If you’ve explored Finance on any level, then you’ve almost certainly heard of the Time Value of Money. But what does Time Value of Money mean? Why does it matter? Let’s find out.
What Does Time Value of Money Mean
Time Value of Money (“TVM”) is the idea that a dollar received now is worth more than a dollar received in the future.
This is because of many reasons, but fundamentally, you can think of it in terms of three things:
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- inflation effects,
- opportunity cost, and
- risk
Let’s now consider how each of these three factors can explain the Time Value of Money.
Inflation Effects
Inflation, in a nutshell, is a general increase in prices. If inflation is say, 5%, that means that prices of products/goods and possibly services increased by approximately 5%.
This means you’re able to buy fewer items with the same amount of money. Let’s consider an example to see why this is the case.
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Imagine you have $1,000 available to spend right now. Assume that you live in the Republic of La La Land where the price of 1 banana is $1.
With $1,000 you can buy 1,000 bananas today (since each banana costs $1).
Now let’s assume that inflation between today and a year’s time is expected to be 5%. This would mean that the price of bananas will increase by 5%, meaning one banana will cost $1.05
How many bananas will you be able to buy next year with the same $1,000?? You’ll be able to buy $1,000 / $1.05 ~ 952 bananas.
This means you’re going to be worse off by 48 bananas, even though you’ll have exactly the same amount of money!
Thus, despite having the same amount of money, your buying power is lower. Put differently, the value of your money has decreased.
So when we think about what does Time Value of Money mean, it’s largely about the fact that money loses value over time. A dollar or pound today is worth more than a dollar or pound in the future.
Now, you’ve already seen how we can explain Time Value of Money and its effects due to inflation, but there are also the factors of opportunity cost and risk. Let’s now consider their impact.
Opportunity Cost
Firstly, what is Opportunity Cost?
It’s ultimately the cost of not doing something.
Every single thing you do has an opportunity cost associated with it.
That’s because if you do one thing, it must mean you can’t, or aren’t doing another thing.
The only exception is probably Hermoine Granger from Harry Potter or anyone else who can time travel.
The opportunity cost of you reading this article is the fact that you can’t watch funny memes, stories, or cute cat and dog videos on Facebook, Instagram, TikTok, Twitter, or {insert social media platform}.
Equally, the opportunity cost of you watching funny memes, stories, or cute cat and dog videos on social media platforms is the fact that you can’t learn about the glorious concept that is the Time Value of Money. Or other concepts in Finance for that matter.
The opportunity cost of you going to work is the time that you cannot spend with your friends, family, or exploring your hobbies.
We hope you get the key idea – everything you do has an opportunity cost associated with it. By doing x, you forego doing y. The opportunity cost is thus the cost of not doing something.
Now, in the context of the Time Value of Money, the opportunity cost plays a crucial role.
Remember, when we talked about what does Time Value of Money mean, we said that it’s the fact that money loses value over time.
But it’s also about the opportunity cost of not having the money now. Suppose you have two options available to you:
-
- Option 1: Get £1,000 today, or
- Option 2: Get £1,000 in exactly 1 year’s time
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If you choose Option 1, you can take the money today and:
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- spend it
- invest it
- save it
- splurge it
- do whatever you want with it for a whole year
If you invest it, you could earn a return on it and grow your £1,000 into something bigger. The same applies to saving money, though the average interest rate at the time of writing is embarrassingly low in most ‘developed’ countries.
Should you spend or splurge the money, it’s probably not the best thing to do from a financial or investing standpoint, but at least you (hopefully) gain “utility” or satisfaction from the purchases.
But if you chose Option 2, then you wouldn’t be able to do any of those things today. Because you’d only receive the money a whole year later!
And so you’d have lost the opportunity to spend, save, invest, splurge, or do whatever it is you want to do with £1,000
Okay, so hopefully, you now know how opportunity cost plays a role in explaining the Time Value of Money. Let’s now consider the final factor, risk.
Risk
While there are several definitions and measures of risk, the general consensus is that it’s the likelihood or value of losing your money.
In the context of what does Time Value of Money mean, risk is a contributing factor because you could end up losing your money, or not receiving it in the future.
Let’s consider the £1,000 today vs. exactly 1 year’s time again. If you decided to take the money now, you’d have it with you immediately.
Sure, if you invested the money, you could end up losing some or all of it, but you could also end up growing it.
If you decide to take the money only a year later, you may never receive it at all. That’s because the person who’s meant to give you the money may default, go bankrupt, change the terms of the agreement, etc.
This somewhat overlaps with the opportunity cost effect, which is unsurprising because the opportunity cost is also seen as a type of risk.
Okay, now that you understand what does Time Value of Money mean, let’s think about why it matters.
Why is the Time Value of Money Important?
As complex as Finance can seem, approximately 70-80% of the concepts within it rely on the Time Value of Money. Strictly, they rely on the formulas that incorporate the Time Value of Money, including:
- the Future Value formula, and
- the Present Value formula
By using these 2 formulas, we can do a variety of things, including (but not limited to):
- stock valuation (using the Discounted Cash Flow valuation method to estimate the intrinsic value of a stock)
- bond valuation
- investment appraisal or capital budgeting (e.g., estimating the Net Present Value)
- personal finance management (e.g., planning loan payments, deciding whether to buy or rent a house, planning your pension, etc)
The Time Value of Money applies to all investments, and influences every investment decision be that:
- investing in the stock market,
- investing in real estate, or
- just saving money at a bank.
We’ve intentionally avoided going into the math of the Time Value of Money in this particular article, but you can of course continue learning how to calculate the Present Value and Future Value in our sister articles.
Also, feel free to apply the Time Value of Money concept by playing with our financial calculators, including:
If the math there freaks you out, please don’t let it freak you out! It’s actually a lot easier than it looks. Plus, if you do have a weak background in math and want to get past your fear of equations, check out our course on Financial Math Primer. You’ll finally get the mathematical foundation you’ve always needed.
Alternatively, if you’d like to learn how to calculate them while also learning investment appraisal techniques, check out our course below.
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