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Walk me through a DCF analysis.
A DCF values a company by projecting its future free cash flows and discounting them back to present value using WACC. You project FCF for 5-10 years, calculate a terminal value, and discount everything back to get enterprise value.
Why Interviewers Ask This
The DCF is considered the most fundamental valuation methodology because it values a company based on its intrinsic cash flow generation rather than relying on market comparables. Interviewers ask this question to assess your understanding of core finance concepts including time value of money, cost of capital, and cash flow analysis. A strong answer demonstrates you understand how to build a valuation from first principles, which is essential for transaction analysis and client advisory work.
How to Structure Your Answer
Structure your answer in five clear steps: First, explain the concept and why we use DCF. Second, walk through projecting unlevered free cash flow. Third, explain calculating the discount rate (WACC). Fourth, describe terminal value calculation. Fifth, explain how to derive enterprise value and equity value. Keep each section concise but show you understand the key inputs and assumptions at each step.
Key Points to Cover
- Start with historical financials and project revenue growth
- Calculate unlevered free cash flow: EBIT × (1 - Tax Rate) + D&A - CapEx - Change in NWC
- WACC = Cost of Equity × (E/V) + Cost of Debt × (1-T) × (D/V)
- Terminal value via Gordon Growth or Exit Multiple method
- Discount all cash flows back to present value
- Sum of discounted FCFs + discounted TV = Enterprise Value
- Subtract net debt to get equity value
Sample Answer
A DCF, or Discounted Cash Flow analysis, values a company based on the present value of its future free cash flows. The fundamental principle is that a dollar today is worth more than a dollar in the future, so we discount future cash flows back to today's value.
Here's how I'd walk through the process:
First, I'd project the company's unlevered free cash flows, typically for 5-10 years. Unlevered free cash flow equals EBIT times one minus the tax rate, plus depreciation and amortization, minus capital expenditures, minus the change in net working capital. This represents the cash available to all capital providers.
Second, I'd calculate the discount rate, which is the Weighted Average Cost of Capital or WACC. WACC equals the cost of equity times the equity weight, plus the after-tax cost of debt times the debt weight. The cost of equity is typically calculated using CAPM.
Third, I'd calculate the terminal value to capture the company's value beyond the projection period. This can be done using either the Gordon Growth Method, where terminal value equals the final year FCF times one plus the growth rate, divided by WACC minus the growth rate. Or you can use an exit multiple approach.
Finally, I'd discount all the projected free cash flows and the terminal value back to present value using WACC, then sum them up to get enterprise value. To get equity value, I'd subtract net debt from enterprise value.
The key sensitivities in a DCF are the discount rate and terminal value assumptions, since small changes can significantly impact the valuation.
Deep Dive: Worked Walkthrough
A discounted cash flow analysis values a business as the present value of the cash it will generate for all capital providers, discounted at the blended cost of that capital. The intuition: a company is worth what it will pay you in the future, adjusted for the time value of money and the risk that those payments don't materialize. Unlike comps or precedents, a DCF is intrinsic — it doesn't depend on what the market thinks about peers today.
**Step 1: Project Unlevered Free Cash Flow for 5–10 years.**
I start with a revenue build. Say I'm valuing a mid-cap industrial with $1,000M of revenue today, growing 6% in Year 1, decelerating to 3% by Year 5. Then I project EBITDA assuming a 20% margin expanding 50bps per year on operating leverage. From EBITDA I subtract D&A (typically 4–5% of revenue), then apply the marginal tax rate — call it 25% — to get NOPAT. I add back D&A (non-cash), subtract CapEx (5% of revenue, tapering to maintenance levels of ~D&A by terminal year), and subtract the change in net working capital (roughly 10% of incremental revenue for a working-capital-heavy business).
| ($M) | Y1 | Y2 | Y3 | Y4 | Y5 | |---|---|---|---|---|---| | Revenue | 1,060 | 1,123 | 1,184 | 1,243 | 1,280 | | EBITDA (20–22%) | 212 | 230 | 248 | 267 | 282 | | Less: D&A | (48) | (51) | (54) | (56) | (58) | | EBIT | 164 | 179 | 194 | 211 | 224 | | Less: Taxes @ 25% | (41) | (45) | (49) | (53) | (56) | | NOPAT | 123 | 134 | 146 | 158 | 168 | | Plus: D&A | 48 | 51 | 54 | 56 | 58 | | Less: CapEx | (53) | (56) | (59) | (62) | (64) | | Less: Δ NWC | (6) | (6) | (6) | (6) | (4) | | **Unlevered FCF** | **112** | **123** | **135** | **146** | **158** |
Critically, I use NOPAT (EBIT × (1 − tax)), not net income, because UFCF is the cash flow available to *all* capital providers — debt and equity. Using net income would double-count the interest tax shield.
**Step 2: Calculate WACC.**
Cost of equity via CAPM: with the 10-year Treasury at 4.2%, an equity risk premium of 5.5%, and a re-levered beta of 1.1, Ke = 4.2% + 1.1 × 5.5% = **10.25%**. Cost of debt: pre-tax yield to maturity on existing bonds is ~6%, after-tax that's 6% × (1 − 25%) = 4.5%. With a target capital structure of 70% equity / 30% debt at market values, WACC = 0.70 × 10.25% + 0.30 × 4.5% = **8.5%**.
**Step 3: Terminal Value.**
The TV captures everything past Year 5. Two methods, and I always cross-check.
Gordon Growth: TV = FCF_Y5 × (1 + g) / (WACC − g) = 158 × 1.025 / (0.085 − 0.025) = **$2,698M**. Use g = 2.5% — long-run developed-market GDP — never higher.
Exit Multiple: TV = EBITDA_Y5 × multiple = 282 × 8.0x = **$2,256M**. Choose the multiple based on where mature peers trade today, not where they trade at the cycle peak.
The two should be within ~15–20% of each other. If they're not, one of the assumptions is broken.
**Step 4: Discount everything back.**
PV of each year's UFCF = CF_t / (1 + WACC)^t, using mid-year convention. Sum the five PVs (~$540M) plus the discounted TV (~$1,800M using GGM, discounted at 8.5% over 4.5 years) for an **enterprise value around $2,340M**.
**Step 5: Bridge to equity value.**
Equity Value = EV − Debt − Preferred − Minority Interest + Cash + Non-operating assets. If the company has $400M debt and $50M cash, equity value = 2,340 − 400 + 50 = **$1,990M**.
**Step 6: Sensitivity and sanity checks.**
I build a 2-way sensitivity on WACC (±100bps) and terminal growth (±50bps), and a separate one on exit multiple. I also check what % of EV comes from terminal value — if it's >75%, the DCF is really a terminal-value model.
**When DCF breaks down.** Early-stage companies with negative FCF make every dollar of value sit in the terminal — garbage in, garbage out. Cyclicals at the top of the cycle look great until they don't; you need to normalize. Banks and insurers don't have meaningful CapEx or working capital — use a dividend discount model instead. For LBOs and highly levered situations, APV is cleaner because the capital structure changes every year.
Likely Follow-Up Questions (with answers)
How do you calculate WACC?
WACC is the blended return required by all capital providers, weighted by market values. Cost of equity comes from CAPM: Ke = Rf + β × ERP — use 10-year Treasury for Rf, ~5.5% ERP, and a re-levered industry beta. Cost of debt is the YTM on outstanding debt times (1 − marginal tax rate). Weights must be at market values, not book. For a typical mid-cap industrial: 70/30 equity/debt, Ke ~10%, after-tax Kd ~4.5%, WACC ~8.5%.
What discount rate would you use for a private company?
Build a synthetic WACC using public comps. Pull 5–8 peers' levered betas, unlever each, take the median, then re-lever to the private company's target capital structure. Add a size premium (Duff & Phelps publishes ~100–400 bps for sub-$500M cap). For Kd, use the rate the company actually pays, or estimate from a synthetic credit rating based on interest coverage. Some practitioners add an illiquidity premium of 200–500 bps to Ke.
What's the difference between FCFF and FCFE?
FCFF (unlevered FCF) is cash to all capital providers before financing decisions: EBIT × (1 − t) + D&A − CapEx − ΔNWC. Discount at WACC to get EV. FCFE is what's left for equity after debt service: NI + D&A − CapEx − ΔNWC + Net Borrowing. Discount at cost of equity to go directly to equity value. FCFE is volatile when capital structure changes — bankers use FCFF for most operating companies.
How do you handle negative FCF in early years?
Three things: extend the projection period to 10 years until steady-state; cross-check the implied terminal multiple — if GGM TV implies 25x EBITDA exit, the growth/margin assumptions don't moderate enough; run probability-weighted scenarios (base/bull/bear) since 90% of value is in the terminal. For pre-revenue, lean on real options or scenario-based valuation.
Why might DCF overvalue vs comparable companies?
Terminal value assumptions compound — a 3% perpetuity rate, plus small WACC errors, swings TV by 20%+. Management projections are usually optimistic (the hockey-stick problem). DCF assumes the company achieves target capital structure smoothly and faces no execution risk — comps implicitly price in that messiness. The right framing: DCF and comps are complements, not substitutes.
What Interviewers Watch For (Red Flags)
Mistakes that flag weak candidates: (1) Discounting net income or levered FCF at WACC — double-counts the tax shield. (2) Forgetting to add back D&A on the cash flow walk. (3) Using book values for WACC weights instead of market. (4) Setting Gordon Growth above long-run GDP (2.5–3%) — implies the company eventually becomes the entire economy. (5) Not cross-checking GGM and exit-multiple TV. (6) Using legacy debt coupon as Kd instead of current YTM. (7) Forgetting mid-year convention. (8) Treating EV as equity value — must bridge through debt, cash, preferred, MI.
Common Mistakes to Avoid
- Forgetting to discount the terminal value back to present value
- Using levered free cash flow instead of unlevered
- Not matching the terminal growth rate with long-term GDP or inflation expectations
- Confusing enterprise value and equity value
- Not mentioning the key assumptions and sensitivities
Pro Tip
Always mention that DCF is highly sensitive to assumptions, particularly the discount rate and terminal value. This shows you understand the practical limitations of the methodology.
