WHAT IS PRESENT VALUE OF MONEY? You must understand this to make sound investment decisions.

What is present value of money? Now we know that the real value of money decreases with time (for those of you who are unfamiliar, please watch my video on the time value of money: can we put a numerical value on money in the future? Yes, we can, but it will never be an accurate representation of what it is truly worth. At best, it can only be an estimation. This is where the present value of money comes into play. Let us use an example to illustrate this concept.
Assume that we are investors are presented with an investment opportunity: Great Cakes, a cake company, is projected to earn $1,000 per year from this year, 2020, and 4 years after that. So, we have 5 years worth of earnings, $1,000 per year, giving us a total of $5,000 of profits in 5 years. Now, is the sum of profits worth $5,000 today (in 2020)? Of course not! Why? Because inflation will occur and deteriorate the yearly earnings’ real value over time. Hence, we need to discount each year’s real value to find the present value of the sum of earnings over 5 years. This is how we estimate the present value of money. In relation to investing, if we were to value the business, we would not buy the business at $5,000 because we know that the value of its future earnings relative to today’s (present) value will be a lot less than $5,000.
So now, let us find the present value of the sum of its earnings. Firstly, we know that on average, inflation causes price levels to increase by about 1~2% compounded every year, which effectively means, the value of money will deteriorate by that same amount every year. Secondly, each year’s earnings are a year later than the previous year, so, the real value of each year’s earnings is less than the previous year’s earnings, hence, it is must be discounted more with each passing year. We require the use present value table to find the amount we need to discount with each year.

Let’s use a conservative inflation growth rate of 3%. So, we select the 3% interest rate column, and we take the value of the first 4 rows (periods) in the 3% column. If you look at the values (highlighted in the red box), Period 1 has a value of 0.971. This means that for year 1, the $1,000 must be discounted to 0.971 of it’s numerical value. This will leave us with a real value of 0.971 x $1,000 = $971. This is the present value of earnings in year 1 (2021), relative to today, year 0 (2020). If we move on to calculate the real value of each year, it would be as follows:
Year 2 (2022) – 0.943 X $1,000 = $943
Year 3 (2023) – 0.915 X $1,000 = $915
Year 4 (2024) – 0.888 X $1,000 = $888
Not forgetting the current Year 0 (2020), earning $1,000, we have a total present value of:
$1,000 (year 0) + $971 (year 1) + $943 (year 2) + $915 (year 3) + $888 (year 4) = $4,717.
From this, we know that the $5,000 sum of profits is actually worth about $4,717 in present value. Hence, from an investor’s standpoint, it is not logical to base the fair value of the business just from the numerical / nominal value of its anticipated earnings; the investor must discount its yearly earnings by some percentage rate in order to get the present monetary value of the business itself.
Stay tuned for my next video on the discount rate! This is where we bring a practical approach to stock valuation, using the concept of present value calculations.

May your days ahead be profitable and productive!

present value of money calculation,discount rate present value,inflation explained,finance 101,stock market for beginners,stock picking,stock picking strategy,stock market investing for beginners,stock market investing 101,stock market investing tips,