The Time Value of Money (TVM)
Time Value of Money Definition, Concept, Application
In short:
Time value of money is the concept that money today is worth more than money tomorrow. More specifically an identical amount of money is worth more today than the identical amount at a later point because of the money’s potential to earn money, this theory holds so long as money can earn interest.
Future Value FORMULA:
Look familiar? This is the same formula for compounding interest.
We can easily rearrange the future value formula to get the present value of money. That is, how much would you have to invest today (given you know the rate of return and time) to get a certain amount in the future.
Present Value FORMULA:
Core concept
Time value of money is a core concept for finance and investing, so understanding it will build a more solid base for an investor.
Let’s look at a logical example of the time value of money to help make more sense of it. If someone could choose between receiving $1,000 today and $1,000 in a year, the vast majority would pick to receive the money today, (this is economically rational). Why? Because there is no incentive to not receive the $1,000 today. Now, if the scenario changes to receiving $1,000 today or $1,100 in a year, the number of people who choose today vs a year will change. More people will choose a year from now rather than today so that they can receive the extra $100, how many change depends on the other opportunities available at the time to use that $1,000.
The extra $100 or 10% represents the Time Value of Money.
How much does it cost for a large number of people to forego having money today for money sometime in the future? This depends on the other opportunities available at the time therefore we can conclude that the time value of money changes at various times.
Choosing an investment using Time Value of Money
So you understand the concept and theory of the time value of money but how do you use it to make an investment decision?
One way is to use it is to compare investment options, for example, say you have the choice between making an investment of $17,000 for three years, at the end, you are guaranteed to have $20,000. Or you have another investment option where you could potentially make 13% to 25% per year, how do you choose?
First, you calculate the rate of return. For the first investment that would look like this:
$17,000 = $20,000 / (1 + (rate of return))^3
Rearranging and solving we find that the rate of return is around 5.57% for the guaranteed return. Clearly, this is a lower return however it is guaranteed. This now leaves you with a choice, how confident are you that the other investment will get the 13% to 25% per year return? You could use even more quantitative reasoning to make a more precise decision but in lieu of getting into details of how to do that the general concept comes down to if you are sufficiently confident in the higher return you would choose the higher return, if not, you would take the guaranteed return.
Inflation – Time Value of Money
When considering any investment inflation is a consideration and can be tied in with the time value of money. Inflation is the loss of purchasing power of money with time. In a quick example, consider how many cans of Pepsi $1 could buy from a vending machine in the early 2000s. Most likely $1 in the early 2000s could buy 2 cans of Pepsi, today it is around 1 can. This is an overly simplistic example but serves to illustrate the point.
Investments are impacted by inflation. If you have an investment that is making 10% over the course of a year and the inflation rate for that year is 2% then your real rate of return (rate of gain after inflation) is 8%. This represents the true wealth gain you have experienced. Why is this important? This is important in low-interest environments where the return you get on a low-risk investment like a money market, cd, or government bond could be below the rate of inflation. If this happens, you are experiencing no wealth gain from that investment and may not want to tie it up in those investments as a result.
You can find a gauge for inflation by checking out the Consumer Price Index (CPI) at https://www.bls.gov/cpi/ this is the U.S Bureau of Labor Statistics who is in charge of keeping track of this information.
This topic relies on ideas found in compounding interest, you can learn more via the link we provided.