Run me through a DCF interview question

Every interview I've had I've been asked "walk me through a DCF analysis". However how technical must you go? Should you go through it in a basic way expecting them to have some follow up questions or should you go in depth throughout?

I try to keep my answer fairly structured so I don't drift away from the question and so when they have any questions they can easily refer back to a particular point. So I normally start off by mentioning it to be a valuation tool used to find the intrinsic value and then begin running them through the steps: calculate FFCF (explaining what it is), calculate the WACC (also explaining what it is), discount the FFCF using the WACC to get to the present value, calculate the terminal value (explain what it is), discount the terminal value using the WACC to get to the PV and then add this figure to the PV for the discounted FFCF. Then depending on how it's going I may finish up with the benefits of using a DCF analysis and then briefly mention alternative valuation tools.

What do you all think of my strategy? Feel free to PM if you have any specific thoughts to change/add

 

Should usually start with how you've thought about forecasting revenue. Pretty much everything else flows from top-line assumptions so be prepared to defend how you did (or would) do the revenue build-up. Then I'd recommend commenting on how you're forecasting margins (expanding, declining, flat, what type of incrementals, why?). Then you can get into the FCF / WACC stuff if you want. Sometimes if a candidate has a demonstrated finance background I will push them on the WACC assumptions a bit, as there's a variety of defensible assumptions and this can tell me a lot about how hard they've thought about valuation.

 

I would say from an Investment banking perspective the FCF / WACC is somewhat crucial. I would recommend going through the line items to arrive at FCFF and then going into your overview of WACC and your terminal value before arriving at your equity value which is typically most important from an IB perspective. Key things to watch are distinguishing between FCFF and FCFE and the different discount rates appropriate for each / adjustment to arrive at equity value. People can then ask questions after that about particular assumptions etc.

One thing I would note, and perhaps some banks are more stringent than others, but you don't generally need to go through the formula for things. Walking through the algebra of calculating WACC isn't particularly insightful on your finance knowledge. You can generally just explain in words.

 

Thanks for your comment!

So when we are first asked the question I should make the interviewer aware that I know the difference between unlevered (FCFF) and levered (FCFE)? So maybe a small comment such as - firstly we must decide whether we are performing the dcf analysis in order to arrive at the equity value in which we would use levered/fcfe, or whether we are aiming to arrive at. Then perhaps say investment banks are more concerned with the enterprise value rather than the equity value so the normal method is to use FCFF (unlevered) to take out the effects of debt.

Then I can begin with line items to arrive at/calculate FFCF, then say to discount it you use the WACC (whereas if it was levered/fcfe you would use capm), then once you discount the fcfe with the wacc you reach present value, then you go onto calculating the terminal value, discount the terminal value using the WACC to get to the PV and then add this figure to the PV for the discounted FFCF and you'll get your enterprise value.

How is this?

Thanks!

 
Best Response

No offense to above posters, but these answers aren't very helpful. You should aim to explain intuitively what a dcf does and then simple high level steps to conducting a dcf analysis. Let the interviewer prod for further detail. E.g...

"A DCF values a company based on the cumulative present value of its future free cash flows. There are three major components to conducting a DCF analysis.. - First, forecast free cash flows for the near­term, until the business becomes stable, then - Determine the terminal value of the business as a going concern beyond the initial forecast period; finally - Discount all cash flows to the present to determine implied enterprise value"

Interviewers expect you to know how to build a dcf. At this point, the dcf question isn't so much an exercise in knowledge as it is in explanation. The interviewer is thinking "Can this kid simplify a concept enough to put it into conversational form or does he feel the need to explain all of this shit that I don't care about?" Being able to provide a concise and articulate explanation of a technical topic is a key on-the-job skill for analysts, so try to work that into all of your technical answers

 
trader_timmy:

No offense to above posters, but these answers aren't very helpful. You should aim to explain intuitively what a dcf does and then simple high level steps to conducting a dcf analysis. Let the interviewer prod for further detail. E.g...

"A DCF values a company based on the cumulative present value of its future free cash flows. There are three major components to conducting a DCF analysis..
- First, forecast free cash flows for the nearterm, until the business becomes stable, then
- Determine the terminal value of the business as a going concern beyond the initial forecast period; finally
- Discount all cash flows to the present to determine implied enterprise value"

Interviewers expect you to know how to build a dcf. At this point, the dcf question isn't so much an exercise in knowledge as it is in explanation. The interviewer is thinking "Can this kid simplify a concept enough to put it into conversational form or does he feel the need to explain all of this shit that I don't care about?" Being able to provide a concise and articulate explanation of a technical topic is a key on-the-job skill for analysts, so try to work that into all of your technical answers

yeah I basically completely disagree with this, but I'm guessing it is dependent on the role you are interviewing for. Maybe for banking roles they are more interested in this "simplify" the explanation thingy? For investing roles, I want to know how you are building your DCF. What assumptions are you using and why? Can you defend why revenue growth should be 15% when the Street thinks it is 8%? Why do you think margins can expand? how much? Can you defend why the cost of capital is only 8% when everyone else wants to use a shorthand 10%?

I am already automatically assuming that a candidate knows what a DCF is and what the purpose of doing one is, how this differs from multiples etc. If someone gave me the explanation you've alluded to above I would view it as pretty much a waste of both of our time, and it would be a snap reject. This being said, I'm used to interviewing MBA's so this may be a completely different ballgame at the undergrad level.

So yeah, I guess the answer is know the role you are interviewing for, and try to anticipate what the interviewer is likely to value for that role.

 

I think we are interpreting OP's question in two different ways. I took it as the classic "walk me through a dcf" ib interview question, not literally walking someone through a dcf. If someone is talking about why they are using a 15% revenue growth rate over 8% consensus in their answer to that basic question, they have severely fucked it up.

if the question is in fact about how to walk through an actual model, I would agree with what you are saying.

 

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