We already have a glimpse on the three considerations before we invest. That is, risk, liquidity and return. In this article, we now tackle the last one, which is the very basic reason why we invest and that is return on investment or simply return.
When assessing an investment, you would like to find out if it will earn enough to recover your initial capital investment whether be it invested in stocks, real estate, or in a business.
In finance, investing in a business requires a study of the return on investment or ROI. It does not only involve the absolute amount of return but also the time it took to achieve that investment return. And this involves two new finance concepts that I will tackle namely, present value and future value. But before I tackle about the two terms, let me first illustrate an example on return on investment:
Scenario 1: Suppose Jack is in a buy and sell business of second hand cars. He has an initial capital of 200,000. He bought a car worth 150,000. After 3 months he later sold it at 170,000.
Scenario 2: Suppose Jill invested 150,000 in a business. He then recouped his investment by earning 100,000 every year for the next three years.
Which between them has the higher return on investment? Jack had a return on investment of 13.33% while Jill had a return on investment of 100%. Looking at the absolute figures, you may have concluded that Jill had the higher return. Unfortunately, Jack earned it in just 3 months while Jill earned it in three years. So annualizing their investment returns, Jack had earned 53.32% (13.33 multiply by 4) while Jill earned 33.33% (100 divided by 3). So undeniably, Jack earned more than Jill!
We now come to the two finance concepts I mentioned above and these are present value and future value.
Future value is simply the future value of your investment with a time reference of investing today expecting a capital appreciation in some future time. Present value is simply the value at present of an investment to be received in some future time. In finance, there’s a relationship between future value and present value and this is represented by the formula:
FV = PV [(1+I) ^n], where FV is future value, PV is present value, I is interest and n is the number of years. Please note that the symbol ^ denotes exponent.
Manipulating it mathematically, PV = FV / [(1+I) ^n].
To illustrate this, we have the following examples:
Scenario 1: Suppose you want to deposit 100,000 in a bank that gives a fixed 10% interest rate per year.
Scenario 2: Now suppose your trusted and dear friend Ana wants to borrow your 100,000 for two years and promised to give it back to you at 120,000. That’s 20% return on investment for 2 years or 10% interest per year.
Now, the question will be which of the two options will be advantageous to you? Would you rather deposit your money to the bank or lend it off to Ana? It may seem that they both provide the same returns as both have 10% annual return on investment but NO. One is better off than the other!
To show this, lets compute for the present value of Ana’s return of 120,000 after 2 years. That is, PV = FV / [(1+I)^n] = 120,000 / [(1+0.10)^2] = 99,173.554.
Alternatively, we can compute for the future value of 100,00 by depositing it in the bank for 2 years giving an interest of 10% per year. That is, FV = PV [(1+I)^n] = 100,000 [(1+0.10)^2] = 121,000.
So comparing the two options, you are better off by depositing your money to the bank which will give you 121,000 after 2 years. You’re better off by 1,000 as against the 120,000 promised to you by Ana. Where do the extra 1,000 came from? That came from the total interest of your money earned in 2 years. Because you left your money untouched, the interest income earned in the first year also earned an interest in the second year. This is what you call compound interest, which I will discuss, in the next article.
Alternatively, the present value of your money with Ana is just 99,173.554 as compared to the 100,000 present value with the bank. So you’re losing 826.446 if you invested your money by lending it off to Ana. So undeniably, you’re better off by depositing your money to the bank!
Present value and future value are two important finance concepts that will help you every time you make financial or investment decision. Not only do you have to consider that your money must earn, but you must also consider the best option available that will maximize your return on investment.
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