Time value of money

To try to explain how financial instruments/institutions work, we have to cover one of the cornerstone of finance, Time value of money! Ever recalled how your parents nagged at you about how precious time was? Well, that basic principle applies here to investment and business... Warren Buffet fundamental investment relies on this too!

When you invest your money and gain dividends/interest payouts, risk factor aside, essentially these financial institutions are paying you for the time value of your money, ie, the lost opportunity of not being able to spend your money today.

The principal behind Time value is that one dollar received today is not the same as one dollar received some time in the future. A simple example would be putting your money in a bank for one month at an interest rate of 5%, if it is compounded monthly, your dollar savings would grow to a $1.05!

So the present value of that $1.05 future value, based on a 5% monthly interest would be $1.00. Assuming that is the only rate of interest in the market, and if someone were to offer to pay you back $1.04 in a month's time or $1 now, you would choose to have $1 today because you can put it into the bank and invest it at 5%.

You must be thinking.. "Ha! captain Obvious! This guy is nuts, anyone knows that!" How true! But putting some theory behind intuition, this very basic idea is the rationale behind all investments. Stocks valued using the dividend discount model and even options pricing model all require analyst to find the present value of all future forecasted dividends to perpetuity or the risk neutral value of options; which we will save for another discussion...

So for Mr Warren Buffet,a high powered investing mogul, he has a high opportunity cost because at any one time he would have lots of investment options to choose from and choosing one means having to forgo the next best.

Acknowledgement: image courtesy of Ernest von Rosen, www.amgmedia.com