How Much is that Investment Worth in Real Money?
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This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics.
A bird in the hand is worth two in the bush.
So, if 1 bird in the hand is worth 2 birds in the bush, that means that 1 bird in the bush is worth ½ = 0.5 of a bird in the hand.
This avian metaphor represents the essence of all financial valuation.
To translate from birds to money: A fistful of cash that you hold now is worth more than the same amount of cash awaiting you in the future. And so, you multiply cash in the future by an appropriate discount factor to determine what it’s worth now. For those birds, the discount factor was 0.5. To revert to a financial example: If I want to know the value, today, of a U.S. government treasury bill that will pay me $10,000 one year from now, I multiply that amount by a discount factor of, perhaps, 0.99 (which is financially more realistic than 0.5). In short, I’d pay $9900 now for a promise of $10,000 in one year, because $9900 in the hand is worth $10,000 in the bush.
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At first blush, this idea may seem simple and even obvious from experience. But it’s extremely potent and underlies all of financial theory and most of financial practice. It can often be translated into mathematics and ramified through powerful calculations. In this essay, I’ll draw out and explore some of its consequences. It has been implicit in some of my earlier essays.
Now, don’t rush ahead of me. If you’re thinking that this is all about inflation, because inflation makes future prices greater than current prices, you’re on the right track, but you’re complicating the issue. We’ll get to inflation another time. Right now, we’re considering a happy world without inflation. And if you recognize that the discount factor is related to interest rates, you’re also right, but bear with me; we’ll get to interest rates a few pages on.
Recall that the value of an investment is determined by its ability to generate cash. As I wrote before:
Everything comes down to the ability of an investment to generate cash now and in the future, because cash gives you the ability to buy stuff.
For example, a stock represents the ability of the company that issued it to generate cash in the future, either in actual dividends or in earnings that the company could convert into dividends, in whole or in part, should it decide to do so.
Even when there will be no dividends or interest payments, as when we buy gold bullion, we’re purchasing the prospect of being paid cash in the future, because we’re hoping to sell the investment for cash.
How to travel in financial time
In order to determine the current value of a stock, a bond, or a gold ingot, we have to measure the future cash that it will produce and figure out what it is worth now. We convert future cash into its current value by means of discount factors. One might say that the future is a foreign country, and the discount factor is the exchange rate between the country of the future and the country of the present.
But the future is not one big undifferentiated “overseas.” It is a world of different countries. There is the country one year in the future, and the country two years in the future, and so on. And there are exchange rates among them, as well as a different exchange rate between each of them and the present.