future. In other words, money received in the future is not worth as much as an equal amount received today.

Why Is Present Value Important?

Present value is important because it allows investors to judge whether or not the price they pay for an investment is appropriate. Calculating present value (and future value) can help investors when they are presented with the choice of earning a fixed sum for the investment at some point in the future, or gaining a percentage of the principal.

Present value calculations are often needed in areas such as investment analysis, risk management, and business financial planning, but the concept is also useful outside of business. For example, understanding the present and future values of an annuity can help you when predicting your retirement income.

The Bottom Line

Present value is a way of representing the current value of future cash flows, based on the principle that money in the present is worth more than money in the future. Present value is used to value the income from loans, mortgages, and other assets that may take many years to realize their full value. Investors use these calculations to compare the value of assets with very different time horizons.

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1. U.S. Securities and Exchange Commission. "Treasury Securities."

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