Discounting

One way to value a share is to add up the cash flows you expect to receive from it in the future and then ‘discount’ them.

Discounting is expressing cash received in the future in today’s money because inflation (for which the compensation as an investor is an interest rate on cash) erodes the value of money over time.

So, for example, £100 received now and invested at an annual interest rate of, say, 5% would be worth £105 in one year, £110.25 in two years (100 x 1.05 x 1.05) and £115.76 in three years.

Similarly, the discounted value (today’s equivalent) of £115.76 due in three years is £100. Or, given the choice between £100 now and £115.76 in three years, assuming annual interest rates of 5%, you should be indifferent as the two are worth about the same on a like-for-like basis.

• See Tim Bennett’s video tutorial: Five ways companies can cook cash flow.

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