Are you planning to buy or sell some assets like a house or may be a stock? Do you want to know the right value of asset you are planning to buy or sell? Valuation is a very important concept in finance and financial strategies of individuals and firms depends largely on their valuations of financial assets. In this article we will introduce you to the basic concepts of valuation like cash flow, present value, future value and discount rate.
What is Cash Flow?
Before going into the details of valuation we need to know what is cash flow. Basically cash flow is the amount of cash generated from a particular asset. An asset might generate some cash now and some cash in future and there might be assets which keep generating cash over a period of time. For example if you deposit some money in the bank in the form of fixed deposit that will keep earning you interest every month or every year depending on the terms of the fixed deposit.
Present Value and Future Value
Once we understand this concept of cash flow it will be easy for us to understand present value and future value of an asset. Present value of an asset is defined as “value today of a future cash flow” and future value is defined as “Amount to which an investment will grow after earning interest”. In simple terms present value gives the value of an asset today and future value gives the value of the same asset at some point of time in future.
Discount Rate and Discount Factor
To calculate the present and future value of assets we need to understand the concept of discounting. It is generally accepted that money today is more valuable than money tomorrow i.e. value of $1 today is more than value of $1 tomorrow. Discount rate captures this diminishing value of money over a period of time. Formally discount rate is defined as “interest rate used to compute present values of future cash flows” and discount factor is defined as “present value of a $1 future payment”.
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