by elmads

Introduction

The time value of money is a financial concept that explains that every amount of money that we receive, save, and invest has a corresponding opportunity to grow more in the future.

Let me give you an example.

Let’s say you have $1,000 right now. What can you do with it other than spend that money? Most likely, you’re thinking of saving that money for whatever purpose you have in mind.

May I ask you then: If you’ll be saving that money, where exactly will you be placing it?

Will you just leave it in a non-interest-bearing checking account (no interest on deposit)? Or would you place it in an interest-bearing savings account (2–5% per year)? Or would you invest in a bond (with 5% above the coupon rate)? Or would you invest it in shares of a company that gives dividends and possible capital appreciation? Or maybe you’ll divide that $1,000 and do two or more of the approaches above?

If you choose to leave your money on a non-interest-bearing checking account, then there is a risk that your $1,000 will lose its buying power due to inflation, and the longer it stays there, the higher the risk that it will lose its previous purchasing capabilities.

But if you place your money in a savings account that gives 3% interest on your deposited $1,000, then after a year you’ll receive an additional $30. This is better than having no returns at all.

Here’s a follow-up question. Would you prefer to put your $1,000 now (at the start of the year) in a savings account with a 3% interest yield or next year?

What’s your point, Evan? Everyone most likely knows about it, but I just want to emphasise that the money you have now has limitless potential to make more money in the future if used efficiently. Every penny we have has a value, and that value can substantially expand over a long period of time. It just depends on you, the owner of that money, on what you do with.

Compound Interest

“All the benefits in life come from compound interest—relationships, money, habits—anything of importance.”

—Naval Ravikant

Our lives that we have now are products of the habits we’ve developed years ago, regardless of whether they are good or bad. Anything that we’ve done consistently compounds the result.

Simple and Compound Interest

A small positive daily habit done consistently (expressed as 1.01, as an example), just for a year (365 days), can lead to life-changing results: 1.01³⁶⁵ = 37.

On the flip side, a small value destroying daily habit done consistently (expressed as -1.01, as an example) just for a year (365 days) can lead to horrific results: -1.01³⁶⁵ = -37.

This concept originates in the financial landscape and is used with money.

Compound interest means that interest is paid on both the original principal and any interest accrued.

It is computed with the following formula:

• Amount (A) or Future Value (FV) = P*(1 + r/n)^nt
• P = principal amount
• r = interest
• n = the number of times interest is compounded per year
• t = the number of years

For instance, let’s say you have $100,000 worth of money you want to invest as a lump sum in an index fund that follows the S&P 500 index solely for retirement purposes.

You plan to compound that money for 25 years. The average S&P 500 return has been around 9% since its inception in 1923. We’ll assume that the 9% compounded return will continue in the future. How much would your initial $100,000 investment then be after 25 years?

It seems like an easy and good way to make money work for you, isn’t it? But this is easier said than done because there are a lot of variables that can affect that amount, such as:

• The rate of return — we used the 9% average return, but what if during your investment period you got a lower rate of return, let’s say 6% for 25 years. Your retirement amount would just then be worth $429,187.07. Almost half of the money was shed off because you got 6% instead of 10%.
  
• Number of years — the shorter your investment period, the less money your investment would
  generate. The longer your money stays in the compounding process, the larger your returns will be.
  
  Principal: $300,000 with a rate of return of 10% over a span of 10 years. That would be worth $710,209.10 after year 10. Despite having a large sum of money, the end amount was still less than our previous example because of the shorter time period for this person’s money to compound by itself.
  
  Just remember this, Warren Buffett made 99.7% of his money after the age of 52. He didn’t even stop playing the game of investing to this day (2023), at age 92.
  
• The principal investment — to be honest, the larger the capital you invest, the bigger the amount of money you will be able to generate over a long period of time. For the most of us, allocating a small portion of our salary for investment purposes is a prudent way to expand the principal investment capital. Dollar-cost averaging anyone?
  
• Emotions— if you always focus on the short-term price volatility of the market and keep on trying to go in when the market goes up, then sell when the market goes down, then you shouldn’t be in the equities market. If you can’t put your emotions at bay, then it would probably be better to just save your money on a certificate of deposit or bank savings account instead. Or better, just not look at the stock price movement of your index fund investments.
  
  Just think of it as buying a home. Do you wake up every day and wonder if the price of your home went down or up? Absolutely not! It’s the same with stock prices; the only difference is that stock prices are shown on a daily basis, unlike with property prices, where you’ll only know how much your current home is when you’re interested in selling it or if you ask a professional to value it.
  
• Behaviour — Successful investing requires the consistent behaviour of saving money for investment purposes. This is more about consistency and having a long-term mindset.

20% of investing is grasping the concept of compounding, understanding the asset classes, how to invest, and the approaches to take.

While the rest, 80%, is about understanding yourself, self-awareness, your own psychology, your beliefs in life and your relationship with money.

This is the reason why you don’t need to be highly intelligent to be successful in this endeavour. What you do need is proper temperament.

Opportunity Cost

Let’s suppose you have a personal project that requires you to make a $20,000 investment now, and based on your best estimates, you expect to receive $25,600 after 5 years of finishing the project.

At the same time, there is a government agency (PagIbig MP2 in the Philippines) that offers a special savings facility with a 5-year maturity, designed for its fund members. For example purposes ONLY, let’s say that for 5 years, PagIbig MP2 will compound your money at a 6% annual rate.

Where would you put your $20,000 investment? It seems like a trick question, isn’t it? But it isn’t.

This is happening every day. In the bigger picture, both will still make you money, and for some, if not most people, choosing the former would also be a way of flexing. Oh, I have a project that would most likely give me $25,600 after 5 years.

But if you don’t know the numbers, then you would miss a better return because the latter, in this case, is a better option. More bang for your $20,000 buck. Unfortunately, it is boring and not sexy for those flex-seeking people. 😂

To find which would give a better compounded annual rate of return, we need to find the “rate of return” for both of the investment options above.

For scenario 2, the return is 6%, while we don’t know the return yet for scenario 1. Thus, we need to find Scenario 1’s compounded rate of return to make an informed financial investment decision based on returns.

• Scenario 1 = A take home of $25,600 with annual compounded return of 5.06% for 5 years, and with flexing rights because you’re doing a “Project”.
• Scenario 2 = A take home of $26,764.51 with annual compounded return of 6% for 5 years. The boring approach.

Kidding aside, this is only an oversimplified example, but clearly scenario 2 would give better returns and have better opportunity in terms of compounded annual return compared to scenario 1.

Not all opportunities are created equal. This is why doing our due diligence is of utmost importance when making money related decisions. There are a lot of things that we need to consider as well, such as our priorities in life based on our short, medium and long-term financial goals, financial responsibilities, our emotional and behavioural awareness, and our life circumstances.

“Opportunity costs are a huge filter in life. If you’ve got two suitors who are eager to have you, and one is way better than the other, you do not have to spend much time with the other. And that’s the way we filter out buying opportunities.”

—Charlie Munger

Compound Interest Formula If Variable “n” Is Equal To 1

Discounted Cash Flow For Financial Decision-Making

A dollar now is worth more than a dollar tomorrow, due to the variables of inflation, potential earnings, interest costs for borrowing, and the effect of risks. Meaning, the buying power of $100,000 today wasn’t the same a decade ago due to inflation, and in contrast, a construction project that gave a total cash income of $1,000,000 this year is not exactly the same amount as two years ago.

Let me simplify my point.

Let’s use a bank savings account with a deposit rate of 3% per year.

You’ve placed $1,000 in the bank last year, which means you’ve already received $30 from it this year, making a total of $1,030 today.

Your $1,030 now and the $1,000 a year ago have the same value to you for decision-making purposes when assessing other financial opportunities, potential projects or investments.

Likewise, we could say that the offer of $1,030 in a year’s time is only worth $1,000/1.10 = $1,000 in today’s terms (or 90.0% of its actual value).

“In a potential investment project, cash flows will arise at many different points in time. To make a useful comparison of the different flows, they must all be converted to a common point in time, usually the present day, i.e., the cash flows are discounted.

The process of converting future cash flows into present values is known as ‘Discounting’ and is effectively the opposite of compounding interest.”

—Kaplan

And here we are now at the door of the discounted cash flow.

Discounting has been one of the important methods used in investment appraisal. You name it; whether it is real estate appraisal, product appraisal, or knowing the value of a business, or business appraisal, to name a few, discounted cash flow is one of the go-to approaches to getting the present value of an asset’s future cash flows.

Discounting is the opposite of compound interest. The variable in the formula is still the same, but the rearrangement will change.

Let me give you an example.

Luis expects to achieve $100,000 after 10 years of investing in the stock market. He is confident that he will be able to achieve 10% compounded annual growth over that 10-year period. How much money would Luis need to invest now as a lump sum to reach his $100,000 goal after 10 years (without adding any additional capital)?

This means that if Luis plans to achieve $100,000 with a compounded annual growth rate of 10% for 10 years, then he would need to invest $38,554.33 today to reach that goal.

📝NOTE: This will only happen if Luis is able to hit his 10% compounded annual growth rate for 10 years. If he generates less than 10% CAGR, then he wouldn’t attain his $100,000 goal in year 10.

To check if our answer is correct, we need to compute the future value of our recently computed present value.

This further solidifies the concept that a dollar today has the potential to grow in value over time, or, in a more concrete definition, any amount of money today can be invested or utilised to earn returns or generate value in the future. It can be thought of as having its own future value.

Similarly, the value of a future amount can be determined by discounting it to its present value today. If an investor’s or businessman’s investment projections do materialise, then his investments today could prove substantially worthwhile based on his own estimations of what he can achieve in the future.

To The Next>>>

Is that it, Evan? You haven’t even explained yet how investors value assets, or in the stock market, the value of a public company, via discounted cash flows.

This is only the first part of a long-discounted cash flow series. In the second part, I’ll take you to the financial world and bore you further with numbers, projections, and assumptions to come up with probable scenarios in the future.

It’s dealing with uncertainties and being comfortable with them. Let’s get it on! 😁

Discounting For Valuing Businesses (Stock Market Investing)>>>

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.