The time value of money
1. The time value of money
Welcome back! In this chapter, we'll review the concepts of the time value of money and evaluating return on investment.2. What is the time value of money?
The time value of money is a fundamental concept in evaluating investment decisions; it is the concept that money is worth more now than in the future due to its earnings potential. For example, had you invested $100 in Amazon in 1997 when the stock was just worth 9 cents, you would have made over $150,000 today.3. Like a timeline...
Think about the time value of money like a timeline.4. Like a timeline...
We can use future value,5. Like a timeline...
and present value calculations to move back and forth on it.6. Future value
Future value is what your investment will be worth in the future.7. Future value
Let’s find the value of $1,000 three years from now at a 5% interest rate. First take the present value of the investment, $1,000, and multiply it by one plus the interest rate.8. Future value
This gives us $1,050. This is what the investment would be worth one year from now, so we need to continue this process twice more to find the value in three years.9. Future value
By the end of three years, the $1,000 becomes $1,157.63.10. Future value
This is the same mathematically as multiplying $1,000 by 1.05 to the third power. But wait, if in year one we only made $50 in return, how did we end up with over $157 in total return?11. The power of compounding
This is because of compounding. Compounding is the process of reinvesting the investment earnings to generate more earnings. The $1,000 investment grew to $1,050 in year 1; then, we multiplied the $1,050 in year 2 to get $1,102.50, and then $1,102.50 to get $1,157.63.12. The power of compounding
This is how investments grow exponentially over time compared to one that doesn't compound.13. The power of compounding
This is why Albert Einstein once said compound interest is the eighth wonder of the world.14. Future value formula
Because of compounding, we can easily calculate future value by multiplying the present value of the investment by one plus the rate to the power of the number of periods. Using this formula for the previous example, we can see how simple this calculation is.15. Present value
Okay, we've learned how to go forward on the timeline; now let's learn how to go backward. Present value is the value of money that will be received in the future.16. Present value
Let's say we want to know the value of receiving $1,157.63 three years from now if our discount rate is 5%.17. Present value
The present value calculation is just the inverse of the future value calculation, which makes sense since we're doing the opposite thing. So we'll divide by one plus the discount rate.18. Present value
After doing this three times, we find the answer of $1,000. It's less because we value having money more today than 3 years from now. Put another way, we would value $1,157.63 3 years from now the same as having $1,000 today if interest rates are 5%.19. Present value
The math here is the same as dividing $1,157.63 by 1.05 to the third power.20. Present value formula
The present value formula simply divides the future value of the investment by one plus the interest rate compounded by the number of periods. And we can see how similar this is to the future value formula, only that we're dividing.21. Return on investment (ROI)
Return on investment is a fundamental profitability ratio that finds the profit earned for each dollar invested. It's simplicity makes it a popular ratio in financial analysis. To calculate ROI, simply divide net income by the investment amount. In this example, ROI is roughly 33%. But how do we know if 33% a good ROI?22. Benchmarks
A benchmark is a point of reference to compare an investment's performance. If our benchmark for ROI is 50%, then 33% seems bad. But if our benchmark is 15%, then 33% seems great! So picking the right benchmark is important because it gives context for investment performance, and often, benchmark rates are used in the present and future value formulas.23. Let's practice!
Alright, let's take some time to practice.Create Your Free Account
or
By continuing, you accept our Terms of Use, our Privacy Policy and that your data is stored in the USA.