Discounted Cash Flow (DCF) Method
The most well-known method of determining the value of fixed-income securities is the discounted cash flow (DCF) model. The DCF method calculates the present value of all the future cash flows of a fixed income investment. Recall that present value is what some future amount would be worth today. This includes every interest payment received, as well as the return of the original principal invested, which is usually the face value of the security. The present value of each payment is calculated using the present value formula:
For example, if a $1,000 bond could be purchased today that would pay $25 every six months for the next ten years, as well as return the original $1,000 ten years from now, the discounted cash flow method would calculate the present value of each one of these future amounts. Once all present values of all the payments are calculated, they’re added to arrive at a total discounted cash flow for the future of the security. If this total is greater than the current price of the bond or fixed income security, it would be considered a good deal and should be bought. This conclusion is based on the belief that the investor is essentially buying the right to the future cash flows of an investment at a discount to what they’re worth when the present value is calculated. Conversely, if the discounted cash flows were less than the current price of the bond or security, this method of valuation would say that it is overpriced and should be avoided.
Example: Imagine that you are considering a bond that pays 5% each year for 5 years. The bond is selling at $950 and will mature at $1,000. Is it a good value? Consider the following payment structure. Imagine that interest rates have risen since the bond was issued and comparable bonds are now paying 5.5%. For the discounted cash flow method, you would use 5.5% as your discount rate. If the bond had just been issued, the discount rate would most like