What it means
The idea behind present value is that a dollar today beats a dollar next year, because today's dollar can be put to work. Discounting simply reverses that logic: if you know what you would need to invest to reach a future amount, that starting figure is the future amount's present value.
The discount rate carries all the judgment in the calculation. It usually reflects what the money could otherwise earn plus a margin for how risky the future cash is, so a safe government payment is discounted at a low rate and a speculative project at a high one.
Small changes in the rate matter more over long periods. A cash flow ten years out barely moves at a 3% rate but shrinks dramatically at 15%, which is why long-dated projects are so sensitive to the assumption you choose.
In practice, present value is rarely used on a single figure. Most decisions involve a stream of cash flows, each discounted for its own number of years and then added up, which is how net present value and discounted cash flow valuations are built.
One nuance is worth remembering when reading other people's models. Present value tells you what a future amount is worth today under one specific rate, so two people can look at identical forecasts and reach very different values simply because they disagree about risk.
In practice
Real-world examples
Example 1
A manufacturer weighing a machine that will save $50,000 a year for six years discounts each year's saving at 9% before comparing the total with the $220,000 purchase price. Without discounting, the six years of savings look far more attractive than they are.
Example 2
A finance team accounting for a five-year office lease calculates the present value of the future rent payments to record the lease liability on the balance sheet. The discount rate used is the rate implicit in the lease or the company's incremental borrowing rate.
Example 3
An employee offered a $30,000 retention bonus payable in three years discounts it at the 6% he could earn on savings, giving roughly $25,000 in today's money. That figure, not the headline number, is what he compares with a competing job offer.
Think of it
Think of present value like determining the value of a coupon. A coupon for a discount in the future might be less valuable to you than a smaller discount today, depending on how soon and how often you shop.
Formula
Calculation
Present value = Future value / (1 + r) to the power of n
where r is the discount rate per period and n is the number of periods.
Suppose a customer offers to pay a supplier $121,000 in two years instead of paying today, and the supplier can otherwise earn 10% a year on its cash. The discount factor is 1.10 x 1.10 = 1.21, so the present value is $121,000 / 1.21 = $100,000.
The arithmetic checks in the other direction: $100,000 invested at 10% grows to $110,000 after one year and $110,000 x 1.10 = $121,000 after two. The same logic shows why a competing offer of $110,000 payable in one year is worth exactly the same today, because $110,000 / 1.10 = $100,000. If the supplier's required return were 15% instead, the two-year offer would be worth $121,000 / (1.15 x 1.15) = $121,000 / 1.3225 = $91,493, so the higher the risk, the less a distant promise is worth.Case study
Seen in the real world
This illustrative and fictional example concerns Thornbury Logistics, a haulage business deciding whether to buy a warehouse for $2,000,000 or continue renting. The purchase would save $260,000 a year in rent for the next ten years, and the fictional finance director used a discount rate of 8% to reflect the company's cost of finance.
Undiscounted, ten years of savings came to $2,600,000, which looked like a comfortable margin over the $2,000,000 price. Discounted at 8%, the same stream was worth about $1,745,000 in today's money, which is less than the purchase price.
The illustrative decision changed once the resale value of the building was included, adding a large single amount at year ten that was itself discounted back. The point of the fictional exercise was that the ranking of the two options flipped purely because the timing of the money was taken seriously.
Watch out
Common mistakes
- Adding up future cash flows without discounting them. It systematically flatters long projects and undervalues quick paybacks.
- Using one discount rate for everything. A safe cost saving and a speculative new product do not carry the same risk and should not share a rate.
- Mixing periods and rates. An annual rate must be applied to annual periods, or converted properly before use with monthly cash flows.
Questions
People also ask
What discount rate should a small business use?
A common starting point is the rate it pays to borrow, adjusted upwards for the risk of the specific project.
Is present value the same as net present value?
No; net present value is the present value of all cash inflows minus the present value of the cash outflows, including the initial investment.
Does inflation belong in the rate?
Either forecast cash flows in today's money and use a real rate, or forecast them in future money and use a nominal rate, but never mix the two.