The Time Value Of Money
It's Monday, time for MBA Mondays.
Last week, I posted about The Present Value Of Future Cash Flows and in the comments Pascal-Emmanuel Gobry wrote:
That being said, before even covering NPV, I would have first talked about the time value of money. To me, time value of money is one of the top 3 concepts that blew my mind in business school and that should be common knowledge. When you think about it, all of finance, but also much of business, is underpinned by that. Once you understand time value of money, you understand opportunity costs, you understand sunk costs, you just view the world in a whole different light.
PEG is right. We have to talk about the Time Value Of Money and it was a mistake to dive into concepts like Present Value and Discount Rates before doing that. So we'll hit the rewind button and go back to the start. Here it goes.
Money today is generally worth more than money tomorrow. As another commenter to last week's post put it "you can't buy beer tonight with next year's earnings". Money in your pocket, cash in hand, is worth more than cash that you don't actually have in hand. If you think about it that simply, everyone can agree that they'd rather have the cash in hand than the promise of the same amount at some later day.
And interest rates are used to calculate exactly how much more the money is worth today than tomorrow. Let's say that you'd take $900 today instead of $1000 exactly a year from now. That means you'd accept a 11.1% "discount rate" on that transaction. I calculated that as follows:
1) I calculated how much of a "discount" you would take in order to get the money today versus next year. That is $1000 less $900, or $100
2) I then divided the discount by the amount you'd take today. That is $100/$900, which is 11.1%.
This transaction could be modeled out the other way. Let's say you are willing to loan a friend $900 and you agree that he'll pay you an interest rate of 11.1%. You multiply $900 times 11.1%, you get $100 of total interest, and add that to the $900 and calculate that he'll pay you back $1000 a year from now.
As you can tell from the way I talked about them, interest rates and discount rates are generally the same thing. There are technical differences, but both represent a rate of increase in the time value of money.
So if the interest rate describes the time value of money, then the higher it is, the more valuable money is in your hands and the less valuable money is down the road.
There are multiple reasons that money can be more valuable today than tomorrow. Let's talk about two of them.
1) Inflation – This is a complicated topic that we are not going to get into in detail here. But I need to at least mention it. When prices of things rise faster than they should, we call that inflation. It can be caused by a number of things, most often when the supply of money is rising faster than is sustainable. But the important thing to note is that if a house that costs $100,000 today is going to cost $120,000 next year, that represents 20% inflation and you'd want to earn 20% on your money every year to compensate you for that inflation. You'd want a 20% interest rate on your cash to be compensated for that inflation.
2) Risk – If your money is in a federally guaranteed bank deposit for a year, you might accept 2% interest on it. If it is invested in your friend's startup, you might want a double on your money in a year. Why the difference between a 2% interest rate and a 100% interest rate? Risk. You know you are getting the money in the bank back. You are pretty sure you aren't getting the money back that you invested in your friend's startup and want to get a lot back if it works out.
So let's deconstruct interest rates a bit to parse these different reasons out of them.
Let's say the current rate of interest on a one year treasury bill (a note sold by the US Gov't that is federally guaranteed) is paying a rate of interest of 3%. That is an important rate to pay attention to. Because it is a one year interest rate on a risk free instrument (assuming that the US Gov't is solvent and always will be). We will assume for now that is true. So the "risk free rate" is 3%. That is the rate that the "market" says we should be accepting for a one year instrument with no risk.
Now let's take inflation into account. If the Consumer Price Index (the CPI) says that costs are rising 2.5% year over year, then we can say that the one year inflation rate is 2.5%. It can get a lot more complicated than this, but many real estate leases use the CPI so we can use it too. If you subtract the inflation rate from the risk free rate, you get something called the "real interest rate". In our example, that would be 0.5% (3% minus 2.5%). And we call the 3% rate, the "nominal rate".
Now let's take risk into account. Let's say you can find a corporate bond in the bond market that is coming due next year and will pay $1000 and it is trading for $900 right now. We know from the example that we started with that it is "paying" a discount rate of 11.1% for the next year. If we subtract the 3% risk free rate of interest from the 11.1%, we can determine that market is demanding a "risk premium" of 8.1% over the risk free rate for this bond. That means that not everyone thinks that this company is going to be able to pay back the bond in full, but most people do.
Ok, so hopefully you'll see that interest rates and discount rates have components to them. In its simplest form, and interest rate is composed of the risk free rate plus an inflation premium plus a risk premium. In our examples, the risk free "real" interest rate is 0.5%, the inflation premium is 2.5%, and the risk premium on the corporate bond is 8.1%. Add all of those together, and you get the 11.1% rate that is the discount rate the corporate bond trades at in the markets.
Which leads me to my final point. Markets set rates. Banks don't and governments don't. Banks and governments certainly impact rates and governments can do a lot to impact rates and they do all the time. But at the end of the day it is you and me and it is the traders, both speculators and hedgers, who determine how much of a discount we'll accept to get our money now and how much interest we'll want to wait another year. It is the sum total of all of these transactions that create the market and the market sets rates and they change every second and always will (at least in a capitalist system).
That was tough to do in a blog post. It's a very simple concept but very powerful and as Pascal-Emmanuel said, it is fundamental to all of finance. I hope I explained it well. It's important to understand this one.
You actually did explain it well. I think that’s as succinct and jargon-free as you can make an explanation of the time value of money and interest rates. If the rest of MBA Monday posts are as good as this one, you should publish the whole series as a book when you’re finished.
Phew. Not easy to do in 30 mins
You wrote it during halftime yesterday?
I was too busy tweeting about the need for some modern acts at halftime
Ditto, nothing against the Stones, Bruce, McCartney or The Who, but enough trotting out the old guard. How about Arcade Fire in 2011. That would be amazing. Heck, the NFL is already using “Wake Up” for their theme song. And why not, such an amazing song.
The NFL is probably just playing to the Superbowl-going demographic, which I’m sure skews older and wealthier, on average.On second thought, though: Cadillac, which probably has a similar demo, is using Phoenix in its ads for its latest rectangular monstrosity.
I don’t think the NFL is playing to the demographic. They are choosing bands that don’t understand the definition of wardrobe malfunction. 😉
Or, technically, cannot do that kind of wardrobe malfunction ‘cuz they ain’t got the goods. LOL
I read that the “geezer” tour is backlash from the wardrobe malfunction several years back with Justin and Janet. I’m a huge Who fan, and I couldn’t stand watching them yesterday. I agree with kirklove, Arcade Fire, The Killers (my daughters current favs), Kings of Leon would all be great choices.
KOL would be the obvious choice, they have big “anthemy” songs, they are young, good looking, they rock, and they put on a great show. i hope someone from the NFL and CBS is reading this thread.
Gimme an “F”Gimme an “O”Gimme an “S”Gimme an “S”Gimme an “I”Gimme an “L”Gimme an “S”What’ve you got??FOSSILS !!!
I agree completely Dave.Thnx Fred.
VMBA. Virtual Masters of Business Aptitude.
Fred, you say “the risk free rate is 0.5%, the inflation premium is 2.5%, and the risk premium on the corporate bond is 10.6%. Add all of those together, and you get the 11.1% rate that is the discount rate the corporate bond trades at in the markets.” Doesn’t the risk free rate already include the inflation premium? So it would be the risk free rate + the corporate bond risk premium only?
i should have said “the risk free real rate”i will make that changegood catch
The mistake originates from here:’If we subtract the 0.5% risk free real rate of interest from the 11.1%, we can determine that market is demanding a “risk premium” of 10.6% over the risk free rate for this bond.’11.1% is nominal, so need to subtract nominal risk free rate (3%). The passage should read:’If we subtract the 3% risk free (nominal) rate of interest from the 11.1%, we can determine that market is demanding a “risk premium” of 8.1% over the risk free rate for this bond.’Great post, and great series. Thanks!
i need to introduce the concept of nominal rates in order to make that make sense.i agree that is the right way to put it but i have to run out.i’ll try to fix it later.
morten, i fixed it just now. if you have a second, give it a quick lookover and let me know if you think i fixed it correctly. thanks again. i love that this community is doing real time quality control on these posts.
Looks great now (lets not split hairs over how to go from real to nominal -adding is fine as an approximation :)).I really love how you interact with the community. It is a real two-waydialog. If only more people in high places could learn!
Great job Fred. I totally agree with Scott, especially if you’re going to get into the finance textbook definition of discount rate or WACC.
scott, i think i fixed it. if you get a second, check it out and let me know if you think i have it right now.
Great job Fred – I just spoke at an Entrepreneurship undergraduate class, and pointed the group to your blog for just this kind of post.I gave a shot at explaining cash cycles and permanent working capital at http://www.askbetterquestio…Keep up the Monday posts!
that’s a great post. when i get to that part of the course, i’ll get you on the blog as a guest lecturer!
very nicely put. certainly one of my favourite subjects (a Degree in Forestry shows you that a business that spends money now and sells trees in 120 years time REALLY needs to understand the time value of money in a major way!).an interesting sideline might be research into why Entrepreneurs and VCs are doomed to have different ‘time values’ on money, given their emotional and mental make-ups 😉
How do you value something for 120 years into the future? That’s got to be a nightmare…
What is the value of a tree in 120 years?Consider the value of the Golden Spruce to the Haida tribe in the following link:http://www.endangeredspecie…I’m in favor of looking at the equations as they fit into different contexts.
Great post. Thank you!This the reason I write all the Business Publications and Newspapers about never using nominal vs real dollars when talking about the economy. And the Federal Government is even worse at fibbing. During a majority of the Bush years we had a contracting economy in real terms but a growing economy in nominal. So most of the Bush years were actually recession years and the Fed’s definition is blatantly wrong (because it will hurt the incumbents to be honest whether GOP or Dem).Similar as with your example for an economy if inflation (CPI) is 5% and GDP expands by 2% then in reality the economy contracted about 3%. This scenario happened almost every year under Bush (and many other Presidents to be fair). So the $100 that grew to $102 could not buy the $100 worth of goods that now costs $105. This is a major deceit that I am lobbying to fix. The Fed Government will be touting the 2% expansion when in fact we lost 3% during that period and they will still be ‘technically’ correct.
I have spent 13 years writing software to run these calculations and trying to explain them to customers. I also spent my college years as a TA in accounting. It’s an extremely difficult concept to grasp, for some reason. Excellent summary.A suggestion for your next post: The logical follow-on is to explain the second half of TVM, which is compounding interest. From an entrepreneur’s perspective, this is why a 10x return on investment isn’t the money invested times 10!
wow. that’s a great feeling to hear that from you.thanks for the suggestion for next week. it’s going to happen.you know what, the commenters to these posts are going to build the curriculum for me. how sweet is that?
You are very welcome. I wouldn’t say it if I didn’t mean it.As for the curriculum, I was thinking the exact same thing when I wrote the comment!
The deeper the understanding, the simpler the explanation is. great post.
I’m surprised you use the phrase “When prices of things rise faster than they should, we call that inflation.” – surely it’s inflation if prices rise at all? I’m not actually sure what price things “should” rise at…
yeah, i should have edited that. it’s wrong.
Fred, I congratulate you for your initiative to start MBA Mondays. I hope it catches up and more people introduce their own internet based video MBA alternatives. College education is maybe the only industry that manage to increase its prices by 5% every year disregarding economic conditions and yet there is enough demand for it. It seems like regulations and culture have made the demand for tradinional college education absolutelly inelastic.Regarding the time value of the money, not always $1 today is worth more than a $1 tomorrow. Deflation makes today’s dollars worth more as the prices of goods, services and assets decline. This is why the yield curve is inverted just before a recession – investors are discounting the expected negative economic growth.Then you say that “you can’t buy beer today with tomorrow’s money”. Well, this is exactly what most people are doing by taking credit = they are borrowing from their future income in order to consume today.
This starts the complexity. But in the spirit of the post you could say that the time value of money not only depends on the fact that we want the beer now, but HOW MUCH we want it now. After 10 beers we will settle for a lower rate, and not just because we are drunk 😀
yes, and if you use a negative inflation rate then you can get to a negative interest rate and then you have money today worth less than money tomorrow.that’s why i added the word “generally” to my first statement on this topic.but i did not dig into this because i thought it would make the whole thing to complicated
Can i get an MBA from AVC University? Seems like it would be a much better value than the traditional way!
“the risk free “real” interest rate is 0.5%, the inflation premium is 2.5%, and the risk premium on the corporate bond is 10.6%. Add all of those together, and you get the 11.1% rate that is the discount rate the corporate bond trades at in the markets.”Actually, 0.5+2.5+10.6 makes 13.6%, not, 11.1%. The risk premium should be 8.0%, then it fits.
In reality the market uses the government bond rate as an all-encompassing risk free rate, which factors-in everything from inflation to the end of the Western World. Fred broke down the risk-free rate into its components by way of explanation, but in reality you don’t even think about what risks it embraces.On a side note, it’s important to choose the treasury instrument which best matches the investment’s time horizon. You use T-bills for short-term investments, T-notes for medium term, and T-bonds for really long term investments.
that part is messed up. a few people noticed it, including you. thanks, i am going to fix it now.
i fixed it. if you have time, check it out and let me know if you think i fixed it correctly. thanks again.
Good summary.I would say that long term banks and the government don’t set rates.Short term they can have a huge impact on rates….which is what you have right now.
yes, well said
Here’s a link to a 4.5 min edu video on the time value of money:http://www.finance30.com/vi…….a little “old school”, but it does its job in explaining the TVM concept using an installment plan on a new laptop computer purchase as an example.
Interesting traditional view of time value of money. But it completely ignores practical realities.What college student in today’s environment can afford to “go to the university computer lab” rather than have a laptop? In the video example, the student can buy a laptop for $45/month, effectively paying 28% interest for that computer, which may seem a rapacious rate. (Not to mention that when you factor in Moore’s law, the resale value of that computer is plummeting moment by moment.)However, with full-time access to the web, via the laptop at a cost of ONLY $45/month, the student now has dramatically increased his productive time, and is back on a level playing field with the other students. The student is also making the best and most productive use of that expensive tuition, housing, and the irreplaceable years of youthful energy and enthusiasm.As valuable as these finance lessons are, they are incomplete when they do not take into account the larger picture.
I think you’re missing the point here. The laptop purchase in the video only serves as a simple illustration for the topic under discussion – that of the time value of money. Not sure how we’d expect an instructional video shot with the intent to explain a financial concept in under 5 minutes to sell viewers on the virtues of owning your own laptop.Would you have thought about the same issues if a similar hire purchase scenario used for the laptop was applied to, say, a laundry machine? I think it would distract my learning itent if I was focused on trying to figure out TVM, and the video suddenly qualifies that buying a laundry machine by hire purchase may be more expensive but you benefit from cleaner clothes…Talking about Moore’s law, personal productivity and the individual’s youth dilutes focus on the intent of the video, causes potential confusion for viewers, and is simply off-tangent.
I would absolutely consider the larger picture if I were buying a laundry machine. I would run a cost/benefit analysis of the value of having the laundry machine right in my home, versus the real money cost of paying coins in a laundromat, not to mention the “overhead” of time and travel to take laundry to the laundromat, versus the few minutes it takes to put clothes into a laundry machine in the home and then take them out when they are done.The video also points out the conventional view of a mortgage and the time it takes to pay it off, using various mortgage strategies. The explanation neglects to note that most houses — historically — have been paid off through a sale, not through repayment of the mortgage. The person who is paying down the principal may be taking money out of circulation that would be better used in other ways, for example, buying the “laptop,” or “laundry machine,” or even starting a well-thought-out business.I believe that business is where formal financial concepts meet the practical realities of “the street.”Moore’s law is an excellent example of a business perspective that illuminates any purchase of computer equipment. I would think that this is very much on target for the interests of those who are in this particular audience.
I’m with you on your point that formal financial concepts should meet the practical realities of “the street”.But I would differ in prescribing a single view on how financial concepts should be articulated. Different people have different perspectives (and levels of financial literacy) on what reality should be. This includes buying decisions on laptops, laundry machines, mortgages and so forth.Would also not divert from the fundamental point of Fred’s post – which is to find a way to explain a complicated but fundamental financial concept in the simpliest way possible.Fred has done it his way, the edu video I posted does it in another way, and perhaps you may have a 3rd way to share that could be superior. Why not take a crack and let others weigh in on what they prefer? I think that’s the best way to democratize financial education.
“Markets set rates. Banks don’t and governments don’t.”This is exactly as it *should* be, but alas, we do not live in such a world. If we did, then there would not have been a stock market bubble in the late 1990’s and a much bigger housing bubble during the last decade. Interest rates would have naturally risen to fend them off.But interest rates were kept *artificially* low by the Federal Reserve. That’s the main purpose of the Federal Reserve, to keep interest rates at *non-market* levels.But how can they do this?Let’s say a supermarket lowers the price of Doritos to 5 cents a bag…This is obviously below market levels. Very quickly the bags of Doritos would be snapped up and you’d have empty shelves.But with money, especially fiat paper money, the Federal Reserve has a work around. The interest rates can be held artificially at 1%…people naturally snap them up at an incredible rate…but the money never runs out. The Fed can print as much as is needed to satisfy all demand.And a crazy bubble is created…which must ultimately be popped.If the market *were* to set rates, and savings were used to finance investment, then interest rates would rise quite rapidly as savings become depleted. A *natural balance* between savings and investment would occur.Your statement is accurate in a world without central banks….but until then we must suffer through these horrible artificial booms and busts.
yes, basically true. some crybabies will argue that bubbles do occur outside of central banking, and will cite the dutch tulip bubble as an example….sure, they are right on a technicality, but the bubbles generated by fake money and credit are way more devastating and cartoonish than the bubbles generated by hysteria alone. it is the lethal combination of hysteria and fake money that creates bubbleland, aka US economy.
rest assured that there were money guys behind the tulip bubble. Don’t know how they succeeded to escape history, though 🙂
lol probably true
they were just covered in Tulip pollen…
I am wondering how long before we see the next bubble in Carbon Credit backed securities…
James Clavelle’s Tai Pan and Noble house – brilliantly describes asian “runs on banks”.
but they correct themselves over time. they are unsustainable
Is the MBA thing a regular series? If so then I definitely need to add this to my reader. Thanks for the great information.
Every Monday for the foreseeable future (at least that’s what Fred seems to be indicating).And I’d recommend adding avc.com to your reader for a myriad of reasons, MBA Monday’s only scratches the surface. Tip #1, don’t be a stranger in the comments section.
Thanks Mike. Point taken.
yes, i started it a couple weeks ago. i know a typepad hack that lets me create an RSS feed of the “MBA Mondays” category. i’ll put that on my to do list.until then,http://www.avc.com/a_vc/mba…
everything about this post illustrates the wrongness of schools and academic institutions, and why they deserve to be pounced on with no mercy, even more than we pounce on jdawg (lol okay well not that much! :D)1. “Money today is generally worth more than money tomorrow.” only in fake money world, i.e. our current reality. not when you have commodity-backed money. i.e. one gold coin buys you a nice men’s suit today, one gold coin bought you a nice men’s garment 2000 years ago too.2. inflation is not a complicated topic. almost nothing is complicated. inflation means the money supply is going up. or, price inflation, which is what most folks refer to, means prices go up because either money supply went up (most common situation) or when demand for currency collapses (stagflation or hyperinflation/currency crisis scenario).3. “Because it is a one year interest rate on a risk free instrument (assuming that the US Gov’t is solvent and always will be). We will assume for now that is true.” lol, what other magical assumptions will we be making? do pigs fly and do frogs become princes in this magical world of ours? no way is this assumption true, which changes everything.4. “but many real estate leases use the CPI so we can use it too.” CPI is a government cooked number because it affects how much govt is going to have to pay out on the inflation protected treasury bonds (not actually inflation protected because CPI is underreported). also, just because everyone else does it doesn’t make it cool. if everyone dissed 9/11 truth, would it be cool to diss 9/11 truth? no, that’s the way ugly people think. good looking people support the truth, regardless of what the ugly people think.5. “Markets set rates.” false on two levels: (1) misleading because it implies freedom, and ignores the federal reserve’s ability to manipulate the market, as well as the overall way money is created (loaned into existence); (2) ignores the fact that our current world is one in which the lines between government and market are very blurred — but, interestingly enough, the same folks are in charge either way (goldman sachs, jp morgan, bank of america, and other banks a part of US finance oligarchy)now, i have lots more bad news for you people, but that’s enough for now. go think about that and spend some time feeling bad. then, when folks are done feeling bad, we can discuss solutions (virtual currencies, kookonomics, and the rise of new school finance)
You have to clarify what is right, the basis, b4 you dive into what is broken. But true, there are immense pressure to devaluate, deprecate and erode public assets. Bubbles are a very efficient periodical haircut to public assets. Housing costs/income ratios increase, and financial markets are really artful in the old trade practice of selling expensive and buying cheap. This is mainly because most people “see” different risks curves than the big players have. If you got $50K you can’t play as if you have $5M, and there are many players that take advantage of that.
thought experiment … if we had stayed on gold standard, would demand for gold be higher or lower than it is now? (Answer: much higher)if that was the case, would the cost of the suit be the same in gold terms, or much lower (A: much lower)for this reason, if you are on the gold standard and the supply of gold remains the same, but there is growth over time in the supply of goods, you have continuous deflation.deflation is not a good thing for capitalism and growth… if you know that if you keep gold in a vault it will be worth more next year, and if you want to build a factory, it will cost less to do so next year and wages will be cheaper, you will not be much inclined to build the factory today.I was at an event honoring Paul Volcker a year or two back, and a buddy braver than me asked him what he thought of Ron Paul and the gold standard…his response was that back in the day, the gold standard was an albatross around the neck of central bankers. (you will recall Volcker implemented a strict money growth rule, but eventually abandoned even that when the back of inflation was broken and the rule was leading policy down a clearly misguided path)right now we are dealing with an excess of debt and issues brought on by unwise central bankers, but there’s a good reason gold was considered a ‘barbarous relic.’
“deflation is not a good thing for capitalism and growth… if you know that if you keep gold in a vault it will be worth more next year, and if you want to build a factory, it will cost less to do so next year and wages will be cheaper, you will not be much inclined to build the factory today.”right, this is the “investors will hoard capital” argument, and so we need a central bank to intervene….central banking operates under the premise that unelected people like bernanke can better regulate the supply of money than the free market can. when there is too much money in a gold standard, demand for gold, drops, gold mining stocks drop, and capital naturally seeks higher returns — not hoarding, when the market is oversaturated with hoarding.the gold standard is not perfect, but IMHO it is significantly better than what we currently have, which is just theft/insanity. i think it is also useful to understand the value of the gold standard to come up with a new and even better solution.
a flexible economy needs a flexible money supply.if you put in any rule it might work for a while, then it will fail per Goodhart’s law. ( http://bit.ly/dD2xY4 )ultimately you will always end back at needing ‘wise men’ to set monetary policy.behind every form of government lurks an oligarchy (ie some form of theft/insanity). but some forms are more or less benign than others…be careful what you wish for lest you receive it.
i’m with druce on this. nicely put “a flexible economy needs a flexible money supply”
Both of you should know, you can manipulate supply/demand of intrinsically valued money. It’s just slightly more difficult…Or at least, that’s how the Romans managed to not still inflation…so moving to gold doesn’t help you…http://en.wikipedia.org/wik…
true dat… since any gold standard is subject to devaluation, and any monetary rule is subject to people periodically changing it, most important is credible explicit policy targets….uncertainty is what really destroys markets and economies.
yup, which is what makes interest rates and risk so interesting in the firstplace…
Contrarian: 1,2,3,4Dystopian: 5Carefully supported claims: -I think it’s great if you want to point out why the system sucks – that can be a valuable way to learn. But it sounds like what you really want to do is throw a wrench into the machine and see the pretty sparks fly. This post is aimed toward teaching something. How did you add to the teaching here?Try to realize that your aversion to the system Fred is attempting to describe is orthogonal to the description itself.
lol…..you are the one who is not carefully supporting your claim that my claims are contrarian and dystopian…..if you think an honest assessment of how money is created is dystopian, than that simply reflects a lack of respect for simple facts on your part…..no doubt i throw a monkey wrench into the machine, and no doubt i get a huge kick out of seeing the sparks fly. i have never denied this and consider it self-evident. one of fred’s investing thesis is that the the internet is playful and i agree wholeheartedly, as evidenced by my behavior.but i do contribute to the discussion, and the relevance of my comment to this discussion should be self-evident to those seeking to genuinely participate in the discussion. if you want to beef with me, you gotta step up and hit me on the facts, not on the appropriateness of my behavior in fredland — tough to beef with a truther who stays relevant to the topic in that regard.
And what Fred discussed in another post, that the circulation is broken, because you spend “here” to drive growth “there”, depleting resources. The save-invest model assumes that you save today, and other invest it. So the time value of money clears between those who save (and invest) and those who take the money for growth. This (huge) leak prevents this healthy cycle and limits good saving alternatives based on real growth value.
Couldn’t have said it better myself. Inflation = one gigantic transfer of wealth. Gotta question who’s giving and who’s receiving. As Mr. Friedman said – “Inflation is always and everywhere a monetary phenomenon”. It’s just that simple.
How does the concept of “time value of money” gel with the idea that a loan is “rented money”? Or, to put that another way, if I have a house I want to rent, can we talk about rents in terms of “time value of my house”?
yes, absolutely. i did that in this posthttp://bit.ly/bK3bfb
Great post Fred. This brings back memories of college and dorm life at University of Michigan.I was reading the original pitch slides for Mint this week and they discussed CAGR when looking at their growth rates. It would be interesting to hear from you what the benefits and limitations are of using such a calculation when speaking with investors.
chris, you are the second person to suggest i address compounding. so it will be next week’s topic.
I think this is incredibly useful information for the majority of people who don’t have a lot of basic financial knowledge. I am sharing this with my Senior Management team who do not normally have access to simple / basic financial literacy. Thank you.ps a good cliche which represents TVM is “a bird in the hand is worth two in the bush”.
that’s the idea. increase financial literacy in the entrepreneurial startup community. i’m so happy that it is working.great cliche
“Paper money eventually returns to its intrinsic value — zero.” – VoltaireMoney, in fiat currency essence, has no value. Especially when the Federal Reserve makes decisions like this: http://www.wallstreetoasis….However, I must say that your article was very well written with a great tutorial.
yeah, well. Gold is actually a stone.
currency is trust, in our case the trust in our federal government, our country, our collective decision to be a functioning society.i recognize that many people are losing that turst, me includedbut i’ll still take that any day over a yellow rock
It worries me that you say that. national debt?
national debt, corrupt and sclerotic government, unwillingness to face facts and tackle hard problems
With the understanding that I have some belief in Keynes-Considering your relationship to risk, risk management and company worth visa vis the microeconomic underpinnings of macro:That opinion doesn’t bode well. It’s up there with a very wide treasuryyield curve spread.It’s like effectively saying- I really don’t trust American money and Iexpect something bad to happen in other forms of risk because the gov’tsucks with all this stuff. Meanwhile we’re investing in US money, andtherefore there should be some sort of hidden risk premium to invest withit?No?
I have a fiddle for rent…
We should triple carbon taxes 😀 congrats for AMEE!http://eu.techcrunch.com/20…
kid and morgan commented on that one. they seem to dislike our amee investment. i tried to leave a comment but wp-comment crashed. too bad techcrunch europe doesn’t use disqus
Great post!I also think that one of the main reasons why money tomorrow is worth more than money today is due to opportunity costs. I can take the money that I have today and spend it for pleasure, or give it to you for something more in return, for Risk + inflation + opportunity cost premium.
Fred-Am a longtime reader but first time poster. I think MBA Mondays is a great theme. I just wanted to let you know that Aswath Damodaran who is a Professor of Corporate Finance at Stern and an expert on valuation has webcasts of all his MBA lectures on his public website. I think they would be a great visual aid to the topics you plan on discussing in the future.This is the link:http://pages.stern.nyu.edu/…
that’s so great to see. hacking education for the win!i will look it over to see if there are good matches for the themes i want to cover
Oh, you are doing as good if not better job than some professors.Though this makes me wonder about bonds moving to lower rates as they get paid off
On the web, “we” sometimes say the “cost” of early monetization suppresses growth/engagement. Should we account for this in the NPV calculation? Or is this just WebTwoDotOh silly talk?
i once wrote a post that’s relevant to this discussion. check it out here.http://www.avc.com/a_vc/200…
Love this meme. To the point you make in the last paragraph, it might be worth looking at the choice we each make as we sit on both sides of the interest equation. As an individual, most of us are both borrowers (payers of interest/buyers of “money today”) and lenders (recipients of interest/sellers of “money today”). The fact that we can choose the balance between the two positions and that we can do both at once through different mechanisms is a very powerful thing.
Just wanted to echo the sentiment that this is a great series of posts that will really fill a niche as you don’t really see anyone talking about them on blogs, etc. It will serve as a great teaching tool for those new to these topics, as well as a refining tool for those who have forgotten or disregarded some of these essential points. Thanks for your work and keep up the great series.
thanks for the kind words. it’s comments like this that keep me going. i mean that.
This is an elegant description of the classic “Time Value of Money.”But I’m very interested in the “Money Value of Time.”Fred spent 30 minutes writing this. How many people have read this? And are better informed because Fred took the time to write? And how much time did all those people spend?If I spend an hour, or two, reading this blog, and the comments, and some of the links as well — and multiply my time investment by the number of people here who comment, plus all the friendly lurkers — how much time did Fred influence with his 30 minute investment this morning?But if I feel “twice as smart” because I spent this time becoming educated, then that’s a pretty impressive “return” for my time investment. And all because Fred was willing to share his years of accumulated wisdom, along with his knowledge, and distill that down in 30 minutes this morning.To me, this is the amazing power of real creativity and entrepreneurship. And we don’t have a way to calculate it in our economy.Thank you, Fred, for increasing my own “intellectual capital” today.
i was talking about the monetary value of time with a friend the other day. i talked about the fact that i buy the largest metrocard you can buy ($45) so that i don’t have to refill it as often. if you compare me with someone who buys the smallest one (maybe $10??), the you can actually calculate my monetary value of time versus the other person.and then he told me you can get an autofill metrocardhttp://www.mta.info/metroca…now i ride the subway every day and i had never heard of this thing. i went home and applied for it that day.i don’t have it yet, but when it arrives, i am going to blog about it.that’s the monetary value of time coming into play
Appears analogous to the auto refill of a SunPass for the toll roads of South Florida. Transit tolls in all its forms. They should now do the same with the Larkspur and Sausalito Ferries. That would have been nice in the day…
Thanks Fred.Appreciate the longer form post. I’m familiar with the time cost a length post can levy on your day.The risk portion sounds pretty fascinating, and I suppose that drives valuations for startups.If I can return an investors money with high probability, and a large return margin a few years from now, I can retain much more ownership of any business I start. And complimentary, if I can get enough investors to compete for shares of a business I start, I can also retain more of the business or at least get more cash for it’s current value.I’m curious how this concept plays against the default valuations (if there is such a thing). I often see numbers between $3-5 million dollar valuations. What causes so many startups to fall into this category (obviously there are exceptions like Square and Zynga).
lower the risk premium investors require and keep more of your company.you are jumping ahead in the curriculum mark.like all gifted students 🙂
Information can be a beautiful thing.Useful knowledge is priceless when acted upon.Of course that’s the test, will I use the info? I’m betting on it with every free moment.
Fred,I am sure you are probably aware of Damodaran @ Stern (http://pages.stern.nyu.edu/…. He started his website almost like a blog format before anybody knew what blogging was about. It was quite mind blowing that there was so much content from his class for FREE for anybody to see without even people going to Stern. He has a lot of excellent stuff online about valuation/corp fin etc… that anybody with an interest in Finance can go and learn. Unfortunately, the site has not caught up with current the blog format and latest technologies and I suspect that’s got to more to do with university infrastructure than Damadoran.It will be great if you can give a shout out to Damadoran in your blog. A great teacher no doubt but even more a believer in free knowledge.I think most of the concepts you are going to cover would also be covered in this book:http://pages.stern.nyu.edu/… For example, see the chapter in Present Value (http://pages.stern.nyu.edu/…Nik
this is the second link to his stuff in this thread. i’ve never heard of him. i am so happy to see that he’s doing this and i will look to use some of his material in this series for sure
Ya damodaran is fantastic. It was impossible to get into his class at stern. For the longest time, people who couldn’t get into this class could view the webcast from his class on his website. He also pretty much wrote the standard textbook on valuation.
Thanks for the excellent post.
Some long time ago I got one of those circulated emails that talked about the value of a penny on the sidewalk relative to the time it took to stop and pick it up.The point was that for different individuals, the value of their time was such that for them to stop in mid-stride, refocus, and pick up the penny, they would lose money in the process.At that point, the author calculated that, against his annual income, Bill Gates would lose about $16,000 by stopping to pick up the penny. Not necessarily an accurate assessment, but certainly thought provoking.(I’d do the auto-load subway card, too.)
I never viewed interest rates as the time value of money. Complex, yet very interesting. How can we as specutaltor and hedgers increase this value to cause the market to fluctuate? By investing in more start ups, and less secured entities? Just curious what your thoughts are on that.ParisGirl111CESI Debt Solutions
Another great post. I love this MBA Mondays idea.
just wanted to comment that i really like this new series.I’ve started companies and raised money yet don’t have a finance background. In the past i’ve had to learn each financial principle as they come. As you’ve shown, they aren’t complicated but they are often not discussed and i don’t feel like buying a textbook to go through them. I love the thought of regularly going through the concepts that you feels are important. Keep ’em coming.
I would like to hear your take on the VC method of valuing pre revenue start-ups. In such a situation traditional methods like the DCF and multiples don’t really make sense. I have been taught that irrespective of the idea/management/future cash flows etc, most VC’s value a pre revenue start up in the range of 1-3 million. How true is this statement? Should entrepreneurs keep this range in mind (1-3 mil) when pitching to VC’s?
there is no hard and fast rule. 1-3mm pre money is a good deal for investorsin my opinioni have posted on this topic in the past. early stage deals are options morethan anything else
Thanks, this is easily the simplest breakdown of TVM I have ever read. I will be passing this along!
Ah, the DNA of financial comprehension! Can’t wait for the elegance of CapM…
Thanks Fred for another excellent post. It’s tough to explain such concepts in a simple matter of fact way and you do a great job. Keep MBA Mondays coming 🙂
Well written. TVM was the single most important concept that was drilled to us when I got my masters in finance. And applied almost everywhere.I found it can take a while to get used to it at first – but once you get it – one starts looking at assets very differently.Is capital budgeting in the future agenda for MBA Mondays?Cheers,Marco
i am sure it will benot sure when yet
A good application of time value of money is provided hereAn investor requires $25,000 in 7 years and bank offers him 6.76% effective interest rate based on monthly compounding. What amount must he deposit now to achieve his goal?On your BA II plus financial calculatorSource: http://www.accountingschola…i) Press 2nd, and then press 2ii) NOM pressiii) EFF= Press 6.76, Enter theniv) C/Y = Press 12, then Enter, thenv) NOM = Press CPTvi) Answer = 6.56%Now we will use this 6.56% in our present value calculation below:N = 7I/Y = 6.56PV = ?PMT = $0FV = $25,0002ND I/YP/Y = 1C/Y = 12CPT & PV = $15,814.49
Aren’t the White Stripes more retro than modern?
If Fred agreed to have lunch with me today, and I was buying him a burger and a beer — but I needed to borrow the money to take him out to lunch — I’d gladly pay a substantial premium for that money.And my willingness to pay an exorbitant rate for that short-term loan may be my carefully considered business decision, based on what I know Fred and I might discuss at our lunch. If you’re loaning me that money, and you have a hunch how that business lunch might go, you might think you’re getting a great ROI on a no-risk loan.John Maynard Keynes emphasized the importance of “animal spirits” in the calculation of business decisions. Unfortunately that key element that incorporates the world of human psychology has been lost in the economic philosophies that have been guiding our national economic policy decisions.An entrepreneur has to look at money in a different way. Otherwise it makes no sense to take the risk of starting up a business. Put that money in the bank and wait for others to “invest” it!
Now that’s a great post!This has perhaps been discussed, but what you said reminds me of Gladwell’s latest piece on entrepreneurship. He says successful entrepreneurs are actually NOT that risky. They just know something that the rest of us don’t know about the particular domain. And therefore, their risk premium for the cash flow (or transaction) is different (lower) from everybody else’s, who are looking at it with incomplete information.This resonates with my strongly. I’ve worked for some brilliant entrepreneurs and I totally don’t buy that they are more risk-seeking than everyone else. I think they’re just plain smarter.http://www.newyorker.com/re…
That is coming back in. Unfortunately, psychology of massive groups seems to be one of the more difficult areas of study…. I feel bad…
putting money in a bank and wait for others to invest it is safe, but you’ll never get wealthy doing that
Thanks for the props. I looked at the abstract of Gladwell’s article, and I look forward to reading it.I disagree, however, with the portrayal of entrepreneurs as predators. I think this is a damaging and inaccurate myth. Yes, some entrepreneurs are predatory, and unfortunately they get a lot of press and become, unfortunately, role models for some.Other entrepreneurs, however, are visionary and can formulate products and business models that empower people and create jobs, while producing revenues and profits. In the words of a “contrarian,” I believe there can be such a thing as a “business plan that saves the world.”
malcolm gadflysometimes i think he writes this stuff just to challenge conventional wisdomentrepreneurs seek risk, they want it, need it, love it
I’m with you on the predatory part. That’s a very fair point. Not helpful for any of us.I share your view on the b-plan that can save the world….or the ‘business that saves the world’. I dig that.
Are you predatory? Visionary?
Smart? Tell us!!!!
Radiohead? Are you serious? Anything from their last album before they started trying to reinvent rock ‘n’ roll (The Bends) would be too depressing for the occasion; anything after that would be too depressing and discordant for a halftime show. This isn’t the symphony, where patrons expect to be punished occasionally (e.g., by being subjected to an excerpt from The Bassarids, as we were once).It’s too bad the Cult is too obscure to be considered for this, because they have some catchy, thumping songs that are still mainstream rock, but sound fresher today than classics by the Who that were beaten to death on the radio 20 years ago.
I get it. And really, really respect it. Tell me more — is it the risk that drives you, or is it the need to create and build something and then the risk comes with the package.I’m not judging; I’m just wrestling with it myself, trying to get clear on what my risk-seeking profile is. Thing is, I’ve done things in my life which conventional people have said Wow, that’s so risky/out there/gutsy. But it often makes me wince because a lot of times it didn’t really feel risky but just was something that clearly had to be done and I needed to do it.But also I hear you say words like “house” and “float” and think ”F-yeah” that’s risky. I have a house. Tuition to scrape up. Using (sparse) savings to build a beta and turned down a job last week too. Money is NOT no object here! It’s a big stress, for sure.I guess maybe I was clinging to Malcolm Gadfly to convince myself that I’m not a risk-loving lunatic? ;-). Charade’s overThanks Charlie Crystle for the free couch time. Worth it’s weight in gold.
i agree about neil and bruce. they still write songs and put out music. thatis the definition of a real band/artist in my mind.
“Just something that clearly had to be done and I needed to do it.” I wonder if Charlie is also saying the same thing.In the last few days I stumbled upon the work of Polish psychiatrist/psychologist Kazimierz Dabrowski. His life work was the study of patterns of personality development, especially a type of development that happens for certain types of people. His “Theory of Positive Disintegration” is not well known, but it has been adopted in certain circles, including among some who work with “talented and gifted” youth. If you follow some of the links at the end of this article, you’ll see what I mean. http://en.wikipedia.org/wik…I wonder if this life path describes some of us who are blessed/cursed with an unavoidable entrepreneurial streak. If so, we’d better be doing all the learning we can, so we’re better able to ground our dreams in this practical world.Thanks, Fred.
Wavelengths — this is a really, really interesting framework. Blows my mind, actually. Thank you so much for putting it forth.A huge amount resonates…although I won’t force you and everyone to suffer through my personal details of in which ways and how! Fortunately, blessedly, the depression part does not for me. But overexcited, and the other things? Uhhh, yep!We have managed to veer *way* off Time Value of Money, but in a cool, unexpected way. I do think that risk tolerance is generally a great topic.You have great things to share! Please share your real identity? 🙂 I am eager to tie your insightfulness to your real persona.Have a great evening.
Nor do they need to consider Lip Synching…just saying…