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Hi all,

This page will discuss Present Value. Please use this page with the corrected page 13 linked below.

Present Value –

In page 13, we used a formula for future value. Once we assign a PE to the future value, we then want to calculate the best price to pay in the present. The formulas for future value and present value are the basis of your discounted cash flow calculators. So, by learning these formulas one can make some rough estimates of a good price to pay for the companies we target to buy.

The formula for Present Value is:

PV = FV / {(1 + r)^n

PV = Present Value or in this case the price we want to pay for the stock.

FV = the price we believe the stock will trade at if certain conditions are met. The conditions to be met are PE ratio estimated by us and earnings growth estimated by us or analysts.

R = The discount rate – When I do a discounted cash flow calculation, I use only one discount rate regardless of perceived risk. I do this because I require a set return for my investment. I will only invest in stocks that I feel will give me a minimum return of 12% annually. This is called my hurdle rate and it is the rate I set for my discount rate. This is just as good a way to do this as any because I have calculated risk in the future price, I don't have to do it twice. In other words I do not have to adjust my discount rate to measure risk; I have already calculated risk when I estimated a future value.

So, if we believe a company is going to be worth $68.64 in five years, and we want 12% return, then the price we must buy the company or present value is –-- PV = 68.64 / ( 1.12 taken to the fifth power or PV = 68.64 / (1.12 ^ 5).

Using the Microsoft calculator ( you can learn how to use it by reading page 13)

Using our Microsoft calculator on scientific mode we push these buttons to get the answer.

Click x ^y button
Click five and then
Click the x ^ y button again.
The answer is 1.76

PV = $68.64 / 1.76
PV = $39

In order to buy the investment to insure we get a 12% return we must buy it at $39. Of course this does not mean the company will grow by 12%. However, if the company grows earnings by 18% (our estimate in page 13) and investors believe it worth 20 times earnings (our estimate)in five years; then yes, five years from now that 12% return is definite.

Knowing how to do this math is very important. But knowing how to input accurate estimates is also very important. Since estimating the unknown is difficult then I try to create several ranges. I would create a range in case my company grew earnings only 12%, 15%, 20%, 25%, etc.

I would also create different PE scenarios. I would create different PE ranges in five years such as; if investors decided that our target company's earnings were only worth a 20 times earnings five years from now and one scenario if investors believed them worth only 15 times earnings five years from now. Perhaps one if investors believed they would be worth 25 times earnings. We can adjust this part of our model each quarter as investors bid our shares up and down.

Some may ask why even bother if we cannot calculate accurately earnings growth for five years, or guess a PE range five years from now? The reason the exercise is a good one is that you can check the company's progress every quarter. Every quarter that they exceed 18% or miss 18% growth, we can revamp our model. We should also track the PE range each quarter. We want to see if they consistently maintain a PE above or below 20.

If we do this quarter by quarter, we will see changes that will allow us to create models with more accurate inputs. As we revamp our model based on our company missing or exceeding estimates while keeping an eye on the PE range, we can be more certain of the price 4 years from now, 3 years or however much time we have left more accurately. We can then continue to project estimates forward.

Many investors make the mistake of looking at estimates and then not adjusting quarter to quarter when the company is not progressing or are exceeding expectations. These adjustments may show that we must increase or decrease our future value estimates. As we track the stock price, we will spot bargains as pricing anomalies occur based on our quarterly adjustments of Future Value. The best part is nothing suggested above is difficult and I always considered it to be fun. It is much more fun when you see that stock prices tend to be far more logical than people believe. And predicting those prices becomes easier the more you practice with each company.

The next page I will show you an example of how to use the PV and FV formulas to value a companies stock price. And how to fine-tune your models.

tom e

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