Translation: Present Value = present value
The present value of future revenues (Present Value) is the value today of amounts expected to be received in the future, after discounting them at a rate that reflects the time value of money and risk. It is based on the principle that a riyal today is worth more than a riyal in the future, and is used to value companies, projects, and long-term contracts.
Formula:
Present value = future value ÷ (1 + discount rate) ^ number of years
A simple definition:
If you had to choose between receiving 1,000 riyals today or 1,000 riyals a year from now, it would be better to take the money today, because you could invest it and earn a return, prices may rise during the year, and the future promise may not be fulfilled. Therefore, 1,000 riyals received a year from now is worth less than 1,000 riyals today.
Note:
Present value is significantly affected by the discount rate used and the timing of the revenues. A higher discount rate or later revenue reduces its present value considerably. Future revenues are also estimates, not guaranteed amounts, so the result varies depending on the assumptions.
Example:
Suppose a company expects to receive 100 million riyals in 5 years, and the appropriate discount rate is 10% per year. In this case, the present value is: 100 ÷ (1.10)^5 = approximately 62 million riyals. In other words, the future 100 million riyals is worth only about 62 million riyals today.
What does this mean for you?
Valuing companies: The discounted cash flow method calculates the present value of everything a company is expected to generate in the future. It is one of the most common methods for estimating a share’s fair value.
Reading long-term contracts and announcements: When a company announces expected revenues over several years, their value today is lower than the announced figure, especially if they will not begin for some time.
Comparing investment opportunities: Present value helps you compare investments that generate returns at different times on a common basis.
Frequently asked question:
Why is present value lower than the future amount?
Answer: There are three main reasons: money available today can be invested to earn a return, inflation reduces purchasing power over time, and future amounts involve a degree of uncertainty. Therefore, the farther away the date when the money will be received, or the higher the discount rate, the lower its present value.