The fundamental concern of finance is the management of money. Specifically, how & when to raise it, how & when & on what to spend or invest it, how to evaluate past investments or spending, and how to deal with differences in the timing of cash flows. Ultimately, finance is the final result of actual economic activity.
Larry Bird from "Ozark" explains it best...
Before jumping into the rest of this, please make sure you have gone over our previous post "The Baby Basics of Finance"!
Note: You do not need to know or use the equations below, they are there to help explain the concepts and build up your financial intuition! All these formulas are prebuilt into our tools!
The Time Value of Money
If I were to offer you $1 per year for life, what do you think that would be worth? How much would you pay me for that?
A common expression is "a bird in the hand is worth two in the bush", meaning that what you have today is better than what you might have tomorrow due to uncertainty. This translates to a common financial expression "a dollar today is better than a dollar tomorrow".
When I offered you $1 per year for life, I was offering an uncertain stream of cashflows. The uncertainty comes in because it is over a long time and I might not be around to pay you in the year 2120... or you might not be around to collect it...
If we both live 100 more years you would get $100 total, so, would you pay $100 today to get $1 per year for life?
No. Why Not? Because of risk! Those cashflows cannot be 100% guaranteed (the future is always unknown) and a dollar today is worth more than a dollar tomorrow, so you would pay less than the sum of expected cashflows.
Risks are discounted using inflation rates, interest rates, market risk premiums etc. They are a percentage that each cash flow is discounted per year to account for risk (known as a discount rate or cost of capital) and to arrive at a fair value of the stream of cash flows. The higher the risk of the investment the higher the discount rate you should use since those cashflows are more uncertain (risky).
A limited 3 year example, instead of simply adding $1 for 3 years...
We can use an inflation rate of 3% as the discount rate to get:
Present Value (PV) can be thought of as "today's value". Meaning we would pay $2.82 today to get $1 per year for 3 years. Just as a scale that is kept in perfect balance by the Present Value, cashflows and discount rate.
Going back to our original example of $1 per year for life we can use a simplification of the formula above used for "infinite" cash flows (since its over a very long time period).
So, you give me $33 today and I will give you $1 per year for life. If we end up living 100 more years, I will end up paying you $100 but you have only paid me $33.
Net Present Value (NPV)
When you invest in any operational asset (a property, a business, a stock etc.) you expect it to generate some sort of return in the form of profits (or Net Cash Flows) which must be summed and discounted to get a Present Value. This is the fair or "intrinsic" value of that stream of cashflows. If you pay above the intrinsic value you are likely overpaying and are at risk of earning a low or negative return on your money, if you pay below intrinsic value you are likely making a good investment that will earn your money back along with profits.
This ultimately generates the Net Present Value (NPV) of Future Cashflows. When you evaluate an investment, you discount only the Net Cash Profits each year (since this is what belongs to the investor or owner). When your annual return is higher than the discount rate you will earn a positive NPV.
Where "r" is the discount rate (e.g. 3% = 0.03) and "n" is the final year of the expected cashflows (meaning if the cashflows end in the 10th year, n = 10). Cashflows that are equal each year and expected to last "forever" can be valued as:
Any NPV above $0 indicates that the investment will cover its costs and risks, generating an increase in wealth for the investor above a minimum required return (the cost of capital).
A $10,000 investment with a 5% discount rate that has a NPV = $0 means that it is earning exactly 5% per year. The higher the NPV the better. Every operational asset is fundamentally worth the Net Present Value of its Future Cash Flows.
The "Law" of One Price
Another aspect to valuing investments is the law of one price. Which states that if there are no barriers to trading, a free market will generate the same price for the same good. This is true for items, commodities and investments.
For example, all stocks of Apple trade at the same price at the same time regardless of where or how you buy them, since each share is identical to another. But other things like cars, phones etc. might have widely different prices depending on where or who you buy them from (even if it’s the same phone model or the same car with the same mileage).
The law of one price is applied to investments in the form of comparisons. Two similar investments should be worth a similar amount. Similar means by industry, type of business, type of asset, location, profit margins, risk factors and growth. Similar businesses should all trade at similar comparison ratios (imagine two similar businesses both worth 5 times their profits despite one being larger). Likewise, two same size houses, same build year, same style on the same street should be almost identical in price because they are so similar.
When prices of two "same" goods differ, an investor could buy the cheaper one and sell it in the more expensive market earning a riskless return (since both items were the “same”). Investors commonly use this principle to help value commodities (currencies, oil, gold, silver etc.) which do not produce cashflows, and as an alternative or in addition to using NPV for operational assets like a business.
Finance and the Timing of Purchases
Without finance, financial institutions and investors the world would move very s-l-o-o-o-w-l-y.
Lets say you are 28 years old and have a job and a young family. Your household income is $78,000 per year (average in Canada), but you don’t have much saved for a house. Well without financial contracts, banks, investors you would have to wait many years before buying your first home (average cost $375,000) depending on what you save each year.
The issue is you need a house NOW because you need space for your kids to grow up. See this is a timing problem solved by finance. You can go to a private investor or a bank, to get a $375,000 loan NOW to buy the house and slowly pay them back with interest (to compensate for the uncertainty they face) at a reasonable expense each year (maybe $16,000). The alternative is you save those $16,000 per year for 24 years and buy that house when you are 52 years old and your kids have already grown up, moved away and you don’t even need the extra space anymore!
TL;DR
At age 28 you HAVE an income stream but no savings to buy a house
You want to buy a house NOW because you need space to raise a family
Alternative is to save your money then buy a house, but by then you won’t NEED it.
So you get a loan to buy the house NOW when its most useful to you.
This is why its important to consider using debt to your advantage (fixing the timing problem) - not all debt is bad!
Businesses face the same consideration; they might want to grow by hiring more people or building a factory but if it had to wait 10 years to save up its own profits to make the investment many products would never come to exist and innovations would take years. So, investors provide the business with money upfront & require a rate of return in exchange. The business can now expand this year instead of in the future and greatly increase sales & profits (if successful).
General Management
Making good investments (by following the principles of time value of money and/or law of one price) and doing so at the right time instead of when you happen to have the money is critical to understand.
From there good financial management involves insuring your revenues are bigger than expenses (Revenue – Expenses = Profits), or for individuals net income is bigger than your expenses. Additionally, past returns should be evaluated to make sure they are earning a healthy Return on Investment (ROI) that’s higher than your cost of capital (interest rate, inflation etc.).
Take these to heart, internalize the concepts and think about them the next time you consider any investment. Luckily, all of these calculations are prebuilt into our tools so all you need to do is download them to get started!
Keep an eye out for our upcoming posts that break down investing fundamentals, by subscribing below!