![]() ![]() The summation of the present value of the individual cash flows that an investment will produce is the value of the investment. This article explains how we can calculate the present value of any known future cash flow. In the case of the safest bonds or of money on deposit at a bank, the cash flows and their timing are known with (almost total) certainty and so step 1 is essentially done for us and we are left with step 2. We must discount these cash flows at an appropriate interest rate to calculate their “present value” as of today. ![]() We must know or estimate the future net positive cash flows, and their timing, that will emerge from the investment, andĢ. Therefore, to place a value on any financial investment we need to do two things each of which is simple to describe but is hard to do:ġ. The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows but in the case of equities, the investment analyst must himself estimate the future “coupons.” Note that the formula is the same for stocks as for bonds. In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. In regards to estimating the value of an investment, Warren Buffett, in his 1991 letter to Berkshire Hathaway share owners said: ![]() Fortunately, there is some standard mathematics that can be applied. Investors are often faced with the problem of knowing the fair value of an investment that is expected to deliver future cash flows. ![]()
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