Formal education will make you a living; self-education will make you a fortune. -Jim Rohn.
The time value of money concept is less understood but really important for long-term investors.
In theory, financial decisions are carried out with the objective of maximizing the value of the firm. It is supposed to be widely applied in financial decisions like investing in stock.
The application of time value of money concept in financial decision making contributes toward value maximization objective.
Retail investors like us vaguely apply this concept in our decision to invest.
Why is it so important in investment decision?
One of the basic applications of the concept of time value of money is widely observed in making long-term investment decisions. All long-term projects require spending huge amount of capital today and with certainty.
However, the benefits from the use of projects occur in small amount over a longer period of time and with uncertainty.
Thus, there is difference in timing of cash out flows and cash inflows associated with long-term investment. Cash outflows occur at presents wheres cash inflows are realized over several period of time.
If you are a short term investors or a day trader, this is less applicable to you.
Future cash inflows are discounted back to present values to compare against the present cash outflow and make investment decision, which is also called discounted cash flow valuation method in stock valuation.
The long-term project also involves risk because of the uncertainty of future cash inflows. So according to the concept of time value of money, we select an appropriate discount rate consistent to the level involved in the project to calculate present value.
Some people use the AAA bond rate or 30 year treasury rate as the discount rate.
Every sum of money received earlier commands higher value than the equal sum of money received later.
A dollar in hand today is valued more than a dollar next year. This is primarily because of following reasons.
- Investment Opportunity
- Preference toward current consumption
- Inflation
In making securities investment decision, future cash flows of securities are discounted back to present value to determine the worthiness of investment securities.
Thus, the concept of time value of money contributes to making long-term investment decisions effective and efficient.