Discounting
A method for converting future amounts into today's value (or the other way round) using an interest rate.
Discounting is a method used to calculate the value of future amounts in today's terms, also known as present value. This is an important technique in economics and finance, particularly when it comes to assessing investments, projects or other long-term financial decisions. By using discounting we can work out what future income or costs are worth today, which helps in making better financial decisions.
How does discounting work?
In general a value can be discounted both backwards and forwards in time:
- Backwards in time (present value): This involves calculating the present value of a future amount. For example, if you receive NOK 1 000 in a year's time, how much is that amount worth in today's terms?
- Forwards in time (future value): This involves calculating the future value of an amount you have today. For example, if you have NOK 1 000 today, what will that amount be worth in a year's time?
The discount rate
In order to calculate the present value of future amounts, a discount rate is used. The discount rate is a percentage that reflects factors such as inflation, interest rate levels and risk. The higher the discount rate, the lower the present value of future amounts.
How to discount backwards in time
Let us say that you are due to receive NOK 100 000 in five years' time, and the discount rate is 5%. To work out what that amount is worth today, we can use the following formula:
Present value (PV) = Amount / (1 + rate)^time = 100 000 kr / (1 + 0,05)^5 = 78 352 kr.
NOK 100 000 in five years' time is therefore worth NOK 78 352 today.
How to discount forwards in time
If you have NOK 100 000 today and want to know what it will be worth in 5 years' time, you can use the following formula:
Future value (FV) = Amount × (1 + rate)^time = 100 000 kr × (1 + 0,05)^5 = 127 628 kroner.
Why use discounting?
Discounting is useful in a range of contexts, particularly in business and socio-economic cost-benefit analyses. For example:
- Investments: By calculating the present value of future cash flows, businesses can determine whether an investment is profitable.
- Project assessment: Discounting helps businesses assess future projects by comparing today's costs with future income.
- Financial decisions: Used to evaluate long-term financial decisions and to make sure that resources are used as efficiently as possible.
More terms in returns and investment analysis
See all →ROE (return on equity)
Measures the return a business generates on the equity its shareholders have invested.
ROA (return on assets)
Shows how efficiently a business uses its total assets to generate profit.
ROCE (return on capital employed)
Measures the return on all capital in the company, both debt and equity.
ROI (return on investment)
Measures the profitability of an investment relative to what it cost.
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