Money receivable in the future is worth less than money received immediately. If you have £1 now and could invest it at an interest rate of 5% in one year you would have £1.05. This means that the 'future value' of £1 in one year is £1.05.
Put it the other way around and the 'present value' of £1 received in one year is £0.952. This is because £0.952 is the amount that would grow to £1, if invested at 5%. The interest rate assumed is known as the discount rate.
This is the concept behind most investment. You pay a lump sum for the right to receive a sum or a series of sums at some point in the future. To know how much you should pay for that right you need to work out its present value.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Discounted cash flow is simply a method of working out how much a share is fundamentally worth based on the present or discounted value of expected future cash flows. This is obviously fraught with difficulty given the nature of forecasting but the simplest version of the calculation is the dividend discount model where the real value of a share is considered to be the present value of the sum of all its future dividends.
See Tim Bennett's video tutorial: Five ways companies can cook cash flow.
-
Where are ISA savers and investors putting their money?With less than three months until the end of the tax year, where are ISA savers and investors putting their money? We look at the latest ISA trends.
-
More than £53 billion held in fixed-rate cash ISAs will mature by April - where should savers move their money?If your fixed-rate cash ISA is maturing soon, we look at the options available to you
