Every investor wants to know the risks they're taking with their money. Every business needs to know if they should buy now or later.
In both of those cases, being able to calculate present worth accurately is important. That's where using a present value calculator comes in handy.
If that sounds confusing, don't worry! This page goes over what the present value formula is, why it's important, and how to figure it all out.
Not every financial situation starts with nice, round figures. The math can get complex, especially when working with larger numbers. There are other factors to worry about than simply multiplying or dividing.
A present value formula calculator (also called a present worth calculator) comes in handy in many situations. If you're expecting a single payout in the future, you want to know how much that is worth today, right?
Investing a sum of money is the same idea. You want to know what the value of the investment is worth today, not just in the future, so you can compare it to other options.
Finally, the present value formula offers you a way to check up on your retirement savings. If you know how much you need to retire, use the formula to estimate where your savings should be today.
Present value gets used both by individual investors and corporate shareholders for analysis.
In personal finance, present value often gets used in retirement planning. If you have an idea of how much you'll need in your retirement fund, present value can help you measure your progress.
It gives you a rough idea of whether you're on the right track or need to invest more aggressively.
In the corporate world, shareholders invest money in a business and use the present value of their expected payoff to figure out if it's worth their investment.
If you plan on investing $1,000 in Company A stocks with an expected return of $1,200 in a year, you need to calculate the present value of the future payoff.
As an example, say the investment is a little risky and carries a 15% discount rate. The present value is:
1,200 / 1.15 (1+15%) = $1,043
That means it's worth the investment because the $1,000 investment in Company A's stocks is the same as having $1,043 cash in hand.
There are many terms and abbreviations when it comes to the world of finance. Sometimes, the terms are interchangeable. Other times, one word can make all the difference.
Present value (PV) is the current value of a future sum of money. No, you don't need to go 88 mph in a DeLorean to find it. See the formula below:
Here, c1 is the cash flow at period 1, r is the rate of return and n is the number of periods.
Net present value (NPV) is the difference between the present value of inflows and outflows over a set period of time. It's a bit more intricate, as you can see from the following equation:
Here:
The present value formula that you use should depend on the complexity of your situation.
The concept of present value is quite logical and based on the theory that current money in hand is more valuable than a future payout.
You are selling a TV for $100 and the buyer says they will pay 8% interest if they can pay you in a year. The present value formula is cash flow divided by (1+ interest rate).
In the case of the TV, that would be 100 divided by 1+8% = 108.
If you sold the TV and got $100 on the spot, the present value is $100. If you took the deal of $108 in a year, it's not valued at $108 today because you don't have it.
To find the present value of the $108 you'll receive in the future, you need to figure out how much you have to invest today to get the $108 in a year.
The present value of $108 in a year with 8% interest is $108 divided by 1.08 (1+8%) = $100.00.
Of course, that could be a risky deal. The buyer may take the TV and run. Now, you're out a TV and the money.
In business, most deals aren't that cut and dry when it comes to risk. But, future payoffs aren't certain either. There's always the chance you won't get the return you expect.
If you took the $100 from a buyer and deposited it into your savings account (let's say it earns has 2% interest), you're guaranteed to have $102 in a year. There was no risk to you since you got your money either way.
It's always riskier to invest with a third party or non-bank. The U.S. federal government backs banks whereas they don't in all cases involving third-party institutions.
The discount rate is the interest rate financial professionals use to calculate future payoffs. It's higher than a bank's rate and depends on how risky the future payoff is.
Money expected to come in from a third party in the future has a higher risk than money backed by a bank. Thus, the discount rate accounts for the risk. The discount rate depends on how high the risk is.
For example, money expected from a reliable source could have a discount rate of 15%. Money expected from a risky source might be set at 20%.
Using $100 as the present value, the reliable client's payment is $115 in one year, while the risky client's expected payment is $120.