As an investor, it is important to understand the time value of money because of the basic concept that a dollar in your ownership today is worth more than a dollar promised in the future. To further elaborate, if you possess a dollar today, you have the ability to invest it and earn capital gains or collect interest. Conversely, a dollar that is promised to you in the future is worth less than a dollar today because you do not have the ability to use it as an opportunity to make more money right now (through investing). Further, the dollar promised in the future is also worthless because of inflation. As a quick refresher, inflation is the term used to describe the rate at which the general level of prices for things are rising — causing purchasing power to fall. For example, according to Inflationdata.com, milk has gone from 35.6 cents per gallon in the year 1913 to $3.53 in 2013. That is nearly a 10-fold increase over the last 100 years. To further understand the time value of money, it is important to recognize that it can be broken up into two distinct areas. The first area is the present value of money, while the second is the future value.
Mathematically, present value is equal to the future cash flows divided by (one plus the rate of return) to the power of the number of time periods. Organized more like true equation, the present value looks like this: PV = (future cash flow) ÷ (1 + rate of return) ^ number of time periods. Seeing the formula written out in a more organized way is helpful, but what does it actually mean? Simply put, the present value determines what a cash flow that will be received in the future is worth in today’s dollars. Moreover, it does so by using the average rate of return and the number of periods to discount the cash flow back to the present date. Therefore, if you take any present value and invest it at the specified rate of return and number of periods, the investment would grow into the future cash flow amount. As such, by following historical inflation trends, you can also estimate what a dollar in the future is worth today if not invested at all.
Like finding the present value, the future value can be found using an equation. This equation is FV = present value • [1 + (rate of return • number of time periods)]. Similarly though, it might not be completely clear what this equation is telling us just by looking at it. To explain, future value takes a cash flow received today and projects what it will be worth in the future — due to interest rates or capital gains. More specifically, the future value formula can calculate what a current cash flow would be worth in the future if it were to be invested at a specific rate of return over the course of a pre-determined number of periods. This can be an important tool for investors when trying to estimate what their portfolio may look like in the future.
While both present value and future value can be extremely useful tools for investors — even accounting for compounding interest or capital gains — it is important to remember that there is no perfect indicator for an investment. There is always risk involved when making investments and projected rates of return are subject to change over time. That said, you might benefit greatly from understanding this concept and I encourage you to continue your own independent research!