How to Use Present Value to Determine the Best Investment

Present value is, sadly, not a concept that is widely taught outside of the financial field. Despite that it can be very useful in peoples every day lives. Present Value is essentially what a future amount (usually the final payout of an investment, or of a series of future payments resulting from an investment). To utilize present value properly you must also understand a concept callep opportunity cost.

The opportunity cost of an investment is basically the amount that could be gained, potentially, from utilizing the money in a different way. If you are presented with two different investment options, lets say investing your money in a certificate of deposit (a cd) or in an account which produces an annuity (a future series of payments), the opportunity cost of choosing one over the other would be the present value of the end result of the option which you did not choose.

Using the above example we could calculate the present value of your CD first. If you had goal of ending the next two years with $1000 in a 2 year CD at 6% interest we could see that:

$1000 = PV x 1.06 *1.06 or simplified as $1000 = PV * 1.1236. Now this is solvable with a little arithmetic. We would then take $1000/1.1236 and see that $890 would be needed as an initial investment to end with that desired result.

We could, using this same method, check the present value needed using our alternate method of investment to achieve the same result. IF we had an investment that offered us a payout of 53% of our initial investment at the end of year one, and again at the end of year two we would check each payment with half of our desired result and add them together:

500 = PV * 1.03 and solving this arithmetically we could see that 500/1.03 = $483.44. The equation for the payout in year two would be the same, and we could see that the total we would need is 485.44 + 485.44 = 970.88.

The amount needed to gain the expected result in the second investment is substantially more than in the first. The difference is largely due to the lack of compounding (compounding is when the interest yu earned in preceding periods earns its own interest in later periods). The most important point for you is that you have to invest more now to get the same amount later.