Imagine a scenario where someone is gifting you $10,000. You can have the money now, or you can have the money in five years. Which would you choose?
Most people would take the money now, and not just because a tropical vacation now is a heck of a lot more enticing than a tropical vacation in five years. Money received now can be invested during those five years, earning a rate of return. That money could be used to pay off debt, saving in interest costs.
If you’ve ever heard the expression “a dollar today is worth more than a dollar tomorrow,” then you’ve had an introduction to the time value of money principle. It’s an important concept for investors to understand when making decisions about their investing strategy and whether to put money into a particular security.
What Is the Time Value of Money?
The time value of money is the relationship between a dollar at one point in time and the value of that same dollar at another point in time. For example, $50 today likely won’t have the same value as $50 a year from now, just as $1 million now is not the same as $1 million 20 years ago.
Several forces are at play here. First, there is the potential for both interest to be earned (on an investment) and income to be paid (on debt). Inflation, the rising of prices over time, is also a consideration. As goods get more expensive, each dollar can accomplish less.
The time value of money is a framework for comparing lump sums of money and/or periodic payments across different time frames. Dollars can be future, present, or past.
The time value of money may seem like a purely academic concept, but has plenty of real-world applications. (And not just in a hypothetical gift of $10,000 paid to you by some long-lost aunt.) The time value of money is used in personal finance, real estate, and investing decisions.
How Does Time Value Work?
The time value of money can look at both the present and future value of money and the value of cash flows. It allows both institutional and retail investors to compare payments or sums of money over different time frames.
To determine the value of money over time, investors use a formula that takes into account the present value and future value of a specific amount, and how it will change over time.
What is the Time Value of Money Formula?
There are two main ways to calculate the time value of money, but in any given situation there are ways an investor might calculate it differently. When compounding interest is involved the calculation can be more complex, but there are online calculators available to help with this.
If you’re determining the value of money to a current dollar amount, that is called a present value calculator. To calculate the present value (PV) of a future cash flow, the formula is:
PV = FV / (1 + i) n
If extrapolating the value of a dollar amount in the future, this is called a future -value calculation. To calculate the future value (FV) of cash flow from the present value:
FV = PV x (1 + i) n
• PV – Present Value
• FV – Future Value
• i – interest rate
• n – number of periods
If there are multiple times per year when interest compounds, the formula can be changed to:
FV = PV x (1 + i/n) ^(n x t)
• i – annual interest rate
• t – number of periods (years)
• n – number of compounding periods of interest per year
If interest compounds daily, monthly, quarterly or yearly can have a big effect on the TMV calculation.
There are always two sides to the value of money equation: a giver and receiver, payer and payee, or borrower and lender. The calculation can be used on either side, to figure out money flowing in or out.
The different variables involved when calculating compound returns are the rate of return, the duration, the frequency of compounding, inflation, and the principal amount invested. A compound returns calculator can help with figuring out how all these factors affect one another.
Time Value of Money and Compound Returns
For the individual investor, there is perhaps no way in which the time value of money is more important than with earning compound returns.
To earn compound returns is to earn a rate of return on both the initial principal invested and all previous profits. As profits grow, so does the potential to earn more and more—and all that this exponential growth requires is that you stay invested.
The key to harnessing the raw power of compound returns is to spend as much time invested as possible. Each year of positive returns is fuel for greater future returns. This can be hard for investors to wrap their heads around because the most powerful results can take decades to reveal themselves. To understand compound returns, it helps to start with a comparison to simple returns.
Comparing Simple Interest to Compound Interest
With simple returns, a rate of return is produced on the principal investment in each period. An example is a bond that pays a 5% rate of return on $1,000 each year for five years. Each year, the bondholder receives a $50 payment ($1,000 x 5%). The amount is not reinvested, and the $1,000 principal is returned at the end of the five years. The investor makes a total profit of $250 (5 x $50).
Compare that to a 5% compounding rate of return. Envision a $1,000 investment in a stock. Each year, the investment grows by 5%. After the first year, the stock is worth $1,050. In year two, that 5% rate of growth applies to both the initial $1,000 investment and the $50 profit from the first year, resulting in a profit of $52.50. The investor is earning a rate of return on a bigger sum of money with each passing year (assuming only positive growth)—without adding money.
At the end of the five years, the investor’s initial $1,000 investment has grown to approximately $1,276. This is a total profit of $276, compared to simple interest’s $250. While this might not seem like much, this gap will continue to grow as compound return growth increases.
Factors Affecting Compound Returns
There are four variables at play when calculating compound returns: the rate of return, the principal invested, the duration, and the frequency of compounding. (Does compounding happen monthly? Annually?)
Check out a compound returns calculator for a better understanding of how these variables interplay. What you’ll find is that all factors can have a powerful impact on the outcome.
Investors should also consider inflation. Inflation, or rising prices over time, also has a compounding effect. There is certainly a time value of money formula for inflation, though in this context it might be easier to simply subtract the expected rate of inflation from the expected rate of investing returns.
You do not have to invest in an individual stock to harness the power of compound returns. The effect works with any investment where the profits are reinvested, whether automatically or manually.
How Does Inflation Impact the Time Value of Money?
Another reason that money is worth more in the present than in the future is because of inflation. As time goes on, inflation pushes down the purchasing power of money. So the same amount of money can’t buy as many goods in the future as it can today. However, invested money that gains more than the rate of inflation won’t lose value.
Recommended: Is Inflation a Good or Bad Thing for Consumers?
Real Life Applications for TVM
Investors use the time value of money to understand the worth of money in relation to time, which helps them understand the value of their funds in the present and the future and how to invest them. Factors such as interest rates, inflation, and risk all affect investments over time, so having formulas to help make decisions is a useful tool.
For example, say an investor has a choice between two different projects to put money into. The two projects are identical except the first project offers a $1 million cash payout in one year, and the second project offers the same payout in five years. At first glance, it might seem like the two projects are the same, but the first project is a better investment because it pays out sooner, giving it a higher present value.
It’s important to choose a rate of return, or discount rate, that makes sense for the situation when calculating the time value of money. The Weighted Average Cost of Capital (WACC) is a popular choice of rate. If the rate used is incorrect, the calculation will not be accurate or useful to an investor.
There is also the option to use the TVM calculation for “sinking funds.” If you’re saving up for something in the future and know how much you need to save, you can figure out how much you need to save each month or year to reach that goal if you are earning interest on those savings.
Real Estate Investments
An investor might look at a property in a high-growth neighborhood and predict that it will be worth a certain amount in five years, but they want to calculate whether it is actually a good investment. They can use the TVM calculation to discount that estimated future value to find out the current value and see how the two compare.
The Time Value of Money is an important calculation for investors to use when building a portfolio. It can help you evaluate a potential investment to determine whether it might make sense for you.
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