Time Value of Money

In courses about finance in the past, as part of job-related investment projections, for personal investments and as part of exercises related to posts in this blog I have discounted cash flows several times. Discounted? To those not initiated: it is about the time value of money.

Many course of finance start with the explanation of time value of money. You can find Wikipedia’s article here.

I recently came across the most descriptive and ancient (to my knowledge) explanation of the concept.

“A bird in a hand is worth two in the bush”, Aesop, 600 B.C.

Seeking Wisdom: From Darwin to Munger, Peter Bevelin.

I found it while reading “Seeking Wisdom: From Darwin to Munger”, by Peter Bevelin, in which the author retrieved a passage from Warren Buffett’s 2000 Letter to the Shareholders of Berkshire Hathaway [PDF, 93KB, pg. 13]

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.