Working in finance, we all understand that a dollar today is not worth a dollar one year from now.
An easy way to understand this is with inflation. If inflation is occurring at a rate of 2% per year, then a year later a dollar is worth 2% less than a dollar today. Or in other words, a dollar tomorrow is only worth 98 cents today!
We also know there is an opportunity cost that comes in to play too. You can save that dollar, and put it into a savings account or certificate of deposit that pays annual interest. If that interest rate is 3%, then a dollar saved today is worth $1.03 next year. Benjamin Franklin famously summarized this as “a penny saved is a penny earned.”
But, just like inflation, this means the same dollar today is not equal to the same dollar amount in the future. In a way, $1.00 today is equal to having $1.03 a year from now. Which means, if you did not save that dollar, you lost 3% in interest. If you refuse to save your dollar, then you should discount it by the 3% interest it will not earn in the future. Economists call this “opportunity cost,” which is the highest cost of doing something different with your time or money. Finance people refer to this as the “time value of money,” which means money you hold today can be invested in helping you earn more money. And, if that money isn’t invested today, it will be worth less to you.
Say we are owed one dollar, but we won’t receive it for one year. If we had received that dollar today, we would have saved it at a 3% interest rate. Since we won’t receive that dollar for a whole year, it is basically worth 3% less to us since we couldn’t save it. That dollar one year from now, is really only worth 97 cents to us.
Say we are owed one dollar a year, for 10 years. Now we are going to miss several opportunities throughout the next ten years to save those dollars at a 3% rate. Our dollar in one year is only worth 97 cents. But our dollar in the second year will be worth even less. It will be worth not only 3% less, but 3% less than the 97 cents. One dollar two years from now will only be worth 94 cents to us. And a dollar in the third year will even be 3% less, which is 91 cents.
What we are effectively doing, is we are discounting our future expected dollars at a rate of 3% year over year. We can then sum up all our discounted dollars over 10 years to calculate what they are worth today. We take 97 cents, plus 94 cents, plus 91 cents etc. If we do that for dollar payments over ten years, our total discounted value of all ten dollars will equal $8.49 today.
This is the idea behind discounted cash flow. Because we can’t save or invest money we don’t have today, it is worth less to us in the future. If we have to wait 10 years to collect all $10 owed to us, then that payment stream is only worth $8.49 today.