A dozen years ago, on my first day of business school, the professor stood at the board and illustrated a concept called “present value.” Truth be told, over my remaining time in school, I don’t think I learned anything more important than I learned in that first hour. It is, in my view, the single most useful tool in all of personal finance. Below, I’d like to walk you through this concept and then illustrate some of the ways it can help you make better financial decisions.

Let’s look at a simple example. Suppose you were presented with this choice: You could receive $90 today or $100 a year from now? Which would you choose?

This question is tricky because it’s asking you to compare apples to oranges—a certain number of dollars today vs. a different number of dollars next year. But this is where present value is so incredibly useful. Here’s how it works. It’s three steps:

**Step 1: **Estimate how much you could earn if you had that $90 today and were able to put it in the bank or invest it. For simplicity, if it’s just a year, let’s assume you could earn just 2% by putting it in the bank. (If it were a longer period, you would choose a higher rate.)

**Step 2:** Calculate the present value of that future $100. In other words, determine the value to you today of the $100 you could receive next year. If you were to do this math on a calculator, it would be $100 divided by 1.02. That works out to $98.04. (In reality, you would use Microsoft Excel or another spreadsheet program to make the math easy; look for the “PV” function.)

**Step 3:** Now you are in a position to do an apples-to-apples comparison. Again, the choice is between $90 today or $100 next year. The first part is easy: The value of $90 today is, of course, $90. And the value of $100 a year from now? In Step 2 we calculated that to be $98.04. Now it’s a simple comparison. Clearly, $98.04 is preferable to $90, so in this case you would want to wait a year to receive $100.

That’s a little bit of an antiseptic example, so let’s look at how you can use present value to make real financial decisions:

**Pension benefits:** If your employer offers a traditional pension, it’s possible they will offer you a buy-out option at some point. For example, if you’re entitled to $50,000 per year for life, they might offer $650,000 as a lump sum alternative. Would you take it? Present value analysis would allow you to compare that lump sum to the present value of all those future annual payments. You could explore different rates of investment return—assuming you took the lump sum—and you could explore different potential life expectancies. Of course, those are both unknown, but present value calculations at least give you a logical framework for making your choice.

**Whole life insurance:** If you’re like most people who own whole life insurance, you’ve considered liquidating the policy. But you might wonder whether, after all the premiums you’ve paid, it’s better to stick with it. If you use present value analysis, you can compare the value of the future death benefit to the cash value today (less taxes, if any).

**Car leases:** If you need a new car, leases are enticing because they offer such low monthly payments. At the same time, you’ve probably heard that it makes more sense to buy. But like all rules of thumb, this isn’t an ironclad rule. If you use present value analysis, you can compare the total cost of buying vs. leasing.

**Extended warranty: **Before you leave the auto dealer, they’ll probably also offer you an extended warranty. Again, these have a reputation for being a bad deal, but it depends. Do a present value analysis based on expected future repairs, then use the result to help negotiate with the dealer.

**Education: **For years, it’s been conventional wisdom to get a college education. But with the astronomical price of tuition, even the president of an educational industry association acknowledges that the cost doesn’t always make sense. You really want to be careful. I’d use present value analysis to help evaluate the choices. Compare the cost of tuition (and financing costs) to the expected increase in lifetime wages. To be clear, I’m not advocating against college. Far from it. I’m only advocating against unjustifiably expensive schools that leave students and their families overburdened by debt they can’t pay.