Time value of Money
The concept of time value of money arises from the relative importance of an asset now vs.in future. Assets provide returns and ownership of assets provides access to these returns.
For example, Rs. 100 of today’s money invested for one year and earning 5% interest willbe worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100 a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100 in future. In the first option he can earn interest on on Rs. 100 while in the second option he loses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paid exactly one year from now both have the same value to the recipient who assumes 5% as the rate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5% interest has a future value of Rs. 105. The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum “present value” of the entire income stream.
For eg. If you earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, you would receive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5% for two years to arrive at the present value of Rs. 110, i.e. Rs. 100.
Valuing future cash flows, that may arise from an asset such as stocks, is one of the cornerstones of fundamental analysis. Cash flows from assets make them more valuable now than in the future and to understand the relative difference we use the concepts of interest and discount rates. Interest rates provide the rate of return of an asset over a period of time, i.e., in future and discount rates help us determine what a future value of asset, value that would come to us in future, is currently worth.
The present value of an asset could be shown to be:
Where
PV = Present Value
FV = Future Value
r = Discount Rate
t = Time
