The value of any asset is the sum of its future cash flows discounted to present value. People make investments to generate more money in the future. The ‘more money’ is future cash flows.

No one would buy an asset that will generate $10 in future cash flows for $20. You would lose money. An asset that produces $10 in future cash flows must (or rather, should) trade for some price below $10. The lower, the better for investors.

The Present Value of Bonds

The present value of bonds are easier to calculate than that of stocks. The amount of each payment is known. The timing of each payment is also known. With a 10 year bond yielding 5%, you know you will get 5% of the bond’s par value every year. On the 10th year, you will get the bond’s full par value.

The Difficulty of Finding a Stock’s Present Value

Stocks are more complicated. If you owned a business outright, the present value would be the sum of the business’ future earnings discounted to present value using an appropriate discount rate. Fractional ownership (stock ownership) of a business is no different. The value of a stock is the present value of its future earnings.

To calculate the present value of a stream of future cash flows you need 3 things:

There are several problems in practice with finding the present value of a stock. These issues are discussed in the sections below.

Problem #1: When will earnings stop?

No business lasts forever. Some businesses last longer than others. Insurers in particular have very long life spans while tech companies tend to have very short life spans.

Since no business lasts forever, using a perpetuity model to value a business is not reasonable. Instead, the amount of time the business will last must be guessed at. If a business is valued as a perpetuity and the company has a higher growth rate than discount rate, the discounted cash flow method would return an infinite value of a business. If you believe a company can have an infinite value, I have some shares to sell you for a very ‘low’ price…