Lesson 02 of 04
Pulling a future sum back to today
Present value reverses compounding. Divide a future amount by (1 + rate) for each period you wait.
Keep these
- Present value is today’s equivalent of a future payment.
- A higher discount rate produces a lower present value.
- The rate is an input you choose, so the output is not a fact of nature.
The lesson
Compounding asks: if I start with this much, what do I have later? Present value asks the reverse: if I want that much later, what is it worth today? For one payment and annual compounding, divide the future amount by (1 + rate) raised to the number of years.
Raise the rate and the divisor grows, so today’s equivalent shrinks. Distant payments shrink faster than near ones. That is why a business story that pays off “someday” is fragile when the rate you demand is high, and why small changes in the rate move the answer a lot.
Nothing in the formula tells you the correct rate for a share. People use rates that try to reflect time, inflation, and risk. Reasonable people disagree. If two analyses differ only because they typed different rates, you have learned something about the analyses, not about a hidden true price.