A discounted cash flow (DCF) analysis values a company by projecting its future free cash flows and discounting them back to present value using the weighted average cost of capital (WACC). It is the most fundamental valuation methodology in investment banking and almost guaranteed to come up in interviews.
The 5-Step DCF Framework
When an interviewer says "walk me through a DCF," structure your answer around these five steps:
Step 1: Project Free Cash Flows
Start by projecting the company's unlevered free cash flows for 5-10 years. Begin with revenue, subtract operating expenses to get EBIT, apply taxes, add back depreciation and amortization (non-cash charges), subtract capital expenditures, and subtract changes in net working capital. The formula is: UFCF = EBIT x (1 - Tax Rate) + D&A - CapEx - Change in NWC.
Step 2: Calculate the Discount Rate (WACC)
The weighted average cost of capital blends the cost of equity and cost of debt, weighted by the company's capital structure. Cost of equity is typically calculated using CAPM: Risk-Free Rate + Beta x Equity Risk Premium. Cost of debt is the company's borrowing rate, tax-affected. A typical WACC for a mature company ranges from 8-12%.
Step 3: Discount the Cash Flows
Discount each year's projected free cash flow back to present value using the formula: PV = FCF / (1 + WACC)^n, where n is the number of years in the future. Sum these up to get the present value of the projection period cash flows.
Step 4: Calculate Terminal Value
Terminal value captures the company's value beyond the projection period. There are two methods. The Gordon Growth Method uses the formula: Terminal Value = Final Year FCF x (1 + g) / (WACC - g), where g is the long-term growth rate (typically 2-3%, roughly matching GDP growth). The Exit Multiple Method applies an EV/EBITDA multiple to the final year's EBITDA. Discount the terminal value back to present value the same way as the cash flows.
Step 5: Calculate Enterprise and Equity Value
Add the present value of the projected cash flows and the present value of the terminal value to get enterprise value. To get equity value (the share price basis), subtract net debt (total debt minus cash) from enterprise value. Divide by diluted shares outstanding to get the implied share price.
How This Comes Up in Interviews
Interviewers typically ask this as an open-ended question: "Walk me through a DCF." They want a structured, 60-90 second answer covering all five steps. Common follow-ups include: "What drives the discount rate higher or lower?" "Why might you use the exit multiple method vs. Gordon Growth?" "What happens to the DCF value if WACC increases by 1%?" and "What are the limitations of a DCF?"
Common Mistakes to Avoid
- Using levered free cash flow instead of unlevered when calculating enterprise value. Levered FCF is after interest payments and corresponds to equity value, not enterprise value.
- Choosing an unrealistic terminal growth rate. Anything above 3-4% implies the company will eventually outgrow the economy, which is unsustainable.
- Forgetting to discount the terminal value back to present value. Terminal value must be discounted just like the projected cash flows.
Key Takeaways
- A DCF values a company by discounting projected future free cash flows to present value using WACC.
- Structure your answer around 5 steps: project FCFs, calculate WACC, discount cash flows, calculate terminal value, and bridge to equity value.
- Terminal value typically accounts for 60-80% of total DCF value, which is why the terminal growth rate and exit multiple assumptions are so important.
- Always mention limitations: DCFs are highly sensitive to assumptions (WACC, growth rate, margins), which is why bankers use multiple valuation methods.
FAQ
**What is the difference between levered and unlevered free cash flow?**
Unlevered free cash flow (UFCF) is cash flow before any debt payments, representing cash available to all capital providers. Levered free cash flow (LFCF) is after interest and mandatory debt repayment, representing cash available only to equity holders. DCFs typically use UFCF to arrive at enterprise value.
**Why does terminal value make up so much of a DCF?**
Terminal value captures all cash flows beyond the explicit projection period (typically 5-10 years), which represents the vast majority of a company's operating life. For a stable, long-lived company, it is normal for terminal value to represent 60-80% of total enterprise value. If it exceeds 85-90%, your projection period assumptions may be too conservative.
**When would you NOT use a DCF?**
DCFs are unreliable for early-stage companies with unpredictable or negative cash flows, highly cyclical businesses where projections are difficult, financial institutions (banks, insurance companies) where free cash flow is not meaningful, and distressed companies where going-concern assumptions may not hold.