The Time Value of Money
A dollar today isn’t worth a dollar tomorrow. We know this, of course, because prices increase such that we can buy less tomorrow than we can today - this is called inflation. But even beyond inflation, money changes value over time. This is a fundamental financial concept and comes into play in many ways, including in valuation. Let’s think about how this works:
In scenario A, we receive a payment today of $100. We put the money into a savings account paying 5% interest annually, and so a year later we have $105. In scenario B, we’re owed the $100 today but we don’t receive it for a year, so in a year we have $100. If we’d received the money today, it would be worth more than it is if we receive it a year from today.
Here’s another perspective: assuming we can get 5% interest, would we prefer to receive $100 today (assuming we’re going to put it in the bank and leave it there) or $105 a year from today? We’re generally indifferent - $105 a year from now is the same as $100 today under these circumstances.
Understanding this allows us to actually calculate the value of money, depending on when we receive it, as long as we know what’s referred to as the discount rate. In the example above, the interest rate is the discount rate. If we’re investing our money then the discount rate used is our cost of capital. It’s also sometimes called the hurdle rate. More on all of this in future articles.
So if we know the proper discount rate to use, then we can determine how much a sum of money that we receive at one point in time is worth at some other point in time. Above, it was a simple matter to determine how much that $100 will be worth in a year, knowing that the discount rate is 5%. It’s only a little harder to know that at 5%, $105 we receive in a year is worth $100 today, and just a little more complicated when we take into account that we need to compound the rate every year. We’ll continue to explore these concepts in future articles, as well as at our many seminars - sign up today!