Time Value of Money

Benjamin Franklin is credited with the famous quote, “Time is money.” Flipping this equation, we can say that money is time. How we choose to spend both of these resources is the recipe for either success or failure.

Investing in stocks, real estate, education, bonds, venture capital, or any other risk-reward mechanism involves a time horizon for the expected return on investment to pay off. Every investor should consider both the monetary return and the amount of time taken to achieve that return.

A dollar today is not worth a dollar tomorrow because we can earn interest on our dollar by investing it. The interest rate is the primary factor determining how much more our dollar will be worth in the future. If we can invest our money at a 10% interest rate, we’ll have more than if we could only invest it at a 5% interest rate. This may seem elementary…because it is. Yet, it’s absolutely essential to understand when making smart financial investment decisions.

Equally as important is the time component of your expected return. If an investment will generate a 100% return, but it takes 20 years to do so, is that an effective allocation of capital? However, if an investment will produce a 20% return in one year, it offers a much better financial opportunity than the former scenario.

In financial markets, you find an interest rate offered that reflects the amount of risk inherent in the investment, so higher rates typically signal riskier deals. The key is to find an investment that you are comfortable with, given the risk level, that presents a reasonable return for your money.

Your money will compound at a return rate over time, which magnifies the importance of the time value of money analysis. Therefore, let’s examine the factors that affect the earning potential of a dollar today.

Discount Rate

The discount rate is a percentage return we expect for a particular investment. This may also be called the required rate of return or cost of capital. A discount rate is the minimum rate of return we are willing to accept from an investment, given the asset’s riskiness and our other options for deploying money. We use this rate to “discount” the potential future cash flows from the investment to a present value today. This is similar to the interest rate, with some additional considerations.

If we have absolute certainty that an interest rate will remain constant over the time horizon of an investment, then we could use the interest rate as the discount rate. We view this as the risk-free rate of return, which is generally accepted as the yield rate of a government-backed US Treasury bond.

The 30-year US Treasury bond has yielded around 3% over the recent decade but can fluctuate based on market conditions. Theoretically, we should do no worse than a 2-3% return on our invested capital since the US government practically guarantees that as a minimum yield.

However, suppose we know there will be additional risk factors to consider for the chosen investment. In that case, we can adjust the discount rate upwards to reflect the additional required rate of return from our investment. There are several formulas to help us quantify the riskiness of an investment, most of which involve calculating the overall market risk and the beta (i.e., volatility) of the company.

For the sake of simplicity and to focus on the topic at hand, we’ll assume that we know what our discount rate will be for our investment.

To determine how much an investment is worth today, we must discount the future cash flows back to the present value. This brings us to the second factor to consider when analyzing any financial investment: the potential earnings or cash flow we expect the asset to provide for us in the future. This could include potential returns on our investment, such as the selling price of a stock, dividend payments, interest earned, or rental income, in the case of investment real estate.

The formula for the present value of an investment is:

Present Value = Future Value x [1/(1+r)^n]

Where r is the discount rate and n is the number of periods (e.g., months, quarters, years) until the cash flow occurs. This means that the present value of an investment equals its future value multiplied by the result of 1 divided by 1 plus the discount rate raised to the power of the number of periods.

Let’s say we expect our favorite stock to be worth $200.00 in 5 years, and our best estimate provides a 12% discount rate, given current market conditions and the inherent riskiness of the company. What’s the present value of the stock?

Present Value = $200.00 x [1/(1.12^5)] = $113.49

Mathematically, we are multiplying $200.00 by 1 divided by (1.12 x 1.12 x 1.12 x 1.12 x 1.12). This is taking our discount rate and compounding it over the 5 years in this example. As you can imagine, the further out the timeframe is, the more significant the discounting effect will be.

If you want to buy this stock today, you should be willing to pay $113.49 per share. You do not want to pay $200.00 today because, during the five-year time frame, you will reap the benefits of the compounding effect and purchase the stock at a discounted present value.

The most challenging part of the present value equation is accurately estimating an investment's future value. For an extensive work of literature on ways to calculate the value of financial assets, see the classic book by Benjamin Graham and David Dodd, Security Analysis (not considered “light reading,” but I highly recommend it for the brave of heart). Numerous factors play into the analysis of future value, which is the topic of another discussion.

Closing Remarks

The fundamental process of discounting a potential investment back to present value should be included in your assessment of any capital allocation opportunity. It provides a vital step in understanding an asset's expected returns and risks.

Investing is a challenging and complex endeavor, which can be very rewarding, both financially and psychologically. Gaining an appreciation for the many intricacies that constitute the dynamic nature of investments will set you up for success in the future. Remember the importance of the time component of money, and you’ll be a step ahead of many other participants in financial markets.

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