Every time the word investment is mentioned most people immediately think of the stock market, crypto, real estate and the likes. You probably do too and you are not wrong.
But, investment in its most simple form means “using an asset you own to generate future profits” and assets don’t always mean money; sometimes it could be time, effort, or a property you own.
With this perspective, we can consider two school kids pledging portions of their lunches to each other as a crude form of investment.
As for profits, it is up to you to define what is acceptable to you, based on the alternatives that surround you. For skilled investors, this is where using the time value of money comes in.
You know that due to inflation there is a consistent decrease in purchasing power of money and investments are always being used as a reliable hedge against such losses. All this put together forms the basics of the time value of money rule which is:
Money received today is worth more than that same amount received in future.
How Is This Applied?
The time value of money is used to guide investment decisions. Before you invest, you want to know which of the options before you promises the highest profits in today’s value. To do this you would grade your investments using either of these time value factors depending on your exact situation.
- Present value
- Future Value
1. Present value
Calculating the present value of money answers the question;
If an investment promises to pay me a certain amount in future, how much is that sum worth today?
2. Future Value of money
This answers the questions:
I have a certain amount in hand today, how much is it worth in future?
The boring stuff: Formulas and Interest Rates
The formula for the present value of future payments is:
n=Number of years.
Interest rates used in the present value or future value formula can also be called discount rate. When considering an investment, it is appropriate to use the opportunity cost of putting your money elsewhere as your interest rate.
This is calculated as:
Opportunity Cost =FO−CO
FO= Forgone option
CO= Chosen option
Choosing the investment with the highest interest rate (returns rate) is viable but this doesn’t work in all cases, because it might be difficult to estimate the return rates on all available options.
The length of time it takes for each investment to pay their respective returns should also be considered, among other factors like cost of investments, the possibility of other cash inflows or compounding interest and any non-quantitative factors.
This is why converting all possible investment returns to today’s value using the Present value formula is considered more appropriate.
Identifying Interest rates/Returns
For bonds, loans or other fixed capital investments their interest rates you can easily identify their interest rate, most time it’s usually in the name. e.g. For a 10% annual loan, you know the interest rate is 10%.
But for equity investment such as shares, identifying possible returns requires a bit more legwork from you. You can learn more about that in this article: How to estimate the benefits of investing in a company.
What You Have Learnt
- The time value of money is vital in making business decisions
- The present value of money can be used to estimate what the profit of your investment is worth in today’s terms.
- Discount rates or interest rates can be determined by considering what return you’ll get from another investment
- And I may or may not have been a middle school business mogul with my lunch. You’ll never know.