Intrinsic Value, Part 2: Why a Dollar Today Is Worth More Than a Dollar Tomorrow
Before the calculations begin, there’s one idea that makes all of them make sense.
In Part 1, I said that a business is worth the sum of all the cash it will generate in the future — but adjusted downward to account for the fact that future dollars are worth less than dollars you have today.
I didn’t explain why. That’s what this post is about.
The concept is called the time value of money, and it is the single most important idea in all of finance. Everything we do in valuation — every formula, every discount, every present value calculation — flows directly from this one principle.
Would You Rather Have $1,000 Today or $1,000 in Ten Years?
This isn’t a trick question. Nearly everyone would choose $1,000 today, and they’d be right to.
But why? Most people’s first instinct is to say “inflation” — the general rise in prices over time that makes a dollar buy less next year than it buys today. That’s part of it. If prices rise 3% per year, $1,000 in ten years will only buy what $744 buys today.
But inflation isn’t the main reason. The deeper reason is this: money in your hands today can be put to work. You can invest it. You can lend it. You can use it to start something. A dollar today has the ability to grow into something larger by the time that future dollar arrives. A dollar you receive ten years from now can’t do any of that work in the meantime.
This is the time value of money: a dollar today is worth more than a dollar in the future because of what that dollar can earn between now and then.
Present Value: What Is a Future Dollar Worth Today?
Once you accept that future dollars are worth less than present ones, a natural question follows: how much less?
That’s what present value answers. Present value is the value today of a sum of money you expect to receive in the future. It’s the answer to this question: if I know I’m going to receive $X in N years, what is that promise worth to me right now?
The answer depends on one thing: the rate of return you could earn on your money in the meantime. This rate is called the discount rate — the rate you use to “discount” (reduce) future dollars back to their equivalent value today.
Here is the formula:
Present Value = Future Amount ÷ (1 + Discount Rate)^Years
The little superscript — the ^Years part — means you multiply the bottom of the fraction by itself once for each year. Don’t let that scare you. The intuition is simple, and we’ll walk through it.
A Simple Example
Suppose someone promises to pay you $1,000 exactly three years from now. You could otherwise invest your money and earn 8% per year. What is that $1,000 promise worth to you today?
Using the formula:
Present Value = $1,000 ÷ (1 + 0.08)^3
= $1,000 ÷ (1.08)^3
= $1,000 ÷ 1.2597
= $794
That future $1,000 is worth $794 today. In other words, if someone offered to sell you that $1,000 promise for $794, you’d be indifferent — you could get the same result by taking $794 right now and investing it at 8% for three years.
Let’s check that. $794 invested at 8% per year for three years:
– After year 1: $794 × 1.08 = $857
– After year 2: $857 × 1.08 = $926
– After year 3: $926 × 1.08 = $1,000 ✓
The math works perfectly. Discounting and compounding are exact opposites of each other.
Two Things That Drive Present Value Down
From the formula, you can see that present value falls when either of two things increases:
Time. The further out in the future a payment is, the less it’s worth today. A payment 10 years from now is worth less than the same payment 5 years from now, which is worth less than the same payment next year. Time gives your money more opportunity to compound, which means you need less of it today to reach the same future amount.
The Discount Rate. The higher the rate you could earn elsewhere — or the higher the risk that the payment won’t actually arrive — the less the future promise is worth today. If you can earn 15% on your money, a $1,000 payment three years from now is only worth $658 to you today, not $794. You don’t need to pay as much now because your money grows faster.
This second point is critical for understanding how risk and value are connected. A risky business — one where the future cash flows are uncertain — deserves a higher discount rate. And a higher discount rate means those future cash flows are worth less today. This is not arbitrary. It’s the mathematical expression of a real economic truth: uncertainty has a cost.
Discounting a Stream of Cash Flows
A business doesn’t produce one lump sum. It produces cash year after year. So instead of discounting a single future payment, we discount each year’s cash flow separately and then add them all up.
Say a business is expected to generate free cash flows of:
– $100 in year 1
– $110 in year 2
– $121 in year 3
And our discount rate is 10%.
PV of Year 1: $100 ÷ (1.10)^1 = $100 ÷ 1.10 = $90.91
PV of Year 2: $110 ÷ (1.10)^2 = $110 ÷ 1.21 = $90.91
PV of Year 3: $121 ÷ (1.10)^3 = $121 ÷ 1.331 = $90.91
Total Present Value = $90.91 + $90.91 + $90.91 = $272.73
Notice something: even though the cash flows are growing each year, their present values are all identical. That’s because the 10% growth in cash flows is exactly canceled out by the 10% discount rate. If the business grows faster than the discount rate, the present values rise over time. If it grows slower, they fall.
This is the core tension in all of valuation — the tug of war between growth (which makes future cash flows larger) and the discount rate (which makes them worth less today).
Why This Matters for Valuing a Business
When we value a company, we are essentially performing this same calculation at scale. We estimate the free cash flows the business will generate over the next several years, pick an appropriate discount rate that reflects the riskiness of those cash flows, and add up the present value of each year’s cash flow.
That sum — plus the present value of everything the business will generate beyond our projection period — is the intrinsic value of the business.
The discount rate we use is called WACC (Weighted Average Cost of Capital — a blend of what the company pays for its debt and what its shareholders require as a return). We’ll build that from scratch in a later post. For now, the important thing is that you understand what it does: it’s the lens through which we translate uncertain future cash flows into certain present-day value.
Every number in our model flows through this idea. Once you’re comfortable with present value, the rest of the calculation is just applying it in a structured way.
The One-Sentence Summary
A dollar today is worth more than a dollar in the future because today’s dollar can be invested and grow. Present value is the tool that converts future dollars into their equivalent today, using a discount rate that reflects both the opportunity you’re giving up and the risk you’re taking on.
That’s the foundation. Now we’re ready to build.
Next: Part 3 — Two Types of Free Cash Flow. Before we start calculating, you need to know which version of free cash flow applies to the company you’re valuing — and why it matters.
— Jim