Main Street investors may not realize it, but there is a time value to money that pegs a financial asset value to cash that you have in your pocket today, and cash you expect to have in your pocket next week or even next year.
Economists call that the "present value" of money, and it's an equation that regular folks and business decision-makers need to know about.
Why? Because in giving proper balance and evaluation to the current and future value of money, you're setting the stage for better financial and investment decision-making, which leads directly to more optimal personal financial outcomes down the road.
What Is Present Value?
The present value of money is a financial formula used primarily by accountants and economists to calculate the present-day value of a financial asset or assets that will be earned or received at a later date.
Economists refer to the relationship between the perceived present and future value of financial assets as the "time value of money." In essence, the time value of money is the theory that any amount of cash today is worth more than the value of that cash at a later date down the road.
In real-world, real-cash terms, the time value of money poses the theory that it's more valuable to receive $500 today than it is to receive $500 one year from now.
That's where present value enters the picture. Instead of evaluating whether it's preferable to receive $500 today or $500 365 days from now, present value offers a different, more intriguing question: Is it better to receive $500 today or $550 a year from now?
Present value aims to answer that question by calculating the present value of money against the future value of money.
Terms Associated With the Present Value of Money
While the present value of money is considered to be in the same mathematical family as the time value of money, it's helpful to branch out and single out the terms that are important to understanding both financial formulas.
Present Value
This accounting term calculates the current value of a financial asset that will be available at a specified later date, at an exact rate of financial return. For example, the present value of $1,100 that you'll earn one year from today at a 10% rate of return is $1,000.
Future Value
Equally valuable to any discussion about the present value is the future value. This means the future value of a financial asset is measured (or calculated) by a fixed financial asset value today. For instance, using the example above, the future value of that $1,000 given a rate of return of 10% is $1,100.
Net Present Value
Known to accountants and economists as NPV, net present value is the total amount of the present value of money, including inflows and outflows, discounted at an estimated rate of return on that money. If you wind up with a net present value in positive territory, that is considered a good outcome. On the other hand, any negative NPV is considered problematic. For instance, if a major automaker planned on building a new manufacturing complex, the automaker's chief executive officer would want to know if the future cash values earned from the production of new vehicles at that complex would be enough to cover the cost of building the manufacturing facility, and how long it would take for that to happen.
Present Value vs. Future Value of Money
The main difference between the present value and future value of a financial asset is based on the simple notion that cash in your bank account today is of higher value than the same amount of money deposited in your bank account one year from now, due to asset appreciation from inflation and compounded interest.
Additionally, a big difference in estimating the present versus the future value of money is there is a risk that you don't earn any interest or rate of return on a future asset. The risk also factors in if the original (present value) asset may or may not appreciate in value over a specific period of time, at a specific compounded rate of interest.
How to Calculate Present Value
Calculating the present value of money can help individuals, organizations, and companies, especially in the formulation of financial estimates in key areas like corporate finance, banking, investing, accounting, and insurance. The following is a formula for present value:
Present Value = Future Value * (1 / [ (1 + Rate of Return) ^Number of Periods])
While there are various formulas used to calculate the present value of money, here's a basic, real-world formula widely used by accounts and financial forecasters. The formula is best represented in this example from the Corporate Finance Institute:
Note: You'll need to know certain variables before trying to calculate present value, including:
- The total amount of money or financial asset in the future
- The amount of time it takes to get that money (i.e., future value.)
- The interest rate or rate of return you may receive if the current money was invested today
- How you'll calculate that interest
To calculate the present value in this example, you're dividing the future value of a financial asset instead of multiplying the present value of that financial asset.
For example, let's compare the outcomes possible of a person receiving $1,000 today or receiving $1,100 one year from today. If an individual could earn 5% by investing the $1,000 right now, at an estimated rate of return of 5%, and you wanted to know if the present value at that rate of return compares to that future $1,000, you would use the following formula.
PV = $1,100/1+(5%/1 ^ (1 times 1) = $1,047
Once that calculation is applied, with a 5% annual rate of return, that individual would have to get $1,047 today to equal the future value of $1,100 one year from today.
Why Is Present Value so Important in Finance?
For individuals, especially investors and business owners/decision makers, the time value of money is a critical concept and needs to be fully understood when assessing financial decisions, for several reasons and in multiple scenarios:
Money Is Worth More Now Than Later
The time value of money concept is based on the notion that $100, for example, is worth more today than it is a year from today, given that $100 today can be invested in stocks, bonds, real estate, annuities, and other investment vehicles and grow in value as interest or capital gains kick in. In contrast, $100 given to you one year from now, does not have that growth factor, and can actually lose value to inflation.
By and large, the sooner you receive a financial asset, be it a dollar bill, a house, or an annuity, the better, as it is worth more now, with all of those investment options in play, than it is in the future.
Real World Applications Are Numerous
Present value calculations can be a game changer in many areas. For example, a company considering building a new factory, a retiree mulling over buying an annuity, or a corporate finance manager trying to estimate cash flow can all benefit from the concept of present value. Even state lottery agencies used present value to estimate winning lottery payouts.
It's a Great Tool for Businesses
Businesses can leverage present value in determining whether to invest their capital. Take a restaurant that is considering buying smart screen devices for each table that allows customers to order food, alert a wait staff member, or provide games and videos to entertain the kids until the food arrives.
Let's say that the smart screens, in total, cost the restaurant $10,000 and are estimated to work well for a period of five years. The restaurant estimates that the smart screens will return, on average, $3,000 due to their popularity with customers, and their ability to attract new customers. But they're not sure about that estimate.
To properly evaluate the purchase, and make the right decision, the restaurant can calculate the present cost of the smart screen installation against its future value five years from now, using time value of money calculations.
