Frequently, investors considering DCF Income Payments are concerned that their funds may be invested ‘too long’ in a long term income stream. But even though we list inventory with a “Term” in years, or maturity, the reality is, this is often not a good representation of a case.
In fact, many cases start repaying principal and interest almost immediately. So while the ‘Term” or maturity of two cases might be the same, their Weighted Average Life, or the average amount of time each dollar of principal is invested, may be widely different. The WAL, therefore, is a more accurate way of comparing.
The final maturity date of DCF Income Payments, just as with bonds, is not always a good measure of the length of the investment. Many bonds return their principal as a single bullet at the bond’s final maturity date. But amortizing bonds, and income streams like DCF Income Payments, repay the principal amount in installments over the bond’s life. This is why the maturity date might not fully explain the liquidity of the investment.
So instead of simply looking at the maturity date, we also consider Weighted Average Life.
A more suitable metric that we prefer to use is Weighted Average Life (WAL). WAL is the average number of years for which each dollar of unpaid principal on an investment remains outstanding. It is the average time that it takes for every dollar of principal to be repaid, weighted by the size of each principal payout. Therefore, the years with higher principal payments will be weighted more heavily in the WAL calculation.
WAL helps investors gauge how quickly bonds pay out their returns. WAL also has implications for risk, because the longer capital from the original investment is held, the longer it is exposed to risks like inflation.
Three example calculations of WAL are shown below, each based on a different principal repayment schedule over a 4 year period. These examples illustrate how the WAL decreases when more repayments are made at an earlier stage in the life of the investment (e.g., end of year 1, vs end of year 3).
WAL is a more exact measurement of a cash flow for DCF Income Payments. It’s also very useful when comparing DCF Payments to other investments like bonds, with smaller coupon payments during the term and a large lump sum out at the end. Typical bonds like this are back-end weighted, and you’ll find DCF Income Payments have a generally shorter WAL when compared to bonds of a similar maturity.