Time value of money
The time value of money is the principle that a sum today is worth more than the same sum in the future because it can earn a return.
A pound today is worth more than a pound next year, and that simple truth is the foundation of all of finance.
The time value of money is the principle that a sum of money is worth more now than the same sum in the future, because money available today can be invested to earn a return. It is the single most fundamental idea in finance, underlying valuation, investment, and the pricing of nearly everything.
Why sooner beats later
Money now is worth more than money later for several reasons. It can be invested to earn interest or returns, so a pound today can grow into more than a pound tomorrow. Inflation erodes the purchasing power of money over time, so a future pound buys less. And the future is uncertain, so a promise of money later carries risk that money in hand does not. Together these mean that the timing of a cash flow, not just its size, determines its value.
Discounting and compounding
The time value of money works through two related operations. Compounding projects a present sum forward, showing what it grows to over time as returns accumulate on returns. Discounting does the reverse, translating a future sum into its worth today by reducing it according to the return it could otherwise have earned. The discount rate, the rate used to shrink future cash flows to present value, is the engine of valuation: it captures the return required and the risk involved, and small changes in it can change a valuation dramatically.
Why it underpins everything
Almost every financial decision rests on the time value of money. Valuing an investment means discounting its future cash flows to the present, the basis of net present value and discounted cash flow analysis. Pricing a bond, a loan, a pension, or a company all depend on it. Comparing options that pay out at different times requires putting them on a common footing through discounting. Without the time value of money, sums arriving at different dates could not be meaningfully compared at all.
The time value of money is the bedrock on which finance is built, the recognition that when money arrives matters as much as how much. It is the reason future cash flows must be discounted to be valued, the foundation of investment appraisal, and the simple but profound truth that makes the whole apparatus of valuation, pricing, and financial decision-making possible.