The key elements that determine the value of an investment include the time value of money, expected inflation rate, risk involved, and potential returns. As investors commit funds for a period of time, they require compensation for the lost opportunity cost and expected purchasing power loss due to inflation. Investments also carry risks, so investors demand risk premiums. Considering these elements, the investment value is the present value of its expected future cash flows discounted at the required rate of return. Proper assessment of investment value requires analyzing factors like interest rates, inflation, and risks inherent in the investment asset.
Time value of money is basis for investment value
The time value of money is a fundamental component in determining investment value. When funds are committed to an investment, the investor loses liquidity and gives up the ability to consume or utilize those funds for a period. This concept forms the basis for charging interest on loans. Similarly, investors want compensation for parting with their money when they purchase investment assets like stocks, bonds or real estate. The longer the investment horizon, the higher the required rate of return to account for the time value.
Expected inflation erodes investment purchasing power
Investment value depends on maintaining future purchasing power. Over time, inflation causes money to lose purchasing power. So investors demand inflation compensation when locking funds in investments, to offset expected price increases over the investment horizon. If $100 today will only buy goods worth $80 a few years later, the investment made today needs to grow to over $100 to beat inflation. Therefore, investment assets need to provide expected returns above inflation to retain value.
Uncertainty of returns increases investment risk
Investments carry risk arising from uncertain cash flows. No one can guarantee definite future returns for stocks or other assets. This uncertainty means actual returns may end up higher or lower than expectations. Investors are generally risk-averse, so they demand extra compensation for higher uncertainty. Riskier assets need to offer higher expected returns to compensate investors. Government bonds carry lower risk than corporate bonds or stocks, so offer lower returns. Assessment of investment value factors in this risk-return tradeoff.
Investment value equals discounted expected cash flows
Considering the time value of money, inflation and risk, the value of an investment asset equals the present value of its expected future cash flows, discounted at the rate of return deemed appropriate given its riskiness. This discounted cash flow model values assets based on projections of dividends, coupon payments, rental income, or other expected payouts. The risk-adjusted discount rate reflects what return investors demand to invest in the asset instead of safer securities like Treasury bills. Comparing an investment’s discounted cash flows to its market price provides an estimate of whether it is undervalued or overvalued.
Investment value depends on the time value of money, expected inflation, uncertainty of returns, and potential cash flows generated by the asset. Analysts evaluate these parameters to estimate appropriate rates of return, discount expected payouts from the investment to present value, and gauge if market prices offer value relative to intrinsic value estimates.