The Discounted Cash Flow (DCF) analysis is one of the most important valuation methodologies in investment banking. Understanding how to build and explain a DCF is essential for technical interviews.
What is a DCF?
A DCF values a company based on the present value of its future cash flows. The core principle is that a dollar today is worth more than a dollar tomorrow due to the time value of money. By discounting projected future cash flows back to present value, we can determine what a company is worth today.
The DCF is considered an intrinsic valuation method because it values a company based on its own fundamentals, not based on what similar companies are trading at in the market.
Projecting Free Cash Flows
Free Cash Flow to Firm (FCFF) is typically used in DCF analysis. The formula starts with EBIT, then subtracts taxes to get NOPAT (Net Operating Profit After Tax). We then add back depreciation and amortization since they're non-cash expenses. Next, subtract capital expenditures and changes in net working capital.
Projections typically cover 5-10 years. Use historical trends, management guidance, and industry research to inform your assumptions. Be prepared to defend every assumption in an interview.
Calculating WACC
The Weighted Average Cost of Capital (WACC) is the discount rate used in a DCF. It represents the blended cost of a company's debt and equity financing. The formula weights the cost of equity and the after-tax cost of debt by their proportions in the capital structure.
Cost of equity is typically calculated using CAPM, which incorporates the risk-free rate, the market risk premium, and the company's beta. Cost of debt can be found using the company's existing debt yields or comparable company debt.
Terminal Value Methods
Since we can't project cash flows forever, we calculate a terminal value to capture value beyond the projection period. Two main methods are used: the Gordon Growth Method applies a perpetual growth rate to the final year's cash flow, while the Exit Multiple Method applies a market multiple to a financial metric.
Most bankers use terminal value assumptions that imply the company reaches a steady state of growth around GDP growth rates (2-3%). The terminal value typically represents 60-80% of total DCF value.
Sensitivity Analysis
A DCF is highly sensitive to assumptions, particularly the discount rate and terminal growth rate. Sensitivity tables show how changes in these assumptions affect the final valuation. This helps establish a valuation range rather than a single point estimate.
In interviews, always mention that you would sensitize key assumptions. This shows you understand the limitations of DCF analysis and think critically about valuation.