The present value is the current value of a future sum of money or stream of cash flow given a specified rate of return. Future cash flows are discounted at a certain discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is key to properly valuing future cash flows, whether they are earnings or debt obligations.
Present value is a key concept in business because it allows companies to determine whether a certain action is worth pursuing or not since by using this concept you can determine if the money you will receive in the future is worth as much or more than the amount you will receive now. To illustrate this example, we can say that $1000 today is worth more than $1000 in 10 years because you could possibly earn returns on the initial capital. Furthermore, even if you don’t get any returns on your initial capital inflation is likely to make the purchasing power of it less in the future. This is why present value is a great tool for companies since many times after performing this type of analysis they can objectively quantify a certain value for a course of action and decide whether to pursue it or not.
Another very important factor we mentioned before is the discount rate, which is the rate of return that is associated with the present value calculation. To put it in simpler terms, the discount rate would be the rate of return that an investor is foregoing in order to accept an amount in the future versus the same amount today, normally the investor will always pick the option with the highest return while using the discount rate as a benchmark. The discount rate that is chosen for this type of calculation is highly subjective because it’s the expected rate of return an investor would receive if you had invested for a certain period of time. The most used benchmarks for discounted rates are the risk-free rate of return, which represents the threshold that needs to be met in order for a project to be worth pursuing and it’s normally tied to U.S. treasury bonds since they are backed by the US government. An example of this would be that if a two-year Treasury paid 2.7% interest or yield, the investment would need to earn a higher rate of return than this in order to be justified. Another common benchmark companies use is the S&P 500 because it mirrors the market and is also a widely available index that companies and individuals can buy with ease. Hence, the thesis is similar to the one of the treasuries: If an opportunity provides a lesser return than a widely available index, it’s probably not worth pursuing it.