Economics » Financial Markets » Present Discounted Value

Applying Present Discounted Value to a Stock

Applying Present Discounted Value to a Stock

Consider the case of Babble, Inc., a company that offers speaking lessons. For the sake of simplicity, say that the founder of Babble is 63 years old and plans to retire in two years, at which point the company will be disbanded. The company is selling 200 shares of stock and profits are expected to be $15 million right away, in the present, $20 million one year from now, and $25 million two years from now. All profits will be paid out as dividends to shareholders as they occur. Given this information, what will an investor pay for a share of stock in this company?

A financial investor, thinking about what future payments are worth in the present, will need to choose an interest rate. This interest rate will reflect the rate of return on other available financial investment opportunities, which is the opportunity cost of investing financial capital, and also a risk premium (that is, using a higher interest rate than the rates available elsewhere if this investment appears especially risky). In this example, say that the financial investor decides that appropriate interest rate to value these future payments is 15%.

This table shows how to calculate the present discounted value of the future profits. For each time period, when a benefit is going to be received, apply the formula:

\(\text{Present discounted value =}\cfrac{\text{Future value received years in the future}}{{\text{(1 + Interest rate)}}^{\text{numbers of years t}}}\)

Calculating Present Discounted Value of a Stock

Payments from FirmPresent Value
$15 million in present$15 million
$20 million in one year$20 million/(1 + 0.15)1 = $17.4 million
$25 million in two years$25 million/(1 + 0.15)2 = $18.9 million
Total$51.3 million

Next, add up all the present values for the different time periods to get a final answer. The present value calculations ask what the amount in the future is worth in the present, given the 15% interest rate. Notice that a different PDV calculation needs to be done separately for amounts received at different times. Then, divide the PDV of total profits by the number of shares, 200 in this case: 51.3 million/200 = 0.2565 million. The price per share should be about $256,500 per share.

Of course, in the real world expected profits are a best guess, not a hard piece of data. Deciding which interest rate to apply for discounting to the present can be tricky. One needs to take into account both potential capital gains from the future sale of the stock and also dividends that might be paid. Differences of opinion on these issues are exactly why some financial investors want to buy a stock that other people want to sell: they are more optimistic about its future prospects. Conceptually, however, it all comes down to what you are willing to pay in the present for a stream of benefits to be received in the future.

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