Valuation
The time value of money
A pound today is worth more than a pound next year. That single idea — the time value of money — is the foundation that all of valuation is built on, and it’s more intuitive than it sounds.
Why is a pound today worth more than the same pound a year from now? Because today's pound can be put to work — invested to earn a return. That's its opportunity cost. Add in the facts that future money is less certain and that inflation erodes what it will buy, and the conclusion is firm: future money is worth less than money in hand today. Putting a precise number on "how much less" is what unlocks valuation.
Present value and discounting
Discounting is the tool that converts a future cash flow into its present value — what it's worth to you today. You divide the future amount by (1 + r) raised to the number of periods, where r is the discount rate. If someone promises you £110 in a year and you require a 10% return, that's worth £100 today (£110 ÷ 1.10). Discounting just runs that logic in reverse: it pulls future money back to the present.
The discount rate moves everything
The discount rate (r) reflects the return you require, given the risk. And it's powerful: the higher the discount rate, the lower the present value of any future cash flow — future money gets penalised more heavily. A lower discount rate makes future cash worth more today. This inverse relationship is why rising interest rates push down the value of almost everything, from bonds to growth stocks: a higher discount rate shrinks the present value of their future cash flows.
Compounding: the mirror image
Discounting has a twin. Going forward in time, money compounds — a present amount grows to a future value at (1 + r) per period. £100 at 10% becomes £110 next year, £121 the year after, and so on. Compounding grows money forward; discounting pulls it back. They're the same equation run in opposite directions.
From concept to valuation
Apply this to a whole business and you get a discounted cash flow (DCF) valuation: project a company's future cash flows, discount each one back to today, and add them up. The result is an estimate of what all that future cash is worth right now. Every valuation model, at its core, is just the time value of money applied at scale.
Key takeaways
- Money has a time value: a pound today beats a pound tomorrow.
- Discounting converts future cash into its present value.
- A higher discount rate lowers the value of future cash flows.
- Compounding is discounting in reverse — and a DCF applies it to a whole business.
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