Intuition
In his 1938 investing text "The Theory of Investment Value" John Burr Williams introduced the ideas of discounting and intrinsic value to investors.
For our purposes "intrinsic value" is synonymous with the value of a business. The value can be expressed as the value of the entire enterprise or (to make easier to compare to the stock price) as a per share value.
"Discounting" is a way of expressing something we understand intuitively, that a dollar today is worth more than a dollar a year from know.
No this isn't another dig on the U.S. dollar. This is true even if our currency wasn't under pressure. No one likes to wait around to reinvest their earnings. If we have to wait then we reasonably expect to be compensated for our time. This compensation for waiting is expressed as a rate, in this case as a discount rate. A discount rate represents our opportunity cost of waiting for a certain cash flow.
A Little Math: What should we pay today to receive $100 in the future?
Let's explore for a moment the math behind discounting the cash paid to us in the future. Here is the formula:
Example: What should we pay today to receive $100 in the future? Let's make a couple of assumptions.
- We will take the money to purchase the future $100 out of our savings yielding 5% (Our opportunity cost or discount rate).
- We are willing to wait 1, 5, or 10 years.
What should we be willing to pay for a cash flow with those characteristics? $95.24
What if we wait 5 years (n=5)? $78.35
And 10 years (n=10)? Only $61.39
Clarification
The implications of the Future Value of money might not be entirely clear. Discounting future cash flows helps us avoid overpaying for money received in the future; our required rate of return is built into the equation. Said another way, should you decide to purchase that 2018 cash flow of $100 for $61.39 today you are assured a 5% rate of return. Clear as mud?
More on why discounting cash flows matter in future posts...
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