What is Present Value?
How much money can you make on an investment? The simple answer is "That depends on how much you sell it for", but real life isn't quite that simple. Suppose you sell ice cream sundaes for $2. The ingredients and workers and advertising all together cost you $1 per sundae. Your profit is $1 per sundae.
Now suppose you buy a dairy and make your own ice cream and cut your costs to $0.50 per sundae. If you still sell each sundae for $2, you now bring in $1.50 per sundae—50% more!
In other words, there are two ways to make more money: raise your prices or cut your costs. The same goes for investments. Yet with investments, you have a little bit more control: the price you pay for a stock determines the profit you make when you sell it.
How Much Profit Can You Make From a Stock?
Start by deciding how much money you'd like to make from an investment. Suppose your goal is 12% annual return. If you invest a thousand dollars right now, you want to have $1120 next year and $2000 in six years. That's a good investment!
To turn $1000 into $2000 in six years, you have to find a stock with a price that's likely to grow around 12% every year. How do you do that?
You find a good company with solid leadership, great products, a verifiable history, and an effective plan to make money year after year. Then you calculate its intrinsic value—how much money the company can produce in the next ten years. Then you figure out the right price for it.
What is the Present Value of a Stock?
What's the right price for a stock? The present value of its intrinsic value! Yeah, that sounds like complicated jargon, but it's easy to understand with a little high school math.
Present value is the price you want to pay today for an investment you want to sell in the future, in order to make a specific profit. If you want to make a dollar in profit off of an ice cream sundae you can sell for $2, you can pay no more than $1 to produce and sell each ice cream sundae. If you want to make $1.50 per sundae in profit, you can spend no more than $0.50 to produce and sell each sundae.
For a stock, if the intrinsic value next year is $1120 per share and you want to make 12% on it, you should pay no more than $1000 per share this year. Walk through the math: you want to sell it in one year. It'll be worth $1120 next year. Subtract 12% of that next year value and you get $1000: the present value of the stock at your desired rate of return. If you can pay less than $1000 per share, great! You're getting a bargain. If you pay more, you're probably not going to get your 12%.
Yes, this calculation leaves out things like dividend payments, but it's a starting point and not the last word on investment.
Is the Present Value of a Stock Reliable?
Buying stocks is riskier than selling ice cream sundaes! Projections of future earnings (measurement of intrinsic value) are just that—estimates. No matter how much care you take to use the best information possible, the future is unknown. The only way to know for certain what the price of any stock will be in one or five or ten years is to wait and see.
Yet over time, the price of a stock tends to follow the money the underlying business produces. Bad companies go bankrupt and out of business. Good companies continue. The burden is thus on you to do your homework: find businesses you understand. Know the market and evaluate their business plans. You don't have to go into the minute details of financial statements, but understand if the way they make money makes sense to you.
Using the present value of a stock can help you identify bargains. You always want to buy good companies; now you can figure out whether that good company is on sale and can help you meet your investing goals.