Investment Banking Interview: Walk me through a DCF

A DCF is a discounted cash flow analysis which is an intrinsic valuation method. This method of valuation is focused on finding the "free cash flow" which is the cash flow that is available to investors. Then you discount these cash flows to find how much they are worth today. This is in line with the idea that a dollar today is worth more than a dollar tomorrow.

How to answer the "Walk Me Through a DCF" Question?

High Level DCF Walk Through

In an interview it is important to keep your technical overview at a high level. Start with a high level overview and be ready to provide more detail upon request.

  1. Project out cash flows for 5 - 10 years depending on the stability of the company
  2. Discount these cash flows to account for the time value of money
  3. Determine the terminal value of the company - assuming that the company does not stop operating after the projection window
  4. Discount the terminal value to account for the time value of money
  5. Sum the discounted values to find an enterprise value
  6. Subtract Net Debt and divide by diluted shares outstanding to find an intrinsic share price

Common Interview Follow Up Questions

What do you use as a discount rate?
Assuming that you are calcuating an unlevered DCF, you would use the weighted average cost of capital (WACC). This is calcuated as the:

Cost of debt * % of debt in the capital structure * (1- tax rate) + cost of equity * % of equity in the capital structure + cost of preferred equity * % of preferred equity in the capital structure.

Why do you multiply by (1-tax rate)?

You do this because interest expense (the cost of debt) is tax deductible so you need to account for this "debt tax shield."

What is the cost of equity?

The cost of equity is calcuated through the Capital Asset Pricing Model (CAPM).

CAPM = Risk free rate + Beta * (expected market return - risk free rate)

What should I use as my risk free rate?

You should use the US treasury yield in line with your projection window (i.e. if you are using a 10 year DCF - use the 10 year US treasury yield).

What is the Gordon Growth Model?

The gordon growth model is: The final year of free cash flow * (1+ the terminal growth rate) / (WACC - terminal growth rate)

What is the exit multiple method for determining the terminal value?

Find an industry average multiple and multiply it by final year revenue (if using EV/Revenue) or final year EBITDA (if using EV/EBITDA).

Detailed Discounted Cash Flow Concepts to Review

Levered vs. Unlevered Free Cash Flow

Unlevered Free Cash Flows find the cash flow that is available to all investors (both debt and equity). Unlevered free cash flows should be discounted using WACC.

Levered Free Cash Flow represents the cash flow that is available to just equity investors (after debt investors have been paid). This adjusts for mandatory debt repayments and interest expense. Levered Free Cash Flows should be discounted using CAPM or the cost of equity.

Diluted Shares Outstanding

Diluted Shares Outstanding take into account basic shares outstanding and all options that are in the money. It is the worst case scenario for the number of shares outstanding.

What is the problem with the Discounted Cash Flow Analysis?
The DCF is based on projections of the analyst performing the analysis and therefore if you put garbage in for your projections, your intrinsic share price will be meaningless.

Reading About a DCF for an investment banking interview?

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Comments (65)

Nov 13, 2011 - 5:59pm

Looks good just make sure you can defend your statements if they begin to pick i.e. (want to use Levered/Unlevered Beta in WACC, drawbacks to DCF, UFCF considerations etc.)

'Before you enter... be willing to pay the price'
Nov 13, 2011 - 5:59pm

What if they asked you what issues could arise a from using the multiple method and how'd you justify using that.

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Nov 13, 2011 - 6:10pm

Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

Nov 13, 2011 - 7:46pm
bluefalcon:
Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

I can answer some of those, but Im not sure how deep they would want me to get.

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Best Response
Nov 13, 2011 - 11:03pm
bluefalcon:
Yeah also you need to explain everything. Why free cash flow? What time frame? Why that time frame? Why EBITDA? Why not another multiple? When would you use another multiple? What exactly is WACC? Conceptually, what is CAPM? What is the equity risk premium that you will be using? Why is that correct? What is next? You have done a DCF, what do you do with it? Why is it important to what we do here?

Not trying to be a dick, have legitimately been asked all these and more when I interviewed at Moelis and Company.

I disagree with this - don't go into more detail than what you have to. otherwise you are bound to get yourself into unnecessary trouble. that being said, you should be able to answer all the questions from the post above, as they are likely to come up in the context of valuations.

Personally, this is how I would go about it (similar to you, but with a few alterations):

First give a 1 or 2 sentence introduction of what a DCF is (ie, an intrinsic valuation of a company based on its FCF).
This is the order I'd walk through the steps:

-Project a company's FCF
-Calculate the company's discount rate (WACC if using unlevered FCF/cost of equity if levered)
(I like mentioning the discount rate at this point because you could theoretically need it to calculate the Terminal value)
-Calculate a company's TV
(briefly mention the two ways you could do this - gordon growth or multiples method)
-Discount the FCF and TV and sum up everything to derive firm's intrinsic value
-If need to get to Implied Equity Value, then walk through necessary adjustments; create sensitivities since you want to look a range of values.

once you are done, then ask the interviewer if he/she would like you to go into more detail. chances are they will want you to, but this approach minimizes the chances of you "losing" your interviewer by talking to much and appearing to be out of focus.

Capitalist
  • 8
Nov 13, 2011 - 11:07pm

3 main things you need:

  1. projection period
  2. wacc
  3. exit method

we project operating performance of the company into the future (5 years normally) and calculate free cash flow from this.

calculate the wacc as weighted average of cost of debt and equity... use this to discount the free cash flows calculated in our projection period.

use either exit multiple method or perpetuity growth method to estimate terminal value. for EMM, we assume the company will sell for a similar TEV/EBITDA multiple at the end of the projection period. for PGM, we assume the company will grow at a certain rate forever, so we use the formula to get terminal value and then discount that back to time 0.

that should be all you need... they'll ask follow up questions.

Nov 13, 2011 - 11:08pm

Know the strengths and weaknesses of the analysis, how it compares to other valuation methods, etc. Other than that don't go into too much detail, you don't wanna bore them. I typically get a couple of follow up questions at the end and usually they interrupt at certain points if they want you to get more detailed

Nov 13, 2011 - 11:09pm

ibankingfaq.com actually gives a really great summary on this question too... I would mention that DCF tends to be the most variable of the three main valuation methodologies due to the transaction assumptions you undertake

and as others mentioned there's no need to talk yourself into a corner... if you hit the main points the interviewer will most likely be sufficed... worst case if you are unsure you can ask if that's what they were looking for or if they wanted more detail...

Nov 13, 2011 - 11:10pm

Answer "walk thru dcf" question (Originally Posted: 10/14/2010)

  1. Project revenues over the forecast period
  2. Make margin assumptions to project expenses and drill down to EBIT
  3. Tax effect EBIT
  4. Add back Depreciation, Amort.
  5. Subtract Capex
  6. Adjust for changes in working capital
  7. Discount to Present Value
  8. Find terminal value using multiple of final year EBITDA or growth model
  9. Discount to Present Value
  10. Add the two Present Values together

Do not start this answer off by blabbering about the WACC or expounding about market trends to project revenues or any crap like that. That will just make you sound like you don't know the answer to the question. Give them the step by step process of how you make this calculation. You're interviewing to be an analyst that will spend countless hours processing. You're answering a question about whether you know how to process the numbers you've been given. So, tell them about the process.

As for how "in depth" you get - as you can see this is not rocket science. It doesn't really get a whole lot "deeper" than what you see above.

Nov 13, 2011 - 11:13pm

There is no such thing as an "unlevered" or "levered" DCF.

There is, however "unlevered" and "levered" FCF's being used to calculate the discounted cash flows.

For all intents and purposes, assume you are using unlevered free cash flows and baking in the cost of debt into the WACC when you discount those cash flows.

That's it.

Nov 13, 2011 - 11:23pm

You don't need to project interest income/expense for a dcf, you're tax affecting your EBIT so it's not involved. You're not going to project based on EBIT margins (usually), but rather EBITDA margins since this is your starting point in the DCF. These are based on a number of different assumptions, but in reality you use either management guidance or research estimates. 3 statements models are used for full merger models and LBOs, which are not as common anymore as a quick DCF analysis.

Nov 13, 2011 - 11:31pm

I always tried to keep this answer very broad so the follow up questions would be easy. I didn't give much detail and it always seemed to work:

1) project cash flows for an explicit period
2) calculate terminal value
3) determine discount rate
4) discount back to pv
5) sum pv's and that's NPV

Follow up's to this answer are usually easy questions like how do you get terminal value and how do you get a discount rate.

This approach never failed when I was interviewing.

Nov 13, 2011 - 11:32pm

I always find these "walk me through" model questions to be hard in live interviews... despite the fact that I can easily build a DCF... it's just ASKING you to forget something / skip over something... there's pressure, etc... I'd prefer a "harder" but pointed/focused technical question

Nov 13, 2011 - 11:33pm

Yes, you need to first calculate a discount rate before you can calculate a terminal value.

  1. Project future cash flows - in my experience, look at historical growth, margins, etc., really the worst part for me, annual reports suck.
  2. Calculate a discount rate (I've only had experience using WACC).
  3. Calculate a terminal value - here, use discount rate minus growth rate in perpetuity, which I have been assuming as 4% (but also performing a sensitivity analysis for +- 1% growth rate and discount rate for a range).
  4. Discount projected cash flow with terminal value added to the last projected year to arrive at Enterprise Value, then find value per share - in my experience, I just subtracted debt and divided by diluted shares.

Thought I'd go through it as a personal exercise.

Out of curiosity, analysts on this board, how long does it take you to do a DCF? How long did it take you when you first started?

Nov 13, 2011 - 11:44pm

As an exercise to get your head around this, look at an lbo model from macabacus.com. You should be able to see how you walk from EBITDA down to FCF. Post-debt service and tax, you then can see FCF to equity. That's the basis for your DCF inputs.

Those who can, do. Those who can't, post threads about how to do it on WSO.
Nov 13, 2011 - 11:55pm

Can someone walk me through a DCF valuation (interview question) (Originally Posted: 08/19/2015)

Can someone walk me through their answer as to how a DCF is used to value a company as if this question was asked in an interview? Just curious to know how people structure their answers and how in depth you really need to go.

Also just a side note, if I am building a DCF, do I have to include other expenses such as R&D, wages and such as other line items or can i just lump them into SG&A?

Nov 14, 2011 - 12:00am

DCF Interview (Originally Posted: 04/25/2016)

When interviewing for a corporate finance role and you're asked to build a DCF model, is it necessary to build the three statements with all their assumptions before building your DCF valuations?

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