Walk me through a DCF analysis interview question
If you’re going for an investment banking 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 model?
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.
They key to answering this question well is a structured approach… and lots of direct experience building DCF models in Excel.
Screen shot of a DCF model from our online financial modeling courses!
DCF Step 1 – Build a 5-year 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 5 years.
The forecast has to build up to unlevered free cash flow. We’ve published a detailed guide on how to calculate unlevered free cash flow, but the quick answer is to take EBIT, less taxes, less capital expenditures, plus depreciation and amortization, less any increases in non-cash working capital.
See our ultimate cash flow guide to learn more.
DCF Step 2 – Calculate the Terminal Value
We continue walking through the DCF model steps with calculating the terminal value. There are two approaches to calculating a terminal value: perpetual growth rate and exit multiple.
In the perpetual growth rate 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/EBITDA. This multiple is typically based on comparable company analysis. This method is more common in investment banking.
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 WACC 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).
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 to the enterprise value. See our guide on equity value vs enterprise value.
At this point in the modeling process, an investment banking analyst will typically perform extensive sensitivity and scenario analysis 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: walk me through a DCF analysis.
Additional investment banking interview resources
By now you all set to answer “walk me through a DCF model” or “how do you perform a discounted cash flow analysis” in an interview.
To make sure you’ll completely prepared, check out these additional resources below: