“A cornerstone of business valuation is the formula for present value, which takes Einstein’s much admired compound interest formula and turns it on its head, using it as a divisor, writes Raymond J. ("RJ") Dragon (Rotenberg Meril Solomon) in his recent blog post, “Present Value and the Power of Time in Financial Economics.” “So PV(CFn) = 1/(1+r)^n, enabling us to take a cash flow in period n and determine its present value.”
On the other hand, John Maynard Keynes’ famous adage “In the long run, we are all dead” is also applicable to BV.Dragon presents a chart to demonstrate that “the present value of $1 using a 25% discount rate is only 1 cent in year 19, and that 99% of the total value of the perpetuity is based on the cash flows in the first 20 years. By year 28, the value of $1 is effectively zero, the perpetuity is ‘dead.’” So it appears Keynes gets “the better of this argument.”
But in fairness to Einstein, Dragon poses the question “what would happen if we grew the perpetuity at the long–term growth rate?” We have to wait until Dragon posts Part II of his article to learn the answer.
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