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I am new to the stock market and currently trying to just get a basic understanding of the stock markets using online sources (investopedia).

I came across this sentence when I was reading on a topic about the representation of a company's value. And I don't quite understand what it meant.

"Because of the time value of money, profits to be earned in the future must be discounted back to represent today’s dollars – just as a dollar put into a bank account today will be worth more in the future after it has earned some interest, but in reverse."

Can someone please clarify this sentence? Why do profits earned in the future must be discounted back to represent today's value (whatever this means)?

Thank you. (Link to this website --> https://www.investopedia.com/university/stocks/stocks7.asp) The sentence is located at the start of the 4th paragraph.

marked as duplicate by Pete B., Nathan L, Rupert Morrish, Dheer, JoeTaxpayer investing Jan 29 at 12:44

This question has been asked before and already has an answer. If those answers do not fully address your question, please ask a new question.

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Time value of money is that if you have money now you can invest it in say a savings account and it will be more at the end.

If you are going to earn say $105 in a years time you don't have the money to use now.
How can you get to use he money now. One way is to get a loan which you pay back $105 at the end of the year when you receive the future earnings. However the lender would want to charge you interest for then. They would say we will give you $100 now and receive $105 in a years time (charging 5% interest) Thus the future $105 earning is worth $100 today. This is the time value of money.

  • And what cause the money to be worth less tomorrow than today? Inflation. And how do we discount back to present day dollars? We use the estimated CPI or inflation rate over the future years? – Victor Jan 29 at 5:12
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    @Victor no - you use the rate of investment. There is time value of money even with no inflaltion – Mark Jan 29 at 12:07
  • If there was no inflation the lender would not give you $105 now in return for the $105 in the future - why should they? – Mark Jan 29 at 12:13
  • If there was no inflation for say 10 years, then in 10 years time you would pay the same for a big mac as you would today, you would be getting zero interest in your bank account, and to get a higher return on your money you would need to take bigger risks. Look at what happened after the GFC when inflation and thus interest rates dropped considerably - you were not getting very much for your money at all. The OP is asking about the future profits of a company being discounted back to present day’s dollars - so what rate of investment would you use for this? You use the estimated CPI. – Victor Jan 30 at 0:02
  • You would not get zero interest on your bank account – Mark Jan 30 at 0:13
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It goes something like this: if something worth $10 today will cost $11 next year, then being paid $11 next year should only be counted as earning $10 today.

That is, you discount the expected (future) payout to work out a fair price to invest today.

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    This is a great way to think about it. "Time Value of Money" is simple conceptually but sometimes hard to explain. The $10 pizza you didn't buy today, if saved and invested instead, is worth $11 next year, $20 in 7 years, $200 when you retire, etc. That's an expensive pizza! – Rocky Jan 28 at 18:08
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It's almost always better to have money now than in the future. If I offered to give you $100 today, or to give you $100 next year, which would you pick? If you had the money today, you could spend it today or hold onto it for a year and then spend it. If I gave you the money a year from now, of course you couldn't spend it today. So by getting the money sooner, you have a choice that you don't have if you get it later.

Furthermore, if I gave you $100 today, you could put it into an account that pays interest, or use it to buy stock, or invest it in some other way, so that a year from now you would have more than $100.

But what if I offered to give you $100 today, or $110 a year from now? That's a harder decision. Which you pick would depend on what you think you might make by investing the money, or by how badly you need money right now.

That's the time value of money. How much would I have to offer you a year from now for it to be equivalent to offering you $100 today? Or how much would I have to offer you today to be equivalent to offering you $100 a year from now? As it would be subjective to evaluate "how much do I need the money?", we generally calculate this based solely on expected investment returns. If we expect to be able to make, say, 5% profit on an investment in one year, than $100 today is equivalent to $105 in one year.

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Because of inflation.

A dollar today would be worth more than a dollar in 10 years time.

Just think of the price of a big mac today compared to what you could buy a big mac for say 10 years ago. The same goes with the future income of a company, $10M earned in 5 years time would be worth less than $10M today, so we need to discount that $10M in the future to what it would be worth today.

We do this by estimating what inflation will be over the next 5 years and discounting the $10M in 5 years time to what it is worth in today's money.

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