What Is Present Value? A Practical Explanation
Understanding how discounting future cash flows helps you make smarter investment and valuation decisions.
Before we can work with more advanced valuation techniques, we first need to understand a foundational concept in startup finance: the Discount Rate. This rate helps answer a crucial question—what is the value of the money you have today at some point in the future? An investor who chooses to put money into your startup instead of a risk-free savings account expects a higher return over time, and the Discount Rate is one of the tools used to evaluate that opportunity.
To value an invention or early-stage business idea, professional investors rely on several analytical tools. Before we can apply meaningful valuation methods such as the DCF method, we first need to introduce the concept of Present Value (PV). PV is the foundation for tools like Net Present Value (NPV) and for calculating a realistic discount rate, which in turn can be supported by models such as CAPM.
This page explains Present Value and the idea of money's worth over time—concepts essential for understanding both NPV and the DCF concepts. At the end of the explanation, we will link to the DCF page where the full valuation logic comes together.
The value of money and the Present Value (PV) of money
The value of your money decreases over time. The Present Value concept is based on the idea that "A dollar today is worth more than a dollar tomorrow," or in other words, receiving 1 dollar in one year's time will not be worth as much as 1 dollar today, even if you are certain that you will receive this dollar in a year's time (which is not always the case). Why is this? This is because a dollar that can be invested today, say at a 10% interest rate (this unrealistic percentage is used for easy calculation), will be worth $1.10 in a year's time in a savings account. Conversely, we can say that with an interest rate of 10%, receiving $1.10 in one year's time is equivalent to $1 today. Or that $1 to be received in one year's time in "today's money" is equal to $1/(1+ 0.1) = $0.90909, which confirms our statement that a dollar today is worth more than a dollar in the future.
So the present value concept is a financial principle that states that the value of a sum of money today is worth more than the same amount of money in the future. This is because money today can be invested today, work for you, and earn interest or returns, increasing its value over time.
When we want to calculate the present value of a future sum of money, we need to take into account the so-called time value of money. For this reason, the future cash flow must be adjusted to account for this time value of money. This is done with the so-called Discount Rate.
The Discount Rate is an important concept in the financial world and is used to determine the value of future cash flows. It is a percentage by which we discount future cash flows to calculate their present value. So it's a way to 'translate' money from the future into today's money.
Why do we need to discount future cash flows? This has to do with the time value of money. Money we have today is worth more than the same amount of money in the future. This is because we can invest the money today and earn interest or returns. However, in the future, we will miss out on that return, and the money will have decreased in value due to factors such as inflation. The fact that money in the future will be worth less is not only about inflation but mainly about the fact that you can invest it now.
The Discount Rate is often based on the risk of the investment and the required return. The higher the risk of the investment, the higher the Discount Rate will be. This is because higher risk means more uncertainty about future cash flows and therefore carries more risk. Additionally, a higher required return often leads to a higher Discount Rate because it requires more compensation for the risk of the investment.
Inflation also plays a role in determining the Discount Rate. If inflation is high, it means that money in the future will be worth less, so the Discount Rate will also be higher.
The Discount Rate is the percentage by which future cash flows are reduced to calculate their present value. The Discount Rate reflects the time value of money, the risk of the investment, and other factors that affect the value of the cash flow. The higher the Discount Rate, the lower the present value of the future cash flow.
When determining the Discount Rate, one must consider the risk of the investment. An investment with higher risk generally requires a higher Discount Rate because there is more uncertainty about future cash flows. In addition, inflation and market conditions play a role in determining the Discount Rate. If inflation is high, the Discount Rate will generally be higher because there is more risk of loss of purchasing power of the cash flow in the future.
In short: by discounting future cash flows with the appropriate Discount Rate, we can calculate the present value. This helps you understand what future cash flows are really worth today and allows you to make better decisions about investments and financial planning. If you want to see how this concept fits into the broader process of valuing an early-stage invention or startup, the Startup Valuation overview page brings all core valuation concepts together.
Money Value, Future Value (FV), and Compound Interest Calculation
Let's revisit the example above, where we put $1 into a savings account with a 10% interest rate, and after one year, this dollar is worth $1.10. Suppose you don't withdraw your savings and leave the $1.10 untouched. Then, after another year, the $1.10 in the savings account will have grown to $1.21 = ($1.10 + ($1.10 * 10%)).
We can continue this process indefinitely, as illustrated in the table below.
| r=10% | r=10% | r=10% | r=10% | r=10% | r=10% | r=10% | r=10% |
| Year(n) | 0 | 1 | 2 | 3 | ... | 30 | ∞ |
| Balance | 1 | 1.10 | 1.21 | 1.33 | ... | 17.45 | ∞ |
The above table can be summarized in one of the most fundamental formulas in the financial world, namely
FV = PV * (1 + r)n
Where FV stands for Future Value, PV stands for Present Value, r stands for Discount Rate (in our example, this was the interest rate), and n stands for the number of time units the money is invested for. It is assumed that the discount rate r remains constant over the period n. Additionally, n can be in years, months, weeks, days, and even hours or minutes.
As an example, suppose you invest $10,000 in a savings account with a 3% interest rate. How much will this amount have grown in ten years?
We plug in PV = 10,000, r = 0.03, and n = 10 and get
FV = 10,000 * (1 + 0.03)10 = 13,439
Compound Interest
It is said that Albert Einstein once said: "The most powerful force in the universe is compound interest."
We can illustrate this with an example. Suppose you can invest $100 for a year at 12% interest, but you have the choice of the following two options:
1. Either you receive the 12% interest all at once at the end of the year, or
2. You receive the 12% interest per month in increments of 1% and add it to the invested amount.
What would you choose? The observant reader will have understood that option 2 yields more than option 1. After all,
FV1 portion of 12% = 100 * (1 + 0.12)1 = 112
while
FV12 portions of 1% = 100 *(1 + 0.01)12 = 112.68
This phenomenon is better known as Compound Interest. Compound Interest is interest calculated on both the original invested amount and the interest previously earned. In the table, we already saw how this works, namely in year two, for example, the amount in the savings account had increased to $1.21 and not to $1.20 because $1 was added by calculating the interest over the previously accumulated interest.
A similar effect is also seen in companies that do not entirely distribute their profits but reinvest a large portion of them in their own business. Very generally, if we have two companies with different dividend policies: one company that distributes all profits (for example, as dividends) and one company that reinvests the profits in the business, we see that a company that distributes all its profits will not grow as quickly as a company that retains the profits to expand. A company with a Return On Investment (ROI) of 20%, for example, that uses a large portion of the profit to fuel additional growth, is often the darling of Wall Street. Incidentally, many articles and even entire chapters have been written about the relevance of dividend policy. It is beyond the scope to go deeper into that here, but it is important to remember that the cash a company generates can be used either for dividend payments or for reinvestment. The latter typically leads to higher profit growth in the future.
With the concept of Present Value now in place, we can move on to the next step in valuation: translating future cash flows into their value today. This is exactly what the DCF method (Discounted Cash Flow) explains in detail..