As investors, we find ourselves searching for ways to accurately calculate what an investment is worth. What is the right price to pay for a stock? For a bond? Will it be enough to help us buy that home, send a child to college or pay for a happy and healthy retirement? What will the money we invest today be worth in five, 10, or even 50 years? There is a financial concept that sits at the heart of these discussions: Time value of money.
Defining TVM
Time value of money (TVM) is the simple idea that a person would prefer to have a dollar today than a dollar tomorrow. Intuitively that feels right; after all, if you had the money today, you could spend it. For that dollar tomorrow, you have to wait a whole day before buying something. TVM is a basic but important tenet of investing that helps us understand how much one dollar is worth today versus its value tomorrow.
In finance we calculate today’s value of the money you will receive in the future by time-adjusting future wealth. This is commonly referred to as present value. It allows us to easily compare the trade-offs of having money today versus receiving money in the future.
Here’s an example: Let’s say you were considering buying a bond that paid $1,000 in one year, with a yield of 5%. What price would you pay for it? If you’re thinking, “Matt! Silly question. Of course it’s worth $1,000. You just said I would get $1,000 in a year!” I’m sorry, but you’d be mistaken. Yes, the bond pays $1,000 a year from now. But today, with that 5% yield, the present value is actually $952.38. Put another way, there would be no difference between having $952 today and having the 5%-yield bond that paid $1,000 in one year. After all, if you have the cash today, you could just buy the one year bond and end up with $1,000 a year from now.
We can extend this concept by looking at bonds with longer maturities. If we were looking at a second bond that paid $1,000 in two years at a 5% yield, then it would be worth $907 in today’s dollars. A three year bond would be worth $864. Below is a graph that shows the present value today of getting $1,000 at different points in the future, all assuming a 5% yield.
Applying TVM to stocks and bonds
When you buy a stock you are buying a series of future dividend payments, as well as a value you think you might be able to sell that stock for in the future. When you buy a bond you are buying a series of future payments, typically semi-annual coupons followed by a return of principal at maturity. The price to pay for the bond is the present value of all of those future cash flows. To price any bond you really just need two things: Cash flows and yield. We’ll explore more of the yield concept in my next post. In the meantime, remember: Don’t just value your money, time value your money.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.