Time Value of Money was an idea that blew my mind. It is logical thinking articulated in a math formula – basically a performance nerd’s dream! A large part of the investable universe is dependent on this concept at one level or another, and at times like these, it cannot be ignored. It’s contributing to stock volatility. Stick with me for a couple of paragraphs, and I’ll explain why.
Time Value of Money pulls attention to the idea that money in your hand is worth more than if someone gave it to you later. When you play this out in the real world, it’s intuitive. Would you rather get $50,000 today or next year? Now – of course. Why would I wait for the same amount of money in a year if I could have it now? The answer: I’d wait if there was some additional incentive for my time.
Let’s say a client offers to pay you $50,000 today or $50,500 next year. The client is assigning a 1% value to that one-year waiting period. Is that correct? Well, if a super low risk investment could yield you 1.5%, then no, it’s not. You need to ask for $50,750 ($50,000 X 1.015) to be compensated for the time; otherwise, you can get that return yourself and you might as well take the money now.
Above, we calculated the future value, but we could use this concept to determine the present value as well. We do a little math switcheroo and the Present Value = Future Value / (1+interest rate). In the simple example above, the offer of $50,500 in a return environment that offers 1.5% is equivalent to being offered $49,754 ($50,500 / 1.015) today. No, thank you.
Why does matter so much right now? Because the interest rate significantly changes present value. For example, if the interest rates are lower, say .50%, then $50,500/ 1.005 results in a present value of around $50,248. Suddenly, $50,500 is a great deal.
THE PRESENT VALUE GOES UP WHEN THE INTEREST RATE GOES DOWN. The chart above illustrates the inverse relationship. The higher the return rate, the lower the current value.
If you haven’t noticed, the investment world is obsessed with the Fed’s signals about interest rate changes. Time Value of Money is part of the reason. The concept is one method used to help determine the value of a stock. In theory, a stock’s price should represent the present value of future cash flows. Like the simplified examples above, this is just a fancy way saying that investors need to be compensated for the time until cash flow, given the specific required rate of return.
The required rate of return used in stock valuation isn’t the US Treasury rate, but it does vary based on the US Treasury Rate for a very logical reason. Because US Treasuries are backed by the full faith of the US Government, they are generally considered one of the least risky investments available. This is true enough that we are allowed to call a three-month Treasury rate the “risk-free rate”. If investments in a risk-free asset are less profitable, then an investor is willing to lower the required rate of return for the stock. If the risk-free is higher, then the investor needs a higher return from the stock to incentivize taking the risk.
This means that as interest rates went down, that low rate helped to create stock valuations that went up. If the rates change upward, the valuations are going to have downward pressure. We saw this a couple of weeks ago. As interest expectations increased, significant portions of the stock market lost value.
My example here (and the calculation) is simplified for a single period and the factors at play in the market are more robust, but the principle holds true. Time Value of Money is a fundamental building block that contributes to volatility during periods of rising or falling interest rates.
As cool as I find real life math, its application here has me expecting some bouncy days ahead. Interestingly, the rate changes are not universally impactful to all segments of the market, but that’s a conversation for a different day – maybe next week?
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