Benjamin Franklin is credited with the famous quote, “Time is money”. Flipping this equation, we can say that money is time. How we choose to spend both of these resources is the recipe for either success or failure.
Investing in stocks, real estate, education, bonds, venture capital, or any other type of risk-reward mechanism involves a time horizon for the expected return on investment to pay off. Every investor should consider both the monetary return as well as the amount of time taken to achieve that return.
A dollar today is not worth a dollar tomorrow, because we can earn interest on our dollar by investing it. The key factor determining how much more our dollar will be worth in the future is the interest rate. If we can invest our money at a 10% interest rate, we’ll have more money than if we could only invest it at a 5% interest rate. This may seem elementary…because it is. Yet, it’s absolutely essential to understand when making smart financial investment decisions.
Equally as important is the time component of your expected return. If an investment will generate a 100% return, but it takes 20 years to do so, is that an effective allocation of capital? However, if an investment will produce a 20% return in one year, it offers a much better financial opportunity than the former scenario.
In financial markets, you find an interest rate offered that reflects the amount of risk inherent in the investment, so higher rates typically signal riskier deals. The key is to find an investment that you are comfortable with, given the risk level, and one that presents a reasonable return for your money.
Your money will compound at a return rate over time, which magnifies the importance of the time value of money analysis. Therefore, let’s examine the factors that affect the earning potential of a dollar today.
Discount Rate
The discount rate is a percentage return we expect for a particular investment. This may also be called the required rate of return or cost of capital. Essentially, a discount rate is the minimum rate of return we are willing to accept from an investment, given the asset’s riskiness and our other options for deploying money. We use this rate to “discount” the potential future cash flows from the investment to a present value today. This is similar to the interest rate, with some additional considerations.
If we have absolute certainty that an interest rate will remain constant over the time horizon of an investment, then we could simply use the interest rate as the discount rate. We view this as the risk-free rate of return, which in general is accepted to be the yield rate of a government-backed US Treasury bond.
The 30-year US Treasury bond has had a yield of around 3% over the recent decade but can fluctuate based on market conditions. As of this writing, the rate has dropped to approximately 2% (U.S. Department of the Treasury, 2019). In theory, we could do no worse than a 2-3% return on our invested capital, since we are practically guaranteed that minimum yield by the US government.
However, if we know there will be additional risk factors to consider for the chosen investment, then we may want to adjust the discount rate upwards, to reflect the additional required rate of return from our investment. There are several formulas to help us quantify the riskiness of an investment, most of which involve calculating the overall market risk and the beta (i.e., volatility) of the company.
For the sake of simplicity and to focus on the topic at hand, we’ll assume that we know what our discount rate will be for our investment.
To figure out how much an investment is worth today, we need to discount the future cash flows back to present value. This brings us to the second factor to consider when analyzing any financial investment, the potential earnings, or cash flow we expect the asset to provide for us in the future. This could include potential returns on our investment such as the selling price of a stock, dividend payments, interest earned, or rental income, in the case of investment real estate.
The formula for the present value of an investment is:
Present Value = Future Value x [1/(1+r)^n]
“where r is the discount rate and n is the number of periods (e.g. months, quarters, years) until the cash flow occurs” (Simko, Farris, & Wallace, 2017). This means that the present value of an investment equals its future value multiplied by the result of 1 divided by 1 plus the discount rate raised to the power of the number of periods.
Let’s say we expect our favorite stock to be worth $200.00 in 5 years and our best estimate provides a 12% discount rate. What’s the present value of the stock?
Present Value = $200.00 x [1/(1.12^5)] = $113.49
Mathematically, we are multiplying $200.00 by 1 divided by (1.12 x 1.12 x 1.12 x 1.12 x 1.12). This is taking our discount rate and compounding it over the 5 year period in this example. As you can imagine, the further out the timeframe is, the larger the discounting effect will be.
If you wanted to buy this stock today, you should be willing to pay $113.49 per share. You would not want to pay $200.00 today, because, during the five-year time frame, you will reap the benefits of the compounding effect and purchase the stock at a discounted present value.
The most difficult part of the present value equation is being able to accurately estimate the future value of an investment. For an extensive work of literature on ways to calculate the value of financial investments, see the classic book by Benjamin Graham, Security Analysis (not considered “light reading”, but I highly recommend it for the brave of heart). There are numerous factors that play into the analysis of future value, which will be the topic for another discussion.
Closing Remarks
The fundamental process of discounting a potential investment back to present value should be included in your assessment of any capital allocation opportunity. It provides a vital step in understanding the expected returns and risks inherent in an asset.
Investing is a difficult and complex endeavor, which can be very rewarding, both financially and psychologically. Gaining an appreciation for the many intricacies that constitute the dynamic nature of investments will set you up for success in the future. Keep in mind the importance of the time component of money and you’ll be a step ahead of many other participants in financial markets.
Enjoyed the read? Subscribe to my blog and spread the word by sharing this article with your circles!
I’d love to hear your take on the subjects we’ve covered in this post. Drop a comment or question below. Let’s keep this conversation going!
Sources
U.S. Department of the Treasury. (2019, September). Daily Treasury Yield Curve Rates. Retrieved from https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
Simko, P., Farris, K., & Wallace, J. (2017). Financial Accounting for Executives & MBAs. Cambridge Business Publishers.
