Behind door number 1 is $100,000, which will be deposited in your bank today.
Open door number 2, and you will find $100,000—but you don’t get it for five years.
99.9999% of us would choose door number 1. And that’s not just because we want instant gratification. That $100,000 is simply worth more right now due to a concept called the time value of money.
Hang on, there is a plot twist. There is still a five-year waiting period, but you will get $200,000 if you choose door number 3. That is going to make quite a few contestants stop and think a little harder. Let’s talk about why that is.
An Investor’s Take on the Time Value of Money
Investment decisions are based on comparing returns from several different options and gauging whether the returns are acceptable based on several criteria (e.g., risk, location, alternative investments, sponsor quality, etc.). But to compare returns, investors must start with the time value of money (TVM).
TVM is a basic principle that is utilized across economics, corporate finance, and investing. While the mechanics may start to feel complex, the concept is relatively simple. A dollar in your pocket today is worth more than a dollar received in one, two, or a thousand years in the future. Why?
- Because you already have the dollar, the risk is lower
- You know the value of your dollar (and inflation will erode the future value)
- You can choose whether to spend or invest your dollar in any number of ways
The concept that a dollar today is worth more than a dollar tomorrow demonstrates a key principle of economics: purchasing power. Over time, your purchasing power of the dollar is eroded by inflation. Therefore, the present value of that dollar you receive in the future is worth less today. Hence, the term “discounted” cash flow. Ok—still with me?
How is the Time Value of Money Calculated?
Time value of money is calculated by creating a discounted cash flow analysis or net present value calculation. It sounds complicated, but it is not that hard. Simply assign all cash inflows and outflows a time period, check your discount rate, and plug it into Excel. The program will crunch the numbers for you.
The bottom line is that each period in the investment is “discounted” from future dollars to present day dollars by reducing its value based on the discount rate. This discount rate could be (1) the prevailing interest rate, (2) the rate you are getting with your other portfolio investments, or (3) your business’ cost of capital.
Add all those discounted dollars up, and you have the net present value (NPV) of the investment today. Because a dollar earned five years from now is worth less than a dollar today, it is called a discounted cash flow. When you have an NPV that is greater than zero, it means your investment of a dollar today will earn you more than a dollar in the future. The higher the number, the better. You can also work the discounted cash flow in reverse. (Though it takes a highly sophisticated calculator.)
The IRR formula takes the same cash flows and determines what discount rate will produce an NPV of zero. Then all you need to do is compare that rate with the rates of other investment options. Of course, you have to take into account the risk of each investment and the quality of the numbers, but the simplicity of the IRR is why it is so often used in investing.
- Time value of money underpins all financial analysis and investment comparisons
- Understand that although calculations for projected returns on any given investment may look rosy, it’s the inputs (or assumptions) that matter.
- You need to understand that garbage in will create garbage out (bad, wrong, or manipulated results)
- Check the underlying cash flow projections for reasonability before jumping to conclusions