Remember that stock prices are not about the past. They are a prediction of future cash flows discounted back to the present.
- Jeff Bezos, 2020 Letter to Shareholders
The first sentence in the financial decision-making lecture notes states: $1 received today is preferred to $1 received sometime later.
This is because if you don't receive the $1 today, you may lose potential income, such as interest; lose purchasing power due to inflation; and increase uncertainty, such as the payer's company going bankrupt.
To calculate the value difference between $1 received today and $1 received sometime later, the concepts of PV and FV are used, where PV stands for present value and FV stands for future value.
FV = PV * (1+ interest rate) years
This leads to the distinction between simple interest and compound interest:
Simple interest: FVt = PV * (1 + t * r)
Compound interest: FVt = PV * (1 + r)t
According to the compound interest calculation cycle, there is annual compounding, daily compounding, and continuous compounding. The formula for calculating continuous compounding is
FVt = PV * er * t = PV * 2.718r * t
Under the same PV, Interest rate, and time period, the shorter the compound interest calculation cycle, the higher the FV.
Of course, extending further, there are more concepts that help in understanding investment returns, including calculating NPV, IRR, Payback, PI:
NPV - Net present value
IRR - Internal rate of return
The interest rate that makes the NPV = 0 in the equation above
PI - Profitability index
Payback and Discounted payback period
Represent the payback time and the payback time calculated by discounting future revenues into PV, respectively.
Run a company like making an investment. We now also calculate NPV, IRR, PI, and Payback for different internal projects, which incorporates factors such as payback period and return size. From the perspective of funding sources, we also consider the cost of capital, after all, as Uncle Buffett said, in addition to finding good companies that can be held for decades, it is also necessary to have long-term low-cost sources of funds. 😊
Tomorrow, I will talk about sunk costs and opportunity costs.