Discounted cash flow (DCF)

Discounted cash flow analysis rests on a single idea: a dollar received in the future is worth less than a dollar today, because today's dollar can be invested and earn a return. To value any asset that produces cash — a bond, a stock, a business, a rental property — you forecast each future cash payment, shrink it by an appropriate discount rate, and add up the results.

Each payment is discounted by dividing it by (1 + r) raised to the number of periods until it arrives, where r is the discount rate. A $1,000 payment due in two years discounted at 5% is worth $1,000 / 1.05², or about $907 today. Bonds are the cleanest application because their cash flows are contractual: discount every coupon payment plus the principal repayment at maturity, sum the present values, and you have the bond's theoretical price.

The discount rate is the judgment call that drives the answer. It reflects the return an investor could earn elsewhere at comparable risk, so a riskier or longer-dated cash flow gets a higher rate and a smaller present value. This also explains why bond prices move inversely to interest rates: when market rates rise, the discount rate applied to a bond's fixed coupons rises, and the calculated value falls.

Comparing the DCF value to an asset's market price produces an investment decision. If the present value of the expected cash flows exceeds the price, the asset looks undervalued; if it falls short, it looks expensive. This is the same machinery behind net present value in capital budgeting.

The Series 65 and Series 66 exams cover discounted cash flow within fixed income and debt valuation. You should be able to explain the mechanics in words, identify the discount rate as the required rate of return, and reason about how a change in rates moves the present value — the exams test the concept and its direction far more often than they ask for a full computation.