Have you ever wondered how much is a certain financial asset or a business worth if you wanted to buy it today? If you ever tried to invest in something, I am sure you have thought through this process. Evaluating a business can become extremely difficult, but if you can come close to being able to discover its true intrinsic value, you are on the right path of becoming a true value investor. Value investing is all about buying businesses when are trading below their intrinsic value.
Therefore, being able to calculate the present value of a series of cash flows will put you a step closer in knowing how to evaluate a business. Now, this is no DCF( Discounted cash flow model) but it is an essential part of the model itself (in much simpler form).
Imagine that you have an opportunity to purchase a financial asset ( a fictional stock) that promises to pay $1,000 per year for 5 years and your rate of return is 12% per year. How much should you pay for this asset today?
Using the basic formula below we get:
PV = A*[1-(1/(1+r)^N))/r]
A = the annuity amount
r = interest rate
N = the number of annuity payments
PV = 1,000*[1-(1/(1+0.12)^5))/0.12]
PV = 1,000 * 3.6047
PV = $3,604.78
Using this formula we have determined that the series of cash flows of $1,000 per year for 5 years is currently worth $3,604.78 when discounted at 12%. We had to discount the 12% interest rate you were getting each year, so we can express them in terms of today’s dollars.
So if someone offered you this financial asset for $4,000 today- you’d be doing him a favor by paying much more than what the asset was worth. Unless, you are quite optimistic that this financial asset (a fictional stock) would bring you more than 12% return a year. If that’s the case you would plug in your expected return and calculate the present value.