:max_bytes(150000):strip_icc()/the-prudent-investor-rule-59aca5719abed500110a00cd.jpg "Why the Time Value of Money (TVM) Matters to Investors")
The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.
Provided money can earn interest, this core principle of finance holds that any amount of money is worth more the sooner it is received. At the most basic level, the time value of money demonstrates that all things being equal, it is better to have money now rather than later.
TVM can be broken up into two areas: present value and future value.
Key Takeaways
- Because of the time value of money, a dollar today is worth more than a dollar in the future.
- The reason that money is worth more today than in the future is because money today can be invested, earning interest and capital gains.
- A dollar in the future is worth less than a dollar today because of inflation, which reduces purchasing power.
- The time value of money can be analyzed in two ways: present value and future value.
- Present value assesses how much a cash flow received in the future will be worth today.
- Future value determines how much a cash flow received today will be worth in the future.
What Is Present Value?
Present value determines what a cash flow to be received in the future is worth in today’s dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is, if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount.
Present value = (future cash flow) / (1 + rate of return)number of periods
Present value is the current value of a future cash flow while net present value (NPV) is the difference between present value cash inflows and present value cash outflows over a specific time period.
What Is Future Value?
Future value determines what a cash flow received today is worth in the future, based on interest rates or capital gains. It calculates what a current cash flow would be worth in the future if it was invested at a specified rate of return and number of periods.
Future value = present value x (1 + (rate of return)number of periods)
Both present value and future value take into account compounding interest or capital gains, which is another important aspect for investors to consider when looking for good investments.
Time Value of Money for Investors
The time value of money helps investors make the best financial decisions: the decisions that will have the most financial returns. Most investors and businesses have many investment opportunities to choose from; using the time value of money helps equalize these opportunities based on timing.
What Are the 5 Major Components of the Time Value of Money?
The five major components of the time value of money are present value, future value, the rate of interest, the time period, and the payment installments. The interest rate is the rate of return over the investment’s lifetime, the time period is the number of installments used to calculate the present value or future value, e.g., weekly, monthly, quarterly, and the installments are the payments received or paid during a period, present value is the sum of money after applying the discount rate on a future cash flow, and the future value is the sum of money after applying the compounding rate on a present cash flow.
What Is the Relationship Between NPV and the Time Value of Money?
The net present value (NPV) considers the time value of money by discounting future cash flows. If future cash flows are known, they must be discounted for the present in order to show that a period of time must pass before they are realized. In this period, interest can be earned on that amount of money, allowing an investor to compare possible investment opportunities.
How Do Financial Managers Use the Time Value of Money?
The time value of money can be used by investors, financial managers, and businesses to make investment decisions. Most investors and businesses have the opportunity to spend their money in a variety of ways. They should make choices based on what the highest return of each will be. Understanding the time value of money will help make decisions on budgeting, cash flow management, financing, and investing.
The Bottom Line
Time is literally money. The value of the money you have now is not the same as it will be in the future. Knowing how to determine TVM by calculating present and future value can help you distinguish between the worth of investments that offer returns at different times.