In finance, the value of any asset is the present value of all of the future cash flows. When someone first told me that, I had no idea what it meant, so let’s run through a quick example.

Assume that someone asks you to borrow \$100 for one year. If you think inflation might be three percent in the next year, you’re going to need to charge a three percent interest rate just to maintain your purchasing power.

Then you realize that you might be wrong about inflation, so to be on the safe side, you up your interest rate to four percent.

As much as you like your buddy, they’re a little hard up and may not pay you back so you decided to throw in three more percent to account for the risk that you might not get back in a timely way, not in full or, worst of all, not at all.

Now you’re loaning out \$100 and one year from now, you expect to get your principal of \$100 and \$7 in interest – those are your future cash flows, or more specifically, your expected future cash flows. In this case, we know the present value, \$100 and the expected future value of \$107, so we can say that the discount rate is seven percent.

Let’s assume that one day later, I hear about the loan from the borrower. I happen to think that inflation will only be two percent and I’m so stubborn that I can’t fathom being wrong.

I also happen to think that the borrower is a totally solid guy that will pay me back, so I think that charging three percent for that is excessive. Maybe one percent makes sense in case he gets hit by a bus, but there’s no reason to get greedy.

Now, I’m looking at that loan thinking about the \$107 that’s coming in one year’s time. Since I’m certain that inflation will be two percent and I am only going to charge one percent for the credit risk, I’m willing to pay nearly \$103 to buy that loan from you.

You’re happy to get a \$4 dollar return in one day, so you quickly make that trade and now I own the loan.

One year later, the borrower is a little short, pays back the principal but only has \$5 in interest. My investment of \$103 turned out to be a bum deal, I earned a little less than one percent on my money, even though I happened to be right about inflation coming in at two percent. I have less purchasing power at the time of purchase.

What’s the point of this story other than it’s a lot of fuss for \$100?

The basic idea is that it’s pretty hard to tell what an investment is worth because you don’t know what the future cash flows will be with much certainty and it’s impossible to know what the discount rate ought to be.

In hindsight, we can see that your estimate would have been more profitable, but maybe our cash strapped friend wouldn’t have engaged in a deal with you if he had known that I would lend him the money for three percent.

If it isn’t apparent yet, this is pretty much how the bond market works. Yields, or expected returns, are mostly comprised of two elements: the term and creditworthiness of the loan.

The term builds in an inflation estimate and a little extra something in case the estimate is too low and the credit works exactly as described above. At the most fundamental level, stocks work the same way, but it’s much, much harder.

First and foremost, the life of a bond is finite. Hopefully, a stock will last forever, so you either have to assume an artificial end to the company or create some kind of perpetuity value.

Second, the cash flows from stocks are highly volatile, unlike most bonds. That’s why Wall Street spends so much time looking at quarterly earnings.

Third, most cash flows from stocks aren’t paid back to investors. Fifty years ago, companies paid out most of their profits in dividends, but today, companies sit on mega cash hoards, go on acquisitions sprees or buy back their own shares in the public markets.

It sounds so simple at first: the value of an asset is the present value of its future cash flows. If only you knew what those cash flows will be or how much to discount them by, investing would be a piece of cake.