IMAGINE YOU’RE a teenager, your older sister is heading off to college and she wants to take the car you share. She offers to buy you out, and says she’ll pay you $5,000 five years from now, after she graduates. But you’d rather be paid today.
What’s a reasonable sum to ask for? The right number might be around $4,500. If you got $4,500 today and invested it, you’d have $5,000 after five years, assuming you could earn a 2.13% after-tax annual return over the intervening period.
In Wall Street lingo, the future value would be $5,000 and the present value would be $4,500. Present value calculations crop up all the time in the financial world:
As you’ll gather from the above examples, we often aren’t comparing just two numbers, a present value and a future value. Rather, we’re cooking up a single number for today that reflects a string of future numbers. Such calculations can be complicated, which is why folks rely on online calculators, spreadsheets and financial calculators to do the math for them.
Be warned: Present value calculations are only as good as the interest rate they assume. For instance, a calculator might indicate that we only need to make a single investment today of $6,502 to have $50,000 for our toddler’s college education—which sounds like a good deal, until we notice that the assumed return for this present value calculation is an optimistic 12% a year.