What is the Time Value of Money?
The time value of money is the concept that money today is worth more than money in the future because it can earn a return if invested today.
In other words, receiving $100 cash today is worth more than a promise to receive $100 cash next year, because there is utility in having control of the cash. The cash can be invested in a savings account or used for purchases.
The promise to receive money in the future should be discounted to the present using a discount rate.
Calculating Present Value
The time value of money principle dictates that money today should be valued higher than money received in the future.
The difference in value between the future and the present can be calculated by applying a discount rate which reflects an appropriate rate of return that can be earned if the money is invested at current rates.
The formula below can be used to discount a future value to a present value.
To illustrate with an example, if someone is promised to receive $1,000 one year from now and the relevant discount rate is 5%, what is the present value?
The present value is calculated to be $952.38.
Investing Implications of the Time Value of Money
The time value of money has implications in making investment decisions because it can aid investors in calculating the present value of investments with future cash flows.
One application is to use the time value of money to evaluate a bond investment.
Bond investments pay interest every year and return the principal when they mature.
You can calculate the total present value of a bond by adding together the present values of each of the bond’s scheduled coupon payments.
Each scheduled coupon payment represents a clear future value and should be discounted at an appropriate discount rate.
Savvy investors compare their estimates of present value against current market prices when making investment decisions.
Discounted Cash Flow Analysis
Another common application is using the time value of money to value businesses.
A technique called the discounted cash flow (DCF) analysis values a business by estimating the future cash flows of a business and discounting them to the present.
The below graphic illustrates how the discounted cash flow analysis uses the time value of money concept to calculate the present value of a business.
The time value of money concept is simple but powerful. You can use the present value calculation to figure out the value of a stream of cash flows or determine whether an investment is attractive.