How to Calculate Compounding & Discounting

Compounding calculates the future value of figures to account for interest or consistent growth. For example, using the compounding formula enables you to estimate the return at a future time, based on present-day information. Discounting is the opposite of compounding and calculates the present value of a figure, based on its future value. The logic behind discounting is that a payment you expect in the future isn't worth the same as a payment today, so discounting enables you to factor in influences like inflation.

Compounding

Step 1

Add 1 to the interest or growth rate. As an example, if your business steadily grows by 10 percent each year, add 1 to 0.1 to get 1.1.

Step 2

Raise this figure to the nth power, where "n" is the number of years in the future. In the example, if you wanted to project your current return to see what it may be in five years, raise 1.1 to the power of 5 to get 1.61.

Step 3

Multiply the result by the present value to calculate the future value. Continuing with the example, if your present annual return is \$100,000, multiply \$100,000 times 1.61 to calculate an expected annual return of \$161,000 in five years.

Discounting

Step 1

Add 1 to the discount rate. A common discount rate is the rate of inflation. If the current rate of inflation is 1.8 percent, add 1 to 0.018 to get 1.018.

Step 2

Raise this figure to the nth power, where "n" is the number of years between the future and present values. Continuing with the example, if a client offered to pay you in five years, raise 1.018 to the power of 5 to get 1.093.

Step 3

Divide the future value by the result. If your client offered to pay you \$10,000 in five years, divide \$10,000 by 1.093 to calculate the present value of \$9,149. This means that a \$9,149 payment today is effectively the same as a \$10,000 payment in five years.