The time value of money (TVM) is the idea that money today is generally worth more than the same amount of money in the future. Would you prefer to get paid $1,000 or $1,000 one year from today? Most people would choose to get paid today. The three main reasons people would want to get paid today are inflation risks, time risks, and opportunity costs of not being able to deploy the cash in other ways. However, what if you were offered $1,000 today or $1,200 a year from now for the same item? Which should you take? To make the best decision, you will need to understand the time value of money.
Understanding TVM is the guiding principle and foundation of investing. The big but straightforward idea is that if the value of the money in the future is greater than the present value, it is called an investment. If the value of the money is less valuable in the future, that is called inflation. As obvious as it sounds, it is not wise to allocate capital where the future value will be less than it is today. Most investors want to hold only a little cash in their portfolio because cash loses value quickly.
Companies of all sizes use mathematical formulas to compute the TVM of projects over extended periods to decide how to allocate capital. For example, companies would use TVM as part of their decision matrix to decide if they should build a new plant or buy a competitor already producing the item. Both options may produce a profitable result, but what is the better allocation of funds and resources? It can be a little overwhelming to consider. Still, a little understanding of big corporations’ decision matrices can help individual investors decide where and how to allocate their investment capital.
The financial industry generally understands TVM in terms of present value, future value, and discount rate. The present value and future value of the money are easy to understand. In our example, the present value is $1,000 today, and the future value is $1,200. The term discount rate is sometimes called the rate of return or the interest rate. The discount rate is the difference in percentage from the present value to the future value. In our example, the discount rate (rate of return) is 20%. The decision matrix will involve several factors to decide if it is a good investment. Some of those factors could be the creditworthiness of the payer, liquidity and cash requirements, time risks, economic factors, and how it fits into the total investment strategy.
There is an equation finance professionals use to determine the TVM. The equation looks for relationships between the present value, future value, and discount rate. It may look scary, but don’t be intimidated by the appearance of the equation. Don’t worry. It’s intuitive.
The math is simple when there is only one period (i.e., one year), or it is simple interest. However, if multiple periods or compounding are involved, it is more important to understand how time affects the math. We will only add one variable to our equation but know it can become more complicated than this article explains. This article gives an overview of the basics. Finance professionals use the variable N for time (number of periods).
For example, we are trying to determine one year's discount rate (rate of return). The N will be one since it is for one year. The Future value is $1,200. The present value is $1,000. Subtract $1,000 from $1,200. Now divide the answer ($200) by the present value ($1,000). $200 is 20% of $1,000. The discount rate (rate of return) is 20%.
PV= Present Value, FV= Future Value, R= Discount Rate (Rate of Return), N=Number of periods
Let's say we are trying to find the future value of an investment three years from now. The present value is $1,000. The discount rate (rate of return) is 5% per year. The math would look like this:
PV=1,000 R=.05 N=3
It can get more complicated, but this equation is the basis for projecting the time value of money. The TVM equation helps investors make decisions and requires three variables.
For example, if one wants to make $1 million in 10 years and currently has $100,000, what would you need your investments to return every year?
Financial calculators make the math easy. Many free online options or financial calculators are available at most large general retailers like Amazon, Walmart, and Target. The answer would be 25.893% per year to turn $100,000 into $1 million over ten years. If your objective is not flexible or changeable, making any investment with projected annual return averages less than 25.893% won’t make sense. For example, suppose an investment opportunity presents itself, offering a 20% return. 20% returns are rare, so that it may seem like a good investment, but you have goals. Will the investment help you reach your goals? Will any strategy or investment get you where you want to go? No more than any interstate will get you to Texas.
The equation removes emotion from the decision process. After ten years, the future value of your money would be $619,173.64. The investment will not achieve the objective of $1 million within ten years, so you should reject it.
This equation also predicts the loss of purchasing power due to inflation. When inflation is higher than the discount rate (rate of return), the TVM becomes negative, which means future dollars are worth less than today's dollars. When the TVM is negative, people will say there is a "loss of purchasing power." For the following example, imagine we are talking about a $1,000 sitting in a mattress or non-interest-bearing, and inflation is 8%. The equation will look like this:
$1,000 that has been sitting in the bank for the last year now only has the purchasing power of what $920 could purchase one year ago. If inflation were 8% for two years, our equation would have looked like this:
After two years, the ledger would still say $1,000. Still, the purchasing power would be the equivalent of $846.40 when you deposited the money. This example requires investments paying at least 8% annually to protect your purchasing power and break even against inflation. If you don't have your money in an asset to keep up with inflation, the TVM is working against you, not for you.
Calculator.net has an excellent and free online financial calculator to help you figure out the TVM of your investments.
It is essential to understand TVM to build a portfolio that outpaces inflation and reaches investment objectives. Before the TVM can help you decide how to reach objectives, you must define what objectives you are trying to achieve.
In our example, the investor’s objective was to turn $100,000 into $1 Million in 10 years. The TVM equation revealed that they need to grow their money by at least 25.893% annually to reach the goal. However, this number does not consider inflation, so the return rate is only nominal growth. The real rate of return is the annual rate minus the inflation rate. It is not an accurate understanding of the increase in purchasing power.
Sticking with an 8% inflation rate, If an asset returns 5% per year:
5% (annual rate of return) -8% (inflation rate)=-3% (decrease in purchasing power)
The average annual inflation-adjusted stock market return over the last 50 years is 5.4%. Finding assets that keep the TVM equation positive when high inflation can take time and effort.
Did you know there are different asset classes within precious metals? Bullion products tend to be best for keeping the TVM near neutral. However, there is an asset class that tends to consistently keeps the TVM equation positive. Most people don’t realize there is an asset class with a long track record of positive double-digit price gains. The asset keeps the TVM positive and has outpaced inflation even when the stock market is down. The asset is Investment Grade Coins from the classic and modern eras. Investment Grade Coins do not trade on their weight. Instead, they trade on their rarity. Investment Grade Coins do not compare well to paper assets. A better comparison will be ocean-front real estate, antique automobiles, or fine art. People tend to be willing to pay more for these assets because of their rarity, and Investment Grade Coins behave the same way.
Here is the historical performance of Gold American Buffalo Proof 70 coins. The average annual price increase since 2006 has been 29.38%. Past performance does not guarantee future results. However, if returns remain as they have been, investing $100,000 would grow in price to $1,314,230.28 using the TVM formula over ten years. Suppose this potential price growth aligns with your investment goals. Is it worth a short conversation with one of our precious metal experts to learn more?