Discounting

Intermediate

Discounting is the process of working out what a future amount of money is worth today, by reducing it to reflect the return that could be earned in the meantime.

Discounting is compound interest run backwards. Compounding takes money today and asks what it will grow to; discounting takes money in the future and asks what it is worth now.

For example, suppose you will receive 1,000 in three years and could earn 6% a year elsewhere. Discounting asks how much you would need to invest today at 6% to have 1,000 in three years. The answer is about 840, so the future 1,000 is worth about 840 today.

The rate used is called the discount rate, and it reflects both the return available on other investments and the risk that the future payment might not arrive. A higher discount rate, or a longer wait, shrinks today's value more.

Discounting is the foundation of most valuation in finance. It is used to price bonds, value companies, compare investment projects and decide whether a future benefit is worth a cost today. Whenever money arrives at different times, discounting puts every amount on the same footing so they can be compared and added together.

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