What it is
Present value is based on the concept that receiving a certain amount of money today is worth more than getting the same amount in the future.
Let’s say you received P5,000 today. Under the present value theory, that money is more valuable than if you received the same amount 5 years later.
This is because of rising inflation and the “missed” opportunity to invest the money during the time that will pass.
What it means for you
Investors use present value to assess whether an investment’s future value is worth the price they’ll pay at present.
It can also tell you how much you need to invest today if you want to reach a certain amount of money within a specific timeframe.
Here’s how to calculate present value:
Present Value = Future Value / (1 + rate of return)investment period
For example, if you want to reach P100,000 in 3 years through an investment with a 5% interest per annum, here’s how much you need to invest:
Present Value = P100,000 / (1 + 0.05)3
Using the formula, you’ll need to invest P86,383.76 to meet your goal.
In another scenario, let’s say you were asked to choose between getting P50,000 in 2 years or receiving P40,000 now.
Which option is better? Assuming you can invest the money today with a 5% p.a. interest, let’s calculate the present value:
Present Value = P50,000 / (1 + 0.05)2
The answer is P45,351.47, which means receiving P50,000 in 2 years is more valuable than getting P40,000 today and investing it at that rate of return.
Calculating present value can help you make investment decisions, especially when comparing 2 or more products.
Keep in mind, however, that returns are not always guaranteed and you still need to consider the risks of each investment.
