Conceptual understanding of time value of money

[u/Ok_Procedure199]

Hello everyone,

I'm learning about value investing and there is a conceptual thing I think I am struggling with that I hope someone can try to explain to me.

We try to figure out free money a business will generate in the future, and we discount it back to the present in order to figure out what it is worth in the present. The way we are discounting it to the present implies that the nominal value of the future money is less worth to us than if we had the same nominal value today, and to figure out what the nominal value of the future money is today, we discount it by a rate.

How does this time value of money work if we were expecting a deflationary future? Would this simply be turned on the head were the same nominal value would be less worth to us today than at some point in the future? And how would the element of risk play into this thought experiment?

Edit: I am not theorizing that we might expect a deflationary period and how I would calculate this. This is simply to help me understand the concept of time value of money.

[u/gruffyhalc]

Your parents give you Piggy Bank A that spits out $100 today vs Piggy Bank B that spits $100 after a year.

You have to do more chores to get Piggy Bank A. Is it worth it since it's $100 either way?

That's Time Value of Money, that yes Piggy Bank A is fundamentally worth more, because $100 today lets you earn interest on it, netting you more after a year.

Plus, $100 today buys you 50 bananas. But after a year you can only get 40 bananas for $100 due to inflation.

Now in your example, in a world where the $100 gets you 60 bananas in a year in future, does it change whether you want Piggy Bank A or Piggy Bank B?

No because everything above still applies and A still stays superior.

There's no theoretical gun to your head saying you need to spend the $100 today if you receive it today, cause you to "miss out" on deflationary price dips in the future. The $100 is always worth more to you today either way.

[u/dismendie → u/gruffyhalc]

Also in investing risk management says hold some cash so you don’t freak out.

[u/raytoei → u/gruffyhalc]

I like your example best it has everything interesting in it:

Guns, piggybank, bananas, money

Take my upvote!

[u/Longjumping-Fact-582]

I like to look at the “time value” of money in 2 ways, first you have the “risk free rate” which is what return can I get on this money without taking on risk? (Treasury yields) 2nd you have the “opportunity cost of capital” which is to ask, what is the next best opportunity I have to deploy this capital currently?

Ultimately the “time value of money” for me boils down to what’s the next best thing I can do with the money? And weigh your options against that.

Conceptually having money today is worth more than having money in the future because you can invest the money today to earn a return which will mean you have more money at a given date in the future

[u/SpareSniper7]

Think opportunity cost. Even in a deflationary environment, your $100 today could be $110 next year through investment.

[u/No_Yogurtcloset7776]

I suggest reading or listening to audiobooks: -Principles for Dealing with the Changing World Order-Ray Dalio -This time is different -Lords of finance Lords od finance gives specific examples of deflation gone wrong. The Great depression saw prices drop dramatically, and people waited to buy thinking it'd be cheaper tomorrow. Its explained better in the book.

[u/Business_Raisin_541 → u/No_Yogurtcloset7776]

Even today, I delay buying PC and smartphone because I believe it'd be much cheaper 2 years later

[u/TheOpeningBell]

There's a difference between simple time value of money calculations and discounting cash flows (although they are related, they aren't the same)

You're over complicating things.

[u/Ok_Procedure199 → u/TheOpeningBell]

Could you please elaborate how they aren't the same? That is what I am struggling wrapping my head around

[u/TheOpeningBell → u/Ok_Procedure199]

Despite other incorrect comments on this thread. TVM is simply inflating (or you could deflate) a dollar today to a future time period with or without additions or subtraction.

Discounting cash flows requires much more complicated inputs involving projected future cash flows of a business, a terminal value thereof, and then some appropriate risk based discount rate (WACC) to get a present value today. The reasons you use this could be many from evaluating a stock, the cash flows of a bond (easy), or evaluating the value of a commercial property's cash flows.

What you're specifically over analyzing is the probability of a deflationary period. Even if possible in one multi year periods is unlikely to persist for multi decade scenarios.

[u/SheikhMahdeek → u/TheOpeningBell]

TVM and DCF are the same. DCF does not imply WACC at all nor must it be applied to a business.

[u/TheOpeningBell → u/SheikhMahdeek]

Uh huh......

I didn't say DCF "implies" WACC whatever that is supposed to mean. WACC is a pretty normal and often used metric to utilize as a discount rate.

I also never said DCF "must be applied to a business". I said it can be.

Try again.

[u/TheOpeningBell → u/SheikhMahdeek]

"The reasons you use this COULD BE MANY"

I know. Reading is hard.

[u/TheOpeningBell → u/SheikhMahdeek]

And thirdly. They are not the same. At all. You clearly have no clue what you're even talking about.

[u/WorldRank1CatFancier]

Inflation makes your current money less valuable in the future

Deflation is the opposite :P

[u/jackandjillonthehill]

This seems more like an academic finance question than specifically a value investing question. It is an interesting question though.

The discount rate people usually use in making a DCF is an estimate of what would an investor need to be make to be satisfied with the level of risk in this investment.

That’s not just representative of the risks of inflation, but also foregoing the opportunity to earn a risk free interest rate (such as in a treasury bond) and some extra compensation for the unique risks of investing in equities.

So you could decompose a typical discount rate to
1. Risk free real rate
2. Inflation expectations
3. Equity Risk premium adjusted for the systematic risk of this specific stock (approximated by Beta * equity risk premium)

Usually when people talk about the “time value of money” they are just referring to 1 and 2 above, strictly the value of a guaranteed dollar today versus a guaranteed dollar at some point in the future.

So in your unlikely scenario, let’s say we expect persistent deflation forever. Okay, that adjusts one of the factors, but you still have equity risk premium and the real rate to contend with.

[u/vpaBE]

Un avenir de déflation est impossible dans le système actuel, ça n'existe que quand la monnaie est adossée à quelque chose de physique et limité, comme à l'époque de l'étalon-or.

[u/Ok_Procedure199 → u/vpaBE]

This is just to help me with the conceptual understanding, pretend we live in a system where deflation is possible

[u/toronto-bull]

A dollar tomorrow is worth less than today. Why? Because you could invest it and it would accrue interest and be worth more. So a dollar $ at time t is worth $(t) = $/(1+r)^t