Do you remember when you could go to a restaurant and order the menú del día for 10€? Maybe less? Or when you could rent a flat for less than 500€ per month?
The value of goods and services changes from one day to the next. But one euro will always be one euro. The Time Value of Money attempts to understand the impact of time on a variety of decision making scenarios comparing what you have today with what you might have in the future.
What is the Time Value of Money?
The theory goes that each euro you receive today will be more valuable than every euro you receive in the future.
With the money you have today you have the opportunity to invest and receive some kind of return, but over time as inflation causes costs to rise, you’ll spend more on goods and services, which leaves you with less money to invest.
Time Value Formulas
Depending on whether you are trying to work out how much money you can earn by investing what you currently have, or what a future value would be worth today, there are two formulas typically used.
However depending on application or purpose there are different formulas that can be applied, with the following variables:
- Present Value (PV)
- Future Value (FV)
- Interest (i)
- The Number of Compounding Periods
If you were to invest your present value you can determine its future worth using a simple formula: FV = PV(1 + i)^n.
And conversely what a future value would be worth today you can use the formula PV = FV( 1 + i )^-n.
However depending on the application of the formula you might find variations. An easy way to look at it would be to break them down into excel.
The following two tables provide a simple example of each formula that you can copy into a spreadsheet, assuming A1 is where the data is pasted, otherwise the formulas will need to be updated accordingly.
They are by no means complete, nor are they a guarantee of returns. They are intended to demonstrate the basic formula.
| Present Value (PV) | 1000 |
| Interest Rate (I) | 0.025 |
| Number of Periods (n) | 12 |
| Interest per Period | =B2/B3 |
| Units of Time (years) | 1 |
| =1+B4 | |
| =B6^(B3*B5) | |
| =B1*B7 |
| Future Value (FV) | 1000 |
| Interest Rate (I) | 0.025 |
| Number of Periods (n) | 12 |
| Interest per Period | =B2/B3 |
| Units of Time (years) | 1 |
| =1+B4 | |
| =B6^(B3*B5) | |
| =B1/B7 |
Time Value of Money in Practice
A variety of examples talk about winning the lottery or getting large bonuses and deciding whether to invest or use the money to treat yourself to a holiday.
But, what about something more down to earth?
Minimum wage can be paid in 14 payments of €1,221 or 12 payments of €1,424.5. Even if you could invest every euro, you’d be better off with the 12 payments.
Although you receive the same amount over the course of a year, the two extra payments of €1,221 typically arrive later in the year, which means that money misses out on considerably more potential returns.
Beyond calculating interest earned, it can be used in a variety of other scenarios such as assessing loan amortization schedules, salary negotiation where bonuses might be involved or capital budgeting in business.
However, bear in mind that it makes assumptions on fixed values and rates, and doesn’t take into account things like fees or taxes, although they can serve as a guide to expected values.
The Time Value of Everything
The concept of Time Value of Money can be applied to all sorts of decision making processes.
In SEO for example, targeting a highly competitive keyword compared to a niche may require considerably more effort to establish yourself in the top spot.
Additionally, by finding a gap you create a target for others, which means any advantage you create is soon worn down by the competition and you need to expend greater energy to maintain a strong position.
A niche, on the other hand, can be less of a target and so provide you with time to gain traction and establish expertise.
Obviously, it doesn’t work directly with money or compound interest in this scenario, but as a tool or model, you can consider the amount of time required for a range of actions in relation to their potential outcomes.