Time Value of Money
And what Discount rates are good for
The time value of money is a key concept in finance, but it is not one that the general public is too familiar with.
Let’s talk about that.
What is the Time Value of Money?
According to Investopedia, the Time Value of Money is:
The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.
The easiest way to think about it is by thinking about a practical example:
If you could get, for free, a new house today, or 10 years from now, which would you take?
Most people would prefer to have it now, if only so that they can get an additional 10 years of use out of it!
When it comes to investing, the same thing applies, money now is more valuable than money in the future.
Of course, how much more valuable it is depends on a lot of things, including your own personal circumstances. If you have a $200 bill to pay tomorrow, those $200 dollars will have a much, much greater value in your pocket today, than in the day after tomorrow.
So how do we determine this difference in value?
The Discount Rate
When it comes to investing we do that by using a discount rate, and then applying that discount rate to the cash we get at the end of the investment, over the time period of the investment.
So for example, if we have an investment that will return $100 a year from now, and we have a discount rate of 10%, then those $100 are actually worth $90 today.
So the real question is…
How did we get that 10% discount rate?
That’s the million dollar question, and if you can crack that code you’ll be a billionaire. That’s the sort of thing institutions spend hundreds of millions of dollars to get just 1% better at predicting the right discount rate.
As a general rule the discount rate has to take into account at least a few different variables:
The Inflation rate
The probability of failure of the investment
The returns of alternative investments
The individual need for the cash during the investment period
Each of these are pretty straightforward, but accurately calculating them is essentially impossible.
There are some very good models on how to do this, and you can get an overview on them from Professor Damodaran here.
The key problem that all of them have is that they inherently rely on a lot of assumptions, and the values they provide will never be entirely accurate, particularly since some of the variables used simply don’t make sense, or are unrelated to the risk of the business.
For example the Betas relative to the market portfolio, or to specific factors, are interesting numbers, but the argument that it accurately reflects the risk of a business rather than the investor sentiment around it is a difficult argument to make, and not one that i subscribe to.
At the end of the day though, whichever method you decide, you should ensure that you use conservative values, and estimate the worst case scenario, since even small changes in the discount rate can cause major changes in valuations… And when talking about investing your (or other peoples) money, you should always strive to be on the safe side.
How do you calculate your own discount rate? Let me know in the comments below!
