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I still believe in Present Value

October 8th, 2008

The end of Present Value… Nikkei, a major economic newspaper in Japan, ran a column corresponding to the current financial meltdown. It argues that this financial crisis was caused by excessive reliance on the idea of Present Value. Investment bankers put illusory values on anything around the world. Even though an asset has no value on balance sheet, they can create substantial value by calculating present value of probable future returns brought by the asset.

But I don’t think Nikkei’s argument is appropriate. Nikkei missed an important point of present value theory, namely risks. Modern financial engineering put great emphasis on estimating and dealing with risks. According to the present value theory, risk is the most important factor that determines a discount rate.

It can be said that banks which bought subprime loans simply took risks to maximizing their profits. Who is to blame is not the present value theory, but the carelessness and negligence of the investors who underestimated risks and didn’t prepare for downside scenarios.

I believe in Present Value and other received financial theories, such as real option. If you deny Present Value, then what do you rely on? Only book-value? No kidding! What to do is not negating financial theories, but better understanding the theories.

Entry Filed under: Business