In his book Expectations Investing, Michael Mauboussin provides a simple explanation of how to calculate the present value of an investment. Here’s an excerpt from the book:
We return to first principles to see why the stock market bases its expectations on long-term cash flows. A dollar today is worth more than a dollar in the future, because you can invest today’s dollar and earn a positive rate of return, a process called compounding. The reverse of compounding is discounting, which converts a future cash flow into its equivalent present value.
An asset’s present value is the sum of its expected cash flows discounted by an expected rate of return—i.e., what investors expect to earn on assets with similar risk. The present value is the maximum price an investor should pay for an asset.1
1. Suppose someone offers you a contract specifying that you will receive $10,000 one year from today.
What is the most you should pay for this contract today? The answer, of course, depends on the rate of return that you can expect to earn over the next year. If the one-year interest rate for investments of comparable risk is 7 percent, then you shouldn’t pay more than the dollar amount, which, when compounded at a 7 percent rate, equals $10,000 by the end of the year.
Since you know next year’s cash flow ($10,000) and the discount rate (7 percent), you can easily determine that the present value, or the maximum that you should pay, is $9,346:
Present value × (1 + Rate of return) = Future value
Present value × 1.07 = $10,000
Present value = $9,346
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