The future value of money today

Q: Can you explain the “time value of money”? — W.L., Phoenix

A: The time value of money reflects the belief that money received in the future will be worth less than money received today. Most of us would rather get a dollar today than a dollar in 10 years. We could invest it and it would grow to more than a dollar in 10 years. Or we might buy something with it — like a slice of pizza. In 10 years, due to inflation, that slice of pizza will probably cost more.

Stock analysts consider the time value of money when they use fancy “discounted cash flow” (DCF) analysis to estimate the value of companies. (This is complicated, but useful to know.) They create DCF models for companies they study, estimating how much cash the companies will generate over time. Future earnings are then “discounted” at a rate that can be tricky to determine.

As a simplified example, imagine that Home Surgery Kits (ticker: OUCHH) will earn $3 per share next year, and you’re discounting that at 10 percent. Take 1 and add 0.10 (for the 10 percent), getting 1.10. Now divide $3 by 1.10, and you’ll get $2.73. So the “present value” of those future earnings is $2.73.