Why are present value calculations so important?

May 18, 2018

Present value calculations can be abstract in nature, which is why most people simply ignore it. But understanding present value is critical to understanding how money works, and to understanding how to make proper decisions in the future. In finance and in investing, there is no good and bad. There is simply comparisons of one strategy to an alternative strategy. Understanding the concepts behind present value will take you a long way to being able to make good decisions for your future.

The Concept

Present value and it’s close sibling future value, are both based on the financial concept of time value of money. It’s a simple idea, money today is worth more than money tomorrow. Why? There are two main reasons.

The first, money devalues over time. If you have a $100 bill in your wallet and you don’t spend it, a year from now you will still have a $100 bill, right? The problem is your purchasing power has gone down. When McDonald’s first opened, their hamburgers were 15 cents. Today a quarter pounder costs around $3.80 (2018) depending on your location. That’s over a 2,400% increase in price over 63 years. So you money won’t buy you as much, it’s worth less over time.

The second, and more important reason for understanding time value of money; in finance we’re always concerned with alternatives. If you invest $100 at 5% interest for one year, you will have $105. Therefore, the person who did not invest, just lost $5.

Why Should You Care?

Understanding present value allows you to properly evaluate investment opportunities. Here’s a hypothetic situation that I think sheds light on how important this topic is. Let’s say you’ve worked hard to build a small business and a competing company has offered to buy you out. Your plan was to retire and invest any proceeds you receive into your favorite bond fund that historically returns 5% annually. In the offer, they are giving you a choice, $1,100,000 up-front, or $250,000 a year for five years.

A simple calculation will tell you that the five-year payout is a better deal. After all, $250,000 for 5 years is $1,250,000, a whopping $150,000 more than the up-front deal of $1,100,000.

But remember, money today is worth more than money tomorrow. Using the 5% rate of return as a discount, we can calculate that the $250,000 a year for five years has a present value of only $1,082,369, $17,631 less that the up-front offer. The simple calculation is wrong, the up-front offer is superior.

The Calculation

The math behind the calculation can be a little daunting for those who don’t do finance or algebra on a daily basis. But remember, even finance experts don’t do the math by hand, they do it in a spreadsheet like Excel or they use a financial calculator. I’ll show you the formula here, and explain the easy way to do it below.

The PV formula is as follows:

“C” represents the expected cash flow, “r” represents the discount rate, and “n” represents the number of periods. For the above example, “C” is $250,000, “r” is 5%, and “n” is 5 years.

One of the most debated number in the formula “r” or the discount rate. I chose to use the historic interest rate of an alternative investment strategy. The idea here is that, if I take the up-front cash, I am really asking what the rate is that it would be invested in. So I want to discount the present value of the future stream of payments, the $250,000, by that rate. The rate you use will no always be this obvious, but it is something you need to figure out. Look for an alternative investment that you want to compare your choses to. Or, if nothing else, use the current rate of inflation on your discount rate.

Using Excel To Calculate PV

Most investors and financial experts would make the calculation on a financial calculator, but I prefer to use a spreadsheet. Spreadsheets allow me to see what I am doing and easily adjust the variables to play “what if” games.

In Excel, place your cursor in any field and enter “=PV(0.05,5,-250000)”. The 0.05 represent the 5% discount rate, the 5 represent the 5 year payout period, and the -250000 represent the $250,000 you expect to receive every year for those five years. If you are proficient in Excel, you can being to set up each number of a separate cell so it’s easy to change the numbers and play with results.

Using Excel To Calculate NPV

Let’s take this one step further. Let’s say the offer is structured a little differently, $1,100,000 up-front, or unequal payments for the five years; $150,000 in year one, $350,000 in year two, $300,000 in year three, $250,000 in year four, and $200,000 in year five. The owner wants to adjust the payments based on his future estimated cash flow, but the total is still $1,250,000 over 5 years.

With unequal payments for the period, we now need to use the NPV or net present value calculation, and again it is very simple to do in Excel. Enter the flowing in any cell, =NPV(0.05,150000,350000,300000,250000,200000) where the 0.05 is the 5% discount rate and each cash flow is separated by a comma. In this case, the result it $1,081,849, still less that the $1,100,000 up-front.

You can also set your cash flows up in a column. Enter each annual cash flow in cells like this: 150000 in A1, 350000 in A2, 300000 in A3, 250000 in A4, and 200000 in A5. Then the formula becomes =NPV(0.05,A1:A5), making it easy to adjust each year’s amount and allow you to maybe come up with a counter offer.