The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.
Provided money can earn interest, this core principle of finance holds that any amount of money is worth more the sooner it is received. At the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
What Is Present Value?
Present value determines what a cash flow to be received in the future is worth in today's dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is, if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount.
Present value = (future cash flow) / (1 + rate of return)number of periods
What Is Future Value?
Future value determines what a cash flow received today is worth in the future, based on interest rates or capital gains. It calculates what a current cash flow would be worth in the future, if it was invested at a specified rate of return and number of periods.
Future value = present value x (1 + (rate of return)number of periods)
Both present value and future value take into account compounding interest or capital gains, which is another important aspect for investors to consider when looking for good investments.
The Bottom Line
Time is literally money. The value of the money you have now is not the same as it will be in the future. Knowing how to determine TVM by calculating present and future value can help you distinguish between the worth of investments that offer returns at different times.