One of my goals is to ensure that investors are able to learn the basics of finance and investing without having to wade through all of the “fluff” contained in many books. That is, I want to focus on just the “need to know” so you learn only the most important information when it comes to investing. So, let’s get started with one of the most important concepts in finance: the time value of money.
The Time Value of Money
If you’ve ever taken an economics class, you’ve probably heard of the “time value of money”. If you haven’t, don’t worry the concept is simple. The whole thing hinges on 1 concept: $100 today is worth MORE than $100 a year from now. Why? Because you can take that money today and put it in the bank so that it earns interest.
Then, at the end of the year your $100 has grown to $105 (assuming 5% interest). We calculate this “future value” by taking $100 + ($100 X 0.05). Using some basic algebra, we can rewrite this as $100(1 + 0.05) = $105. How about after 2 years? We simply do the same thing and calculate Future Value = $100(1 + 0.05)(1 + 0.05) = $110.25. Notice that the interest is compounded, since the result of $100(1 + 0.05) is then multiplied again by (1 + 0.05).
Figure 1
In sum, we can express the equation above using C as the future cash flow, i as the interest rate, and y as the number of years in the future as:
Present Value
This paves the way for the next important topic: present value. Present value is simply the reverse of future value. So, if we multiply to get future value, we simply divide to get present value. As an example, let’s assume we want to figure out how much $110.25 is worth today if we are going to receive it 2 years from now. Easy, we just divide:
Once again, let’s rewrite it with variables as:
This is a concept you will see in business and investing time and time again. Now that you understand it, let’s apply it by building a model for valuing stocks in Excel.
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