1. Future value
Welcome back to Financial Analysis in Power BI. In this chapter, we'll review the time value of money and future value.
2. What is time value of money?
Time value of money is a fundamental concept in financial analysis that is used in evaluating investment decisions.
Time value of money is the concept that money is worth more now than in the future due to its earnings potential.
For example, would you rather be given $100 today or back in 1957?
Had you invested that $100 into the S&P 500 in 1957, it would be worth over $200,000 today!
Because money can be invested, we should value having it as soon as possible so that we can use it to invest in things like company projects, or the S&P 500.
3. Future value (FV)
Future value is what your investment will be worth in the future, based on a rate of return and length of time.
To find future value, take the present value, which is the current value of the investment, and multiply it by one plus the interest rate, which is usually quoted as an annual rate, and compounded by the number of years it will be invested for.
Let’s look at an example.
Let’s say we want to find the value of $1,000 three years from now at a 5% interest rate.
First, we'd start with the equation, then we’d plug the numbers in and solve.
So now we know it will be worth $1,157 and 63.
4. Future value (FV)
It might also be helpful to see the math in a different way. Each year, the investment grows as it earns interest. That interest goes on to earn more interest. This process is called compounding. Instead of calculating out each year, the future value formula simply compounds the interest and then multiplies it by the present value.
5. The power of compounding
Compounding is a powerful mechanism in investing, and it doesn't just happen once a year. Interest can be compounded as little as monthly, or daily.
Let’s look at an example where we compare $1,000 compounded annually versus daily over 50 years at 10%.
This graph shows over time that the difference is huge! About $30,000. The more something compounds, the more it will earn.
6. Calculate with compounding interest
We can calculate compounding interest with two easy steps.
First, divide the interest rate by the number of compounding periods. Then multiply years by the number of compounding periods.
This causes the periodic interest rate to decrease, but the exponent increases. The net impact is the effective interest rate increases.
This is why Albert Einstein once said, "Compound interest is the eighth wonder of the world."
If we follow the same example as before and compound monthly instead of annually, we'll see that our future value grows to $1,104 and 94 cents, which is roughly $3 more than without monthly compounding.
7. Annuities
In finance, we often don't always get everything in one lump-sum. Sometimes, we can receive or payout cash flows.
Annuities are a specific cash flow structure where fixed payments are made at regular intervals. Fixed means the payment does not change. Pensions, lottery winnings and mortgage payments are good examples of this.
In this example, there are four fixed payments of 500 dollars each.
8. Annuities
To find the future value of this annuity, we would compound each payment by it's period minus one, and then add them all together.
9. Annuities
Assuming a 5% interest rate, the equation would look like this.
10. Annuities
Then we would start to solve...
11. Annuities
And we'll find that the future value of this annuity is $2,155 and six cents.
Don't worry, it's much easier to do this in Power BI and we'll cover this more in the screencast.
12. Let's practice!
But before we get there, let's test your knowledge with a pop-quiz!