The Reverse of Compounding?

Amar Pandit , CFA , CFP

Do you know the answer to this headline question?

It’s called discounting, which converts a future cash flow into its equivalent present value. An assets (or investments) present value is the sum of its expected cash flows discounted by an expected rate of return. That return is what investors expect to earn on assets with similar risk.

The concept of discounting is often referred to in financial terms as the time value of money. While compounding projects cash flows forward in time, discounting does the opposite — it brings future cash flows back to their present value. To put it simply, discounting answers the question: “What is the value today of a sum of money to be received in the future, given a specific rate of return?”

Consider this example: Suppose you have the option to receive Rs.100,000 now or Rs.100,000 a year from now. Intuitively, most would prefer to have the money today because it can be invested immediately to earn a return over the year. Therefore, Rs. 100,000 received in the future is worth less than Rs. 100,000 received today. Discounting helps us figure out exactly how much less.

For individual investors, discounting is important for personal financial planning purposes, such as calculating the present value of retirement cash flow needs and understanding how much needs to be saved and invested today to satisfy future expenses.

Do you know what your discount rate is or should be?