If you’re going for an investment banking interviewInterviewsAce your next interview! Check out CFI's interview guides with the most common questions and best answers for any corporate finance job position. Interview questions and answer for finance, accounting, investment banking, equity research, commercial banking, FP&A, more! Free guides and practice to ace your interview, you’re almost guaranteed to get a question along the lines of… “Walk me through a DCF analysis” or, “How would you build a DCF modelDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow?”
The super fast answer is: Build a 5-year forecast of unlevered free cash flow based on reasonable assumptions, calculate a terminal value with an exit multiple approach, and discount all those cash flows to their present value using the company’s WACC.
Of course, it’s also a bit more complicated than that… To answer this interview question in more detail, we’ve broken it down into several basic steps below.
The key to answering “Walk me through a DCF” is a structured approach… and lots of direct experience building DCF models in Excel.
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DCF Model Template
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Walk me through a DCF Step 1 – Build a forecast
The first step in the DCF model process is to build a forecast of the three financial statements based on assumptions about how the business will perform in the future. On average, this forecast typically goes out about five years. Of course, there are exceptions, and it may be longer or shorter than this.
The forecast has to build up to unlevered free cash flowUnlevered Free Cash FlowUnlevered Free Cash Flow is a theoretical cash flow figure for a business, assuming the company is completely debt free with no interest expense. (free cash flow to the firm or FCFF). We’ve published a detailed guide on how to calculate unlevered free cash flow, but the quick answer is to take EBITEBIT GuideEBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue., less capital expenditures, plus depreciation and amortization, less any increases in non-cash working capitalNet Working CapitalNet Working Capital (NWC) is the difference between a company's current assets (net of cash) and current liabilities (net of debt) on its balance sheet..
See our ultimate cash flow guideValuationFree valuation guides to learn the most important concepts at your own pace. These articles will teach you business valuation best practices and how to value a company using comparable company analysis, discounted cash flow (DCF) modeling, and precedent transactions, as used in investment banking, equity research, to learn more about the various types of cash flows.
DCF Forecast Period
Walk me through a DCF Step 2 – Calculate the Terminal Value
We continue walking through the DCF model by calculating the terminal valueKnowledgeCFI self-study guides are a great way to improve technical knowledge of finance, accounting, financial modeling, valuation, trading, economics, and more.. There are two approaches to calculating a terminal value: perpetual growth rate and exit multiple.
In the perpetual growth rateTerminal Growth RateThe terminal growth rate is the constant rate at which a firm’s expected free cash flows are assumed to grow, indefinitely. technique, the business is assumed to grow it’s unlevered free cash flow at a steady rate forever. This growth rate should be fairly moderate, as, otherwise, the company would become unrealistically big. This poses a challenge for valuing early-stage, high-growth businesses.
With the exit multiple approach, the business is assumed to be sold based on a valuation multiple, such as EV/EBITDAEV/EBITDAEV/EBITDA is used in valuation to compare the value of similar businesses by evaluating their Enterprise Value (EV) to EBITDA multiple relative to an average. In this guide, we will break down the EV/EBTIDA multiple into its various components, and walk you through how to calculate it step by step. This multiple is typically based on comparable company analysisComparable Company AnalysisThis guide shows you step-by-step how to build comparable company analysis ("Comps") and includes a free template and many examples.. This method is more common in investment banking.
Walk me through a DCF Step 3 – Discount the cash flows to get the present value
In step 3 of this DCF walk-through, it’s time to discount the forecast period (from step 1) and the terminal value (from step 2) back to the present value using a discount rate. The discount rate is almost always equal to the company’s weighted average cost of capital (WACC).
See our guide to calculating WACCWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. for more details on the subject, but the quick summary is that this represents the required rate of return investors expect from the company and thus represents its opportunity cost.
The best way to calculate the present value in Excel is with the XNPV function, which can account for unevenly spaced out cash flows (which are very common).
Discounting cash flow in a DCF model
Additional DCF Notes
At this point, we’ve arrived at the enterprise value for the business since we used unlevered free cash flow. It’s possible to derive equity value by subtracting any debt and adding any cash on the balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. to the enterprise value. See our guide on equity value vs. enterprise valueEnterprise Value vs Equity ValueEnterprise value vs equity value. This guide explains the difference between the enterprise value (firm value) and the equity value of a business. See an example of how to calculate each and download the calculator. Enterprise value = equity value + debt - cash. Learn the meaning and how each is used in valuation.
At this point in the modeling process, an investment banking analystInvestment Banking Career PathInvestment banking career guide - plan your IB career path. Learn about investment banking salaries, how to get hired, and what to do after a career in IB. The investment banking division (IBD) helps governments, corporations, and institutions raise capital and complete mergers and acquisitions (M&A). will typically perform extensive sensitivity and scenario analysisScenario AnalysisScenario analysis is a process of examining and evaluating possible events or scenarios that could take place in the future and predicting the to determine a reasonable range of values for the business, as opposed to arriving at a singular value for the company. By now, you’ve really satisfied the question of “Walk me through a DCF analysis.”
Additional investment banking interview resources
By now, you’re all set to properly answer “Walk me through a DCF model” or “How do you perform a discounted cash flow analysis” in an interview.
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To make sure you’ll be completely prepared, check out these additional resources below:
Top Investment Banking Interview QuestionsInterviewsAce your next interview! Check out CFI's interview guides with the most common questions and best answers for any corporate finance job position. Interview questions and answer for finance, accounting, investment banking, equity research, commercial banking, FP&A, more! Free guides and practice to ace your interview
Why Investment Banking?Why Investment Banking?Almost every investment banking interviewer will ask the question: why investment banking? I want to work in investment banking because it's the fastest way to learn financial modeling, valuation, Excel, and understand the nature of large corporate transactions. I'm aware the job has a strict hierarchy, very long hours
Financial Modeling GuideFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
DCF Modeling GuideDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow
Financial Analyst Certification
Become a certified Financial Modeling and Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! by completing CFI’s online financial modeling classes and training program!
