If we combine the learning from the previous three sections of this chapter we get to the meat of the method here: discounting a stream of future cash flows into a present value. The determination of what the cash flows are (not simply the revenue or profit from sales!!!) is very important and we will discuss this in detail in the next section. For now, let’s assume we know what the relevant cash flows are.

I'll start the explanation of discounting by first discussing a more common and related process: compounding interest. The idea of compounding interest simply says that as time goes on and you're earning interest on invested money (like the dollar in the opportunity cost reason for present value methodology mentioned above) and on the interest earned on that invested money. Here is a simple example:

If you earn interest of 10% per year, compounded yearly, on a one dollar investment you will have $1.10 at the end of the first year. If you invest the dollar at the same 10% rate for two years, you will not have $1.20 but rather $1.21. The reason is compounding: the second year you had $1.10 invested since you earned 10% or $.10 the first year. Interest in the second year was based on the $1.10 and not the original $1.

Discounting is the same concept in reverse. You are bringing that value back in time from the end of second year $1.21 to a present value of $1.00. Discounting is simply the establishment of a future value in today's terms. Here is another example:

If someone promises $10.00 in one year if you invest with them at a 10% return, what is that investment worth today? Don't jump too quickly to say $9.00 because $9.00 at 10% in one year is 9*1.1 = $9.90, not $10! The actual answer is $9.09. If you were to sell that investment at $9.00, you would have made a bad deal!

Now think about the complexities added if it were a two-year investment! Here is the math behind the discount model:

(future value)/(1+investment rate)^n) were n is the number of periods. Here is our example above in both the one-year and two year versions:

One Year: 10/(1.1)^1 = 9.09 Two Year: 10/(1.1)^2 = 8.26

You can see that the further out the investment goes, the less the present value. This coincides with everything we've covered so far, particularly the three primary reasons that a dollar today is worth more than a dollar some time in the future. To tie another part in with this, consider your own "required return" for your money. Let’s say your bank will give you 10% on any funds deposited into your account. If someone asked you to invest money in their project and they promised $10 back in one year, the maximum you would invest for that $10.00 would be $9.09. Otherwise, you could just go to your bank. The idea here is that the project probably carries some sort of higher risk and you would demand a higher return and therefore invest less today for the same $10 next year. For example, if the project was medium risk (i.e. there is a slight chance it will not payoff) you may look for an expected return of 13% and therefore look to invest 10/(1.13)^1 = $8.84 today for a $10.00 return a year.

Now that you are armed with the understanding of risk, the role of risk in the discount rate, and the idea of discounting future cash flows into a present value, we can move on to determining what those cash flows actually are in a given website or collection of websites that we may be valuing.

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