What is a Fixed Deposit, and how to value a fixed deposit?

Interesting question, right?

We have heard about stock valuation. But “who” values fixed deposits of banks?

Whether it is necessary? Is it worth an effort?

Necessary? Not really. 

Worth an effort? Yes, because it helps us get a perspective about the process of valuation.

Before one goes ahead to learn stock valuation, understanding how to value a fixed deposit can frame the basics.

What is valuation?

Valuation if the process using which we can estimate worth of an “asset”.

What are assets? Anything which generates positive cash flows in future. 

If there are no “positive cash flows”, it is not an asset.

As an investor, it is very important to realise the following about ones investments:

• What will be the future cash flows (CFs)?
• What is my holding time (T)?

To be an asset, the investment must generate positive future cash flows (CFs). 

Once a person is aware of “CFs and T”, the next step is to estimate the “present value” of all CFs. 

This process of estimating future cash flows (CFs in time T), and calculation of “present value” of CFs is called valuation. 

Confused? Lets take an example.

# Car is an asset?

On purchase of a car (Cost Rs.600,000), what will be the future cash flows?

Suppose one wants to hold the car for next 5 years only.

Lets make another set of assumptions:

• Cost of fuel refilling per month = Rs.2,500.
• Cost of maintenance per year = Rs.20,000.
• Resale Value after 5 years = Rs.300,000.

Based on these assumptions what are the future cash flows related to this purchase?

All Cash Flows in next 5 years:

CF (year 1) = – (Rs.2,500×12 + 20,000) = – Rs.50,000

CF (year 2) = – (Rs.2,500×12 + 20,000) = – Rs.50,000

CF (year 3) = – (Rs.2,500×12 + 20,000) = – Rs.50,000

CF (year 4) = – (Rs.2,500×12 + 20,000) = – Rs.50,000

CF (year 5) = – (Rs.2,500×12 + 20,000) = – Rs.50,000

CF (year 5) = + Rs.300,000 (resale value)

Present Value of CF1 + CF2 + CF3 + CF4 + CF5 is negative. 

Hence car is not an asset.

What is an asset?

Present Value of CFs > Cost of Purchase. 

The process of calculation of present value of all future CF’s is called valuation.

I know the example of car was like a deviation from our topic. But I though to use this diversion to make a point.

What is the point?

Estimation of “all” future cash flows, whether they are negative or positive is essential for correct valuation of an investment.

Why we must learn correct valuation technique?

One of the bigger objective of life is to become financially independent one day.

To achieve this objective, one must buy assets, and not liabilities.

In the above example, car purchase was an example of “liability purchase” and not an asset purchase. 

We often buy more liabilities in life than assets. 

This peculiar habit of ours prevents us from becoming financially independent. 

How to get rid of this habit? By learning how to value things (financially). 

How this will help?

Valuation will help in differentiating assets from liabilities. 

So, how to learn valuation? 

Step one can be to learn how to value a fixed deposit (FD).

How to value a fixed deposit?

To value a fixed deposit, we must use this valuation formula:

V = Present Value, n = Holding Time, I = Interest Earned Each Year, P = Principal, r = potential return.

Lets value this fixed deposit of an Indian Bank using the above formula. 

• Deposit Value (P): Rs.100,000.
• Interest Rate Offered: 7.25% p.a.
• Period (n): 5 Years. 
  

In addition to these values, lets factor-in the “potential of the market (r)“.

What does this mean?

An investor, who is buying a fixed deposit does not want to take lot of risk. 

But there are debt based mutual funds which can also be considered safe. 

Such debt based mutual funds can easily generate 8% p.a. for time horizon of 5 years. 

Hence we can say that, the market has potential to generate a risk free return of 8% p.a.

In this example, we will consider r = 8%. 

#Case 1 – Interest payable at end of each year

What will be the future cash flows?

All Cash Flows in next 5 years:

CF (year 1) = + (Rs.100,000 x 7.25%) = + Rs.7,250.

CF (year 2) = + (Rs.100,000 x 7.25%) = + Rs.7,250.

CF (year 3) = + (Rs.100,000 x 7.25%) = + Rs.7,250.

CF (year 4) = + (Rs.100,000 x 7.25%) = + Rs.7,250.

CF (year 5) = + (Rs.100,000 x 7.25%) = + Rs.7,250.

CF (year 5) = + Rs.100,000 (principal amount).

Lets apply the formula_1

V = Rs.28,948 + Rs.68,058 = Rs.97,005

What is Rs.97,005? Return. It is the present value of all future cash flows generated by the FD. 

It also answers this question, what is the true value of FD available today at price of Rs.100,000 @7.25% per annum?

Its value is Rs.97,005.

Is it worth investing in this FD? No. 

• How much is invested? Rs.100,000 today.
• What Return in expected? Rs.97,005 in 5 years.

Return in less than the invested value. This is not an asset. 

Not worth investing. 

#Case 2 – Interest payable at maturity.

What will be the future cash flows?

All Cash Flows in next 5 years:

CF (year 5) = Rs.41,901 [ P*(1+r)^n – p] 

CF (year 5) = + Rs.100,000 (principal amount).

V = Rs.28,517 + Rs.68,058 = Rs.96,575

Is it worth investing in this FD? No. 

• How much is invested? Rs.100,000 today.
• What Return in expected? Rs.96,575 in 5 years.

Even worse than Case-1. 

Conclusion…

Yes, you heard me right fixed deposits are not worth investing in. 

For me, fixed deposits are not investment option.

They are a great savings option. But they are not good investment. Why?

Because there are other options available in the market which can generate higher returns than FD, for almost the same risk level. 

So, what we can finally conclude from this article?

Two things:

• Always value your investments before buying. 
• Use FD only as a saving option.
• Liquidate savings to buy assets. 
• Assets generate higher returns. 

Read more about goal based investments. 

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