time value of money

It’s About Time (Value of Money)!

Since in my last post I discussed inflation and why people invest in the stock market, I decided that a natural next concept to introduce would be something called time value of money or TVM for short. This concept is the basis for most everything in finance. Stock investing, private equity, venture capital, bond investing, savings and loans, capital budgeting and much more hinge on the concept of TVM so I’ll try to explain it as clearly as possible.

At the base of it, time value of money means that 1 dollar today is worth more than 1 dollar in the future, and conversely 1 dollar today is worth less than 1 dollar one year ago. It may be tempting to attribute this to inflation but that is not the reason that this is true. The reason that a dollar today is worth more than the same amount in the future is because a dollar today can be invested until next year at which point it that dollar plus the return from investing would be more than just the one dollar being given to you one year from now. If this does not make sense to you, that’s okay, the followinf example will help clarify.

You have two people James and Sally. I tell them each that I’ll give them $100, they can receive it now(March 29, 2014) or they can receive it exactly one year from now (March 29, 2015). Naturally Sally takes her $100 now, James decides that he would rather receive his $100 exactly one year from now. Sally goes home and puts her money in her bank account which we’ll say pays 5% interest compounded annually. On March 29 2015, one year from the starting point, I give James his $ 100 dollars and he puts it in his bank account. At this point Sally has $105 in her account while James has only $100. Time value of money is true because any money that a person receives today can be invested and earn returns.

In the case of James and Sally, we would say that the presesnt value of both James and Sally’s money was $100. We would also say that the Future Value of James’s money was $100, while the Future value of Sally’s money was $105 because she earned interest on her money.

In order to further understand this concept we must consider the TVM formulas. OH NO MATH!!!!! Relax, there is no reason to panic when it comes to this math, it’s really easy to understand and it applies the same way across all areas of finance.

The future value formula is as follows.

The Future Value of Money Formula

The Future Value of Money Formula

FV is your future value and in the case of this formula, the number that we are trying to find. PV is the present value of money, as I said before this is the amount of money that you have right now, or in other words the amount of money is being invested. The variable is your interest rate if you are lending money or your rate of return if the money is invested in stocks. The variable is the number of compounding periods per year, which means the amount of times you take the returns you’ve made and reinvest them. Finally, the variable  is the number of years that you are keeping your money invested.

In the case of Sally if we substitute in the appropriate numbers into the formula we get the result shown below.

FV sally

And of course when we work this out we do get $105.

The other formula used in TVM is when we are told what our future value will be and we have to figure out what that would be worth toady. For that we would use something called the present value formula which is shown below.


As you can see all I did was use algebra to isolate the PV variable from the previous formula. Suppose we knew that Sally had $105 in 2015 and that her bank paid 5% interest compounded annually and we wanted to find out how much she started with. All we’d have to do is fill out the formula.

PV sally

The Present Value of Money Formula

And when this is simplified we do get our $100 starting amount.

I understand that all of the math in this might come off as boring now, but it is a necessary evil and it will come in use when I discuss things like dividend discount and discounted cash flow valuation techniques for stock valuation. It will also come in use when learning what it means to beat the market or to beat a benchmark.

If you have any questions please post them in the comments below and I will attempt to get back to you.

As always, thanks for reading!,

Mohit D. Patel, Author



The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is for purely educational purposes. The author is not liable for any decisions a reader makes based on the content this article.

If you have any questions please post them in the comments below and I will attempt to get back to you!




Why Invest in Stocks? An Introduction to Inflation and Investment

In last week’s post I explained what the three main forms of business ownership are: sole proprietorship, partnership and corporation and I explained that a stock is a share of corporate equity or basically a piece of ownership in a corporation. So why do people invest in stocks? There are all sorts of things out there that people believe about the stock market. Some believe that that the stock market is practically a casino since stock prices change randomly, others believe that stocks are controlled heavily by big business and that its none of their business to be involved in in them, yet other people believe that they can simply do without stock investment simply because they don’t care about finance or business. All of these things are simply untrue. The stock market is not a casino because an intelligent investor can grow their money safely by buying stocks below their intrinsic value and holding them for the long term. As for the second assertion it is true that businesses do have a direct effect on their stocks but the idea that the management officials in a company somehow work for their own benefit is completely without base. The managers of a corporation must act in the best interest of the corporation’s owner, that is, the stockholders, and not just the institutional ones according to the law, because they are considered agents of those owners. Though I cannot cite any specific source I’m certain that lawsuits have occurred where stockholders have sued their corporation’s mangers for not acting in their best interests. The third reason that people avoid that stock market is the one that I seek to explain most thoroughly.

Simply not being interested in stock is not a valid reason to avoid stock investments. The first step to understanding why is inflation. Most people know inflation as a general rise in prices in the economy, which is true. It is more important for anyone who has saved any significant amount of money is that inflation also corrodes the amount of “stuff” that their money can buy. For example let’s say that I have $100 dollars and as of right now in 2014 the price of one gallon of milk is $10 then say that over ten years inflation occurred such that the price of milk is $20 in the year 2024. In 2014 at the price of $10  I could buy 10 gallons of milk. After the ten years pass and the price of milk changes to $20 if I still have my $100 under my mattress, I would now only be able to buy 5 gallons of milk. On average each year for this to work about 7% inflation would have had to occur. If I had invested my money in stocks, bonds, certificates of deposit, or anything else and earned a return of 7%, I would still have the buying power to buy 10 gallons of milk. The effects of this effect on a larger scale say on money being saved for retirement savings can be devastating, since more money and a greater number of years exist in which inflation can act. The only way to completely or partially counteract this effect is through intelligent investment practices. Thus our purpose as investors is not to get rich quick, but rather to mitigate the effect of inflation and the decrease in buying power of money.

Why can’t I just invest in bonds or put my money in a bank? In the long run stock outperform bonds by a long shot. In the last 12 months the Standard and Poor’s 500 stock market index had returns of 17.78 percent while the Barclays Aggregate Bond market Index had returns of 0.50 percent within the same period. The rate of inflation for this year was 1.5%.  Bonds would not have cut it and bank accounts would not even have come close. The only investment that couldn’t shielded against inflation was the stock.

To recap, investment is performed to allow a person’s savings to maintain their buying power in the face of inflation. While there are many types of investment choices out there, stocks are the ones that are most likely to provide an investor returns above the level of inflation in the long run.


The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is.

If you have any questions please post them in the comments below and I will attempt to get back to you!