Time Value of Money and Discount Rates

Why this matters

Valuing a business means valuing money it will make in the future, often many years from now. To compare that with a price paid today, you need a way to convert future dollars into today's dollars. That's the time value of money, and it sits underneath every valuation method in this module.

In his 1992 letter to shareholders, Warren Buffett summarized the idea, drawing on the economist John Burr Williams: the value of any stock, bond, or business is the cash it can be expected to produce over its remaining life, discounted at an appropriate interest rate.¹ This lesson explains what "discounted" means.

Forward and back in time

Compounding showed how money grows when invested: $1,000 earning 5% a year becomes $1,000 × 1.05 × 1.05 after two years. Discounting runs the same calculation backward. If you can earn 5% a year, then $1,000 promised in two years is worth less than $1,000 today, because you could invest a smaller amount now and end up with $1,000 then.

Future value = Present value × (1 + rate)^years

Present value = Future value ÷ (1 + rate)^years

Discount rate	Calculation	Worth today
2%	$1,000 ÷ 1.0210	$820.35
5%	$1,000 ÷ 1.0510	$613.91
10%	$1,000 ÷ 1.1010	$385.54

The same promise is worth more than twice as much today at 2% as at 10%. The further away the money and the higher the rate, the less it's worth now.

A series of payments

A business produces cash every year, not once. Its value today is the sum of each year's cash, each discounted by its own number of years.

Payment	Calculation	Worth today
$100 in year 1	$100 ÷ 1.08	$92.59
$100 in year 2	$100 ÷ 1.082	$85.73
$100 in year 3	$100 ÷ 1.083	$79.38
Total		$257.71

$300 of future payments is worth about $258 today at an 8% discount rate. A discounted cash flow valuation does exactly this, with a company's projected cash flows.

What the discount rate means

The discount rate is the yearly return you require to give up money now in exchange for money later. It has two parts:

• A safe return, what you could earn with very little risk. Investors often use US Treasury yields: the 10-year Treasury yielded 5.29% on September 30, 2026.²
• Extra return for risk, because a company's future cash is far less certain than the US government's promise to pay. The next lesson, Cost of Capital, covers how to estimate it.

This is why interest rates matter so much to stock prices. When safe rates rise, investors require more from everything else, discount rates go up, and the present value of a company's future cash falls, even if nothing about the business has changed.

Key takeaways

• A dollar today is worth more than a dollar later, because it can grow and because the future is uncertain.
• Present value = future value ÷ (1 + rate)^years. A series of payments is valued by discounting each one.
• The discount rate is a safe return plus extra return for risk.
• Higher discount rates mean lower present values, which is why interest rates affect every valuation.

Check your understanding

What is $1,210 received in two years worth today, at a 10% discount rate?

1. $1,100
2. $1,000
3. $968

Interest rates on safe government bonds rise sharply. Without any change in a company's expected cash flows, what tends to happen to its value?

1. It falls, because a higher discount rate makes future cash worth less today.
2. It rises, because higher rates mean the company earns more on its cash.
3. Nothing changes, since the expected cash flows are exactly the same.

What's next

The hardest part of the discount rate is the extra return for risk. The next lesson, Cost of Capital, explains how investors estimate it.