A company creates value when the present value of the cash flows from its investments is greater than the cost of the investments. In other words, one dollar invested in the business becomes worth more than one dollar in the market. Discounting future cash flows makes sure the investment is attractive relative to the capital’s opportunity cost, and the return on the next best alternative.
Here is one way to think about it. A company invests $10,000 and the opportunity cost is 8 percent. In the first scenario, the investment generates a cash flow of $500 per year into perpetuity, which equals a value of $6,250 ($500/.08). This fails the one-dollar test and illustrates why positive earnings do not always equate to value creation.
