The Little Book of Valuation, Updated Edition

Chapter TwoPower Tools of the Trade: Time Value, Risk, and Statistics

SHOULD YOU BUY NVIDIA (NVID), a company that pays no dividends now but has great growth potential and lots of uncertainty about its future, or Altria (MO), a high dividend–paying company with limited growth prospects and stable income? Is Altria cheap, relative to other tobacco companies? To make these assessments, you must compare cash flows today to cash flows in the future, to evaluate how risk affects value, and be able to deal with a large amount of information. The tools to do so are provided in this chapter.

Time Is Money

The simplest tools in finance are often the most powerful. The notion that a dollar today is preferable to a dollar in the future is intuitive enough for most people to grasp without the use of models and mathematics. The principles of present value enable us to calculate exactly how much a dollar sometime in the future is worth in today's terms and to compare cash flows across time.

There are three reasons why a cash flow in the future is worth less than a similar cash flow today.

1. People prefer consuming today to consuming in the future.
2. Inflation decreases the purchasing power of cash over time. A dollar in the future will buy less than a dollar would today.
3. A promised cash flow in the future may not be delivered. There is risk in waiting.

The process by which future cash flows ...