Do Not Waste Your Time Studying Finance Until You Have Understood This One Underlying Principle

Finance is an enormous field and subject area – yet it all boils down to a single concept.

One principle.

One idea.

The idea that the value of anything – anything at all – is always, always, always based on…

The Present Value of Future Expectations

But what exactly does that mean?

Well, the good news is…

  • You’ve applied all your life.
  • You’re applying it now.

And guess what

  • You’ll continue to apply it, for the rest of your life.

Lets ask a few questions

  • Why are you reading this? – to gain a solid understanding of the one underlying principle of finance.
  • Why do you go to College / University? – to get a good degree, learn, grow, become employable, acquire new skills, etc.
  • Why do you go to the cinema? – to watch a good movie and relax.
  • Why do you go to the gym?  to keep fit and healthy.
  • Why do you go for a walk? – to feel refreshed perhaps.

Notice that with all the examples above, there’s one thing in common – a trend, if you like.

You take actions in the present, based on future expectations. Sure, it may not pan out the way you planned…

For instance, you could go to the cinema with the expectation of watching a good movie and relaxing.

But the movie could be just plain awful.

But you don’t go to the cinema expecting the movie to be awful. Why would you?

But it could turn out to be awful nonetheless.

You take a chance.

You take a risk, if you will… with the expectation of a benefit in the future.

See where we’re going with this?

Finance bases itself on this very simple principle…

The Value of Anything is Always, Always, Always Based On The Present Value of Future Expectations.

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Notice the term value? Yeah, this is where it gets really cool.

Finance not only evaluates future expectations… it quantifies them.

It then allows you to see whether or not it’s worth taking the action right here, right now.

You actually do this too.

Yes, you do. Knowingly or unknowingly, you quantify your expectations.

Let me prove it. Imagine…

A Justin Bieber concert is coming up soon (so help us God).

You will…

  1. Be incredibly excited about it and can’t wait to get tickets, then experience… well, Bieber erm… sing? You get the idea. OR
  2. Be annoyed that the concert will take place, and that that’ll mean people talking about it – something that’s the equivalent of you eating marmite if not worse. OR
  3. Not really care about it since you’re indifferent to Beiber.

Depending on your expectation, you’ll take a decision in the present to…

  1. Buy a ticket and go for the concert, OR
  2. Not buy a ticket, but stay really annoyed / mad about the notion that a lot of people will be talking about it, OR
  3. Not do anything, and not care

Finance works in exactly the same way!

Of course, most of the time we don’t spend our time quantifying Bieber’s concerts, although we’re confident, sadly (in our opinion), that there’ll be people doing that too.

In the context of Finance specifically, the quantifying stays focused on monetary items.

Questions this principle helps us solve and find answers to include:

  • Should we invest in a particular company? A project? An idea?
  • Should we buy a machine, rent it, or lease it?
  • Should we buy that property today? Next year? Later than that?

In evaluating any of those, we want to be able to quantify the risks associated with them.

There are broadly 2 kinds of risks

But they both have several names – even though they all refer to the same thing.

And that’s because we love jargon!

So what are these 2 kinds of risk?

There’s the kind of risk that we can’t control ourselves individually, nor do anything to impact it.

We call this type, the ‘Market Risk’. This includes things like:

  • Inflation
  • Deflation
  • Recession
  • Depression
  • Boom (for some businesses)
  • Changes in interest rates (for several reasons, but don’t worry about that)

And because we love jargon, we’ve come up with several different obnoxious sounding terms to refer to the ‘Market Risk’. These include:

  • Systematic risk
  • Non-diversifiable risk (because we can’t do anything about it, we can’t eliminate it, we can’t diversify it away)
  • Non-unique risk

Then there’s the kind of risk that we can actually control, and do something to impact / influence it.

We refer to this sort of risk as ‘Firm Specific Risk’

And of course, there are several other terms for it, and we’ll get to that – don’t you worry!

This type of risk would include:

  • The risk of the company going bankrupt
  • The founder / CEO dying (sure, we can’t make them immortal, but we could put in steps to ensure their death doesn’t have a significantly adverse (bad) impact on the firm.
  • Idiotic managers
  • Poor decision making
  • Accounting scandals, money embezzlement, money laundering, and other dirty things

Did we mention we love jargon? Here’s 5 other terms that all mean, and refer to exactly the same thing: firm specific risk…

  • Unsystematic risk
  • Unique risk
  • Idiosyncratic risk
  • Diversifiable risk (because we can do something about it, we can eliminate it, we can diversify it away)
  • Standard Deviation of Epsilon (this is more technical than something that’s commonly used)

It’s reasonable to suggest / expect that most if not all investments, companies, projects, etc will have exposure to both types of risks to some extent or the other.

And given that fact, it’s of course important for us to incorporate all of those risks when we’re evaluating any sort of investment.

That dear student, is exactly what finance empowers us to do.

It enables us to incorporate all of these risks into one, tiny little, beautiful and elegant number.

A number we commonly refer to as… The Discount Rate.

It’s also called “r”, the cost of capital, and 10 other terms. Because we love jargon.

And that little, beautiful number incorporates all of those risks:

  • Market risk: i.e. inflation, deflation, recession, depression, boom, changes in interest rates.
  • Firm specific risk: i.e. bankruptcy, death of the founder/CEO, idiotic managers, poor decision making, nasty things like accounting scandals, money embezzlement, etc.

Well… at least it should!

And whether it does, depends on how you compute it.

You could compute the discount rate using any of the following models

  • Capital Asset Pricing Model (“CAPM”)
  • Dividend Yield
  • Dividend Discount Model
  • Dividend Discount Model with Growth (“Gordon Growth Model”)
  • Arbitrage Pricing Theory (APT)
  • Weighted Average Cost of Capital (“WACC” – by applying algebraic manipulations)
  • Modigliani & Miller I (“M&M I”)
  • Modigliani & Miller  II (“M&M II”)
  • Interpolation

By the way, Modigliani & Miller can be thought of as the rock stars of Finance – we’d equate them to the Beatles band.

Each of these models has its own benefits and flaws – but that’s a whole other topic – a topic we’ll be talking about in a future blog post.

The important thing to note is that you have a variety of choices (we intentionally avoided the word ‘options’ here, for reasons we’ll talk about in a future post), to achieve 1 objective – incorporating risk when valuing assets.

The way you value something is also influenced by how frequently it makes you money.

For instance…

  • Does it earn you money one time, and one time only?
  • Does it make you that money today, next week, next month, next year, a few years later?
  • Does it earn you money several times?
  • Is it the same amount of money each time? If so, does that start from next week, next month, next year, a few years later?
  • Does that last for several years?
  • Does it last forever?

There are 16 different formulas that help us assess and estimate the value of each of those alternatives (and other alternatives), today.

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Finance as a whole can be broken down into:

  • Corporate Finance, and
  • Asset Markets

Depending on which books you read, who your professor is, each of the areas will have between 10 and 30 different ‘topics’ or chapters. Perhaps even more. But the important thing is that the one underlying principle…

The value of anything is always, always, always based on the Present Value of Future Expectations can be applied to most concepts – about 90% of concepts.

For instance, it applies to…

  • Time value of money
  • Investment Appraisal (aka Capital Budgeting)
  • Stock Valuation
  • Bond Valuation
  • Firm Valuations
  • Project financing

Each of those can be broken down into several ‘mini’ topics. For instance, the underlying Principle will apply to all forms of stock valuation, be they…

  • Valuation using discounted cashflows through DDM, Gordon Growth etc)
  • Valuation using multiples (P/E, Enterprise, Turnover)
  • Valuation using options

It also applies to most investment appraisal techniques like:

  • Net Present Value (“NPV”)
  • Internal Rate of Return (“IRR”), indirectly
  • Profitability Index (“PI”)
  • Discounted Payback

But it doesn’t apply to ‘Accounting Rate of Return’ – which is a flawed technique anyway, so that doesn’t really count!

You get the idea. We’re going to stop for now dear student.

But we will be writing other interesting finance related blog posts in future, covering a variety of areas.

If you’d like us to do a post on any specific topic you’re struggling with, feel free to share that by commenting below. We’d love to write about it and help you get one step closer to acing your exam and loving the beauty that is Finance!