So - would you rather take $100 today or $100 next year? You’ll have a gut feeling for the right answer already - read on to understand why!
In its simplest form, the time value of money refers to the fact that most people would prefer to take cash today, as they view it as more useful to them today than if they were to wait and take the cash in the future.
Why is it more useful today? Well - because it has the potential to grow in value between now and the future.
For example, you could invest or deposit the $100 into a bank account and earn a 5% return over the year for example, to leave you with $105 next year. Sucks to be the person who waited a year for that $100, huh? This is known as the Future Value of money - the value it compounds to be worth in the future.
Turning it the other way round, you could look at that $105 next year, and conclude that today it is worth $100 to you - because investing the $100 today at a 5% interest rate is not a bad return and will take you to $105 next year. This is known as discounting.
Turns out, the concept of discounting ie. of working backwards from the “future value" ($105 in our example above) to the “present value" ($100) is a cornerstone of modern finance. The idea is, what’s expensive today ($100) is cheap tomorrow (because that $100 is worth more in the future), if you’re working on compounding value / growth / inflation.
This means the time value of money - and the associated concept of discounting - is crucial because it allows you to decide how much something should be worth today - also known as it’s present value (current price)!
This concept can be expanded and applied to estimate the value of many things including stocks, bonds, options, derivatives, houses, TVs, cars, the list goes on…!
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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