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A DOZEN YEARS AGO, on my first day of business school, the professor stood at the board and illustrated a concept called “present value.” Truth be told, over my remaining time in school, I don’t think I learned anything more important than I learned in that first hour. It is, in my view, the single most useful tool in all of personal finance. Below, I’ll walk you through the concept and then illustrate some ways it can help you make better financial decisions.
Let’s look at a simple example. Suppose you were presented with this choice: You could receive $90 today or $100 a year from now. Which would you choose? The question is tricky because it’s asking you to compare apples to oranges—a certain number of dollars today vs. a different number of dollars next year. But this is where present value is so incredibly useful. Here’s how it works:
Step 1: Estimate how much you could earn if you invested for one year. Let’s assume just 2%, because the time horizon is short and you can’t take a lot of risk. If it were a longer period, you might assume a higher rate of return.
Step 2: Calculate the present value of the future $100, assuming that 2% rate of return. In other words, determine the value to you today of the $100 you could receive next year. If you were to do this math on a calculator, it would be $100 divided by 1.02. That works out to $98.04. (In reality, you would use Microsoft Excel or another spreadsheet program to make the math easy. Look for the PV function.)
Step 3: Now you’re in a position to do an apples-to-apples comparison. Again, the choice is between $90 today or $100 next year. The first part is easy: The value of $90 today is, of course, $90. And the value today of that $100 a year from now? In step 2, we calculated that to be $98.04. Clearly, $98.04 is preferable to $90, so in this case you would want to wait a year to receive the $100.
The above example is a little antiseptic. Let’s look at how you can use present value to make real financial decisions:
Pension benefits. If your employer has a traditional pension plan, it’s possible you’ll be offered a buyout at some point. For example, if you’re entitled to $50,000 per year for life, your employer might offer $650,000 as a lump sum alternative. Should you take it?
Present value analysis would allow you to compare that lump sum to the present value of all those future annual payments. You could explore different rates of investment return—assuming you took the lump sum—as well as different potential life expectancies. Of course, those are both unknown, but present value calculations at least offer a logical framework for making your choice.
Whole life insurance. If you’re like most people who own whole life insurance, you’ve considered liquidating the policy. But you might wonder whether, after all the premiums you’ve paid, it’s better to stick with it. If you use present value analysis, you can compare the value of the future death benefit to the cash value today (less taxes, if any).
Car leases. If you need a new car, leases are enticing because they offer such low monthly payments. At the same time, you’ve probably heard that it makes more sense to buy. But like all rules of thumb, this isn’t ironclad. If you use present value analysis, you can compare the total cost of buying vs. leasing.
Extended warranties. Before you leave the dealership, the salesperson will probably also offer you an extended warranty. Again, these have a reputation for being a bad deal, but it depends. Do a present value analysis based on expected future repairs, and then use the results to negotiate with the dealer.
Education. For years, it’s been conventional wisdom that a college education is a good investment. But with the astronomical cost of tuition, room and board, many are starting to ask whether the conventional wisdom is still wise.
Again, I’d use present value analysis to help evaluate the choice. Compare the cost of college, plus financing costs, to the expected increase in lifetime wages. To be clear, I’m not advocating against college. Far from it. I’m only advocating against unjustifiably expensive schools that leave students and their families burdened by debt they’ll struggle to pay.
Adam M. Grossman’s previous articles include Passive Stampede, Adding Value, Three Risks and Room to Disagree. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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“present value calculations at least offer a logical framework for making your choice.” I think that is the most important sentence in a fine article. PV is an essential tool in the toolbox for so many applications.
Present Value (PV) is a tool to help you quantitatively compare alternatives. Its goal is to make today’s apples and tomorrow’s oranges into the same fruit so you can decide which is more valuable to you. Adam’s illustration of $90 today or $100 a year from now was both perfect and wildly oversimplified. On the latter, dealing with the complexity of multiple future cash flows (in and out) on various dates (regular “periodic”, and irregular) in various risk environments (thus different interest rates) is a matter of using the same math repetitively. This is what computers were made for, so that’s the easy part.
The real difficultly is fully grasping the implications of Adam’s illustration. This means choosing the interest rate(s) to discount tomorrow’s dollars into today’s (my prof called it CIF, or cash-in-fist). For important decisions, you should choose at least (3) interest rate scenarios for best, worst and most likely given that we’re guessing about the future.
Additions to Adam’s intro:
1. What about inflation? Say it’s 2%, thus next year’s dollars are expected to be worth 2% less than today’s, add that to the assumed market return of 2% and we now have a discount rate of 4%. Thus the PV of $100 a year out is now worth only $96 instead of $98.
2. Does this mean you still choose the future payment over today’s $90? Not necessarily. What if you have to do some work or go through some hassle to get this future payment? You need to increase the discount rate to cover this. How much? Depends on you! What if you’re very risk adverse and emotionally don’t like waiting for CIF? Increase the discount rate again! How much? Same answer. 🙂
3. PV can be used with outflows just as well as inflows. Is that up-front discount for the monthly club fee a good deal or not? What about those car, home, etc., payments vs. paying up-front?
Software makes the math easy, but it won’t help with choosing discount rates which really are different for everyone and this difference compounds the further out into the future the comparison takes you. If you have the time or interest (yuk, yuk), I’d highly recommend taking Adam’s advice and integrate PV into your decisions.
Software:
Online and free is a good start.
My favorite Windows desktop software I’ve been using for 25+ years can do anything.
Excel can do anything too, but it’s more work to learn and use.
Quicken’s most powerful Windows version has a retirement planning module that is powerful, fully PV oriented and accurate. I don’t know of any documentation or websites that go into detail on it’s use, but I’d be glad to help anyone that asks: measurement at me dot com.