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Monday, August 07, 2006

What is a Stock Worth? Part 1 – The Time Value of Money

By William Trent, CFA of Stock Market Beat

It is easy to find out how much a share of stock costs. The current (or recent) share price is published in numerous places, such as Yahoo! Finance. It is another thing, however, to find out how much a stock is worth. Why are you better off buying a share of stock as compared to a bond, or a certificate of deposit, or just spending the money on a new plasma TV?

The place to start (figuring out the value of a stock, that is) is the Time Value of Money, which is the most basic financial concept there is. Just as a bird in the hand is worth two in the bush, a dollar today is worth two in the future (depending, of course, how far in the future.) The reasons for this are uncertainty and inflation. Uncertainty means you might not actually get that future two dollars, and inflation means that if you do get it, it won’t buy you as much as it would today.
With a certificate of deposit, they tell you up front what the time value of your money is. If the CD pays 5% per year, that is the time value of your money. The 5% compensates you for inflation and for being unable to access your money for a certain amount of time. Since most CDs are covered by FDIC insurance, though, they are not compensating you for much (if any) uncertainty that you won’t get the money in the future.

You can figure out how much money will be worth in the future by multiplying the amount by (1 + r)n where r is the return paid and n is the number of years.

For instance, the value of $100 in five years in a 5% CD is $100(1 + .05)5 or $127.63. Likewise, you can figure out how much $100 in five years is worth to you today by dividing it by (1 + r)n.

In this case, $100/(1 + .05)5 = $78.35. If you plug $78.35 into the first calculation, you will see that putting that much into a CD today would give you $100 five years from now.

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