By Daniel Archibald | CFA
"The two most powerful warriors are patience and time." - Leo Tolstoy
"Someone is sitting in the shade today because someone planted a tree a long time ago." - Warren Buffett
We all understand the concept of investing over time and earning interest on money we lend to others. In essence, a dollar today is worth more than a dollar tomorrow and most of us require a return for parting with our own capital. This return may be in the form of interest, dividends, rent, distributions, capital appreciation or some other income.
There are a number of ways to work out how much return you require, or how much you will receive, when investing or lending money. And a good way to think about it is by using 'risk premia'. You could have a risk premium for any number of factors, but common factors include:
- Time preference risk premium - This is typically the base premium for a required return and is usually the risk-free rate. That is, it is the rate of return we require when we don't take on any risk, and the only thing we need to be compensated for in parting with our cash is time. The risk-free rate is usually estimated as the long-term Government bond rate
- Market risk premium - This is the overall risk to investing in the broader market
- Business risk premium - This is the risk of the specific investment not captured in the market. This is sometimes measured as a sensitivity (beta) to the market rather than a premium on top of the market
- Credit risk premium - This is the risk of default and recovery and usually associated with debt investments
- Other premiums - Investors/lenders may add risk premiums for other factors including additional liquidity risk, country risk, currency risk or manager risk, depending upon the type of investment
This build-up approach to calculating the required return on an investment highlights the relationship between risk and return (i.e. the higher the risk, the higher the return required). Risk and the associated required return are fundamental in understanding the price we should pay for an investment. And at the heart of all valuation models lies this concept of risk, return and time. The less risk and the less time required to receive benefits, the greater the value of an investment.
There are thus 3 ways to increase the value of a business or other asset:
- Increase cash returns (profits/benefits)
- Decrease risk to receiving cash return
- Decrease time taken to receive cash returns
Thus, a good investor will not only focus on profitability. Maximising values is not only about maximising profits. Nor is it just about minimising risk. The value of time is a critical component of the end return to investors and should play a key role in the investment decision-making process.
"My favorite things in life don't cost any money. It's really clear that the most precious resource we all have is time." - Steve Jobs