Walk Me Through a DCF: Discounted Cash Flow Like a Banker

“Walk me through a DCF” – A question candidates must know inside-and-out for an investment banking interview or even a coffee chat. Showing up unprepared for this question is like wearing a suit without putting on a tie. 

❌The bad news: Stumbling on this question and you’re out of the race! 

✔️The GOOD news: We’re here to give you the best answer with killer techniques and tips for a successful interview. 

Disclaimer: This article requires an intermediate level of financial knowledge. If you are a complete beginner, please consider some other Financial 101 articles in our series! 

  • Finance – 3
  • Accounting – 3
  • Valuation – 3 -> DCF 
  • Mergers & Acquisitions (M&A) – 3
  • Initial Public Offerings (IPO) – 2
  • Miscellaneous – 1

1. Walk me Through A DCF: Always Start with A Big Picture

Interview: In a Superday, spitting out everything they know is how inexperienced candidates tend to do it when interviewees give out this question. However, such an approach can only result in a poorly communicated message and decrease your chance of advancing to the next round. 

Be SUCCINCT

A Concise Answer Is All You Need! 

At least for the first 2 – 3 minutes. In extreme cases, bankers might even time you on how quickly you can answer this question! 

SUPER FAST ANSWER:

  • Build a 5-year forecast of free cash flow to the firm (FCFF) based on reasonable assumptions
  • Calculate a terminal value 
  • Discount all cash flows to their net present value using a discount rate (often WACC)

“But it’s more complicated than that!”

“But if everyone says the same thing, isn’t that boring?”

Yes, it’s simplified. And yes, it’s structured. Yet, what differs one candidate from another is how crisp they can be on elaborating each step because there are always follow-up questions.

2. Walk Me Through A DCF: A Detailed Step-by-step Answer

It’s rewind time!

What exactly is DCF anyway?

  • DCF (Discounted Cash Flow) analysis is a valuation method for projects, assets, or companies using the concept of the time value of money. 
  • Simply put, if you consider buying a house for lending to others, you will want to know whether the profit you get in the future is worth the price you are paying today or not? 

Why does net present value matter?

  • Do you want a dollar now or a dollar in the future? I hope your answer is NOW
  • The general assumption is that $1 today is always worth more than $1 tomorrow! Because, as we all know, INFLATION.

 

2.1 Walk Me Through A DCF Step 1 – Building A Long-term Forecast for FCFF

Let’s look at the example of buying a house again. If you want to know whether it’s worth it to invest in the house or not, the first step is always to guess how much money the house can generate for you in the future. 

On a bigger scale, in DCF analysis, you need to build a long-term forecast of the project to get the cash flows based on the three financial statements for a period of time. 5 years is the most used number, but a project can be shorter (2 – 3 years) or longer (7 – 8 years) than that. 

Important! Anything that goes beyond 10 years should be taken with a grain of salt. 

When I say “cash flow”, I mean unlevered cash flow or free cash flow to the firm. It is called “free” because it’s unburdened by debt and available to the entire firm. Although there are 2 types of cash flows, bankers just want you to use the unlevered one. (So make sure you clarify which one you use!) 

Free Cash Flow to Firm Formula

  • Most used by analysts:

Detailed explanation:

  • Others:DCF4

Since we have “unlevered”, there is definitely “levered” one. In case you’re curious about that, here is a quick comparison:

Levered Cash Flow

  • The amount of cash a business has after it has met its financial obligations
  • Crucial figures for investors since it is a better indicator of the actual level of a company’s profitability

Unlevered Cash Flow

  • The amount of cash the business has before paying its financial obligations
  • Cash available to both debt holders and equity holders, representing industry norm and allow for apple-to-apple comparison -> widely used in a DCF model

2.2 Walk Me Through A DCF Step 2 – Calculate the Terminal Value

Reminder!

Enterprise Value = PV of projected cash flows + PV of terminal value 

First thing first, what is terminal value?

  • Terminal value is the present value of all future cash flows beyond the projection period 

How do I calculate it? 

Again, we have another fight between 2 approaches to calculate the terminal value

DCF5

 

Perpetuity Growth (Gordon Growth Method) – Professors’ To-Go:

  • Can a business last forever? Maybe, but maybe not. It doesn’t matter. What matters is the assumption that a business can operate at a constant rate forever so we can get a terminal value. 
  • Choosing the constant rate: 
    • Since this rate is forever, we have to be extra careful in choosing it. 
    • A good rule of thumb is to choose either the average long-term expected GDP growth or the inflation growth rate. 
    • Example: US GDP grows < 3%, so anything less than 3% is a reasonable rate for US-based companies. Anything beyond it, you must have very good reason for choosing that! 
  • Formula:

    • FCF = terminal free cash flow
    • R: discount rate
    • G: growth rate
  • Why Professor’s To-go? Because hardly any bankers use it! The assumption that a business will grow constantly at a fixed rate sounds ridiculous! However, there are many explanation and proofs that have gone into the study of this method, so:

Exit Multiple – Bankers’ Favorite:

  • Considering selling the business at the end of the project? Then you need to value it on a market multiple basis. 
  • Two common market multiples:
    • EV/EBITDA
    • EV/EBIT
  • Is one better than the other? It depends on the company’s assumptions and the industry.

 

  • Formula: 
    • Terminal value = NTM/LTM EBITDA/EBIT x Exit multiple
  • Choosing exit multiple:
    • Is this a cyclical industry? If current multiples are 12.0x, but the historical average is 8.0x, it is NOT appropriate to select 11.0x – 13.0x as your exit multiple ranges.
    • How are you deriving the exit multiple? Are there good comparables? -> Always conduct comparable company analysis to choose a good industry multiple.

If it’s bankers’ favorite, does this mean Exit Multiples win? 

Unfortunately, the answer is no! 

Why? Because it’s easy to pick a multiple that makes no sense at all! 

Good news: Fixing this is easy since you can always cross-check! 

  • Best practice: Calculate the EBIT/EBITDA multiples implied by a perpetuity growth terminal value and vice versa as a test of reasonableness.

2.3 Walk Me Through A DCF Step 3 – Discount Cash Flows Using WACC for Net Present Value

Once we have projected cash flows and terminal value, it’s time to discount them!

In analysts’ world, WACC is the only discount rate that should be used in a DCF model. 

What is WACC then? 

  • WACC or Weighted Average Cost of Capital is the required rate of return for a firm given the risk to investors from investing in the business. 
  • Since a firm can either be financed through debt or equity, it’s obvious that 
    • Cost of Capital = Cost of Debt + Cost of Equity 

Why this one?

  • Because it is a function of all alternative investment opportunities available to the firm and the riskiness of making an investment compared to those available alternative returns 

Put simply, if you spend money on buying a house, that money cannot be spent on anything else (not just other houses), so you have to factor in the lost opportunities other things can give you.

The golden formula to remember:

WACC = KE + [E / (D+E)] +KD * (1 – T) * [D / (D + E)]

where:

  • KE: cost of equity
  • KD: cost of debt 
  • E: market value of equity 
  • D: market value of debt 
  • T: marginal tax rate

If this formula doesn’t look familiar to you, it’s time you get a full revision of how to calculate WACC

The final final step

So you’ve got the discount rate, simply plug it in the formulate to get net present value of all unlevered free cash flows to get the enterprise value of the business, like this:

HOORAY! Now we’re done with “Walk me through a DCF”! 

Actually, we’re not quite done, yet… A professional banker will continue to conduct extensive sensitivity and scenario analysis to get a reasonable range of values for a project, instead of relying on a single number and let fate decide the result. 

Examples of sensitivity analysis:

  • Revenue Growth vs. Terminal Multiple
  • EBITDA Margin vs. Terminal Multiple
  • Terminal Multiple vs. Discount Rate
  • Long-Term Growth Rate vs. Discount Rate

3. Pros and Cons of DCF

It’s never enough to just know how to do a DCF analysis without truly understanding its strengths and weaknesses.

PROs CONs
  • Theoretically the most sound method if the analyst is confident in his assumptions
  • Not significantly influenced by temporary market conditions or non-economic factors
  • Especially useful when there is limited or no comparable information
  • Valuation obtained is very sensitive to a large number of assumptions/forecasts, and can thus vary over a wide range
  • Often very time-intensive relative to some other valuation techniques
  • Involves forecasting future performance, which is very difficult

 

4. Other DCF Commonly Asked Questions & Answers

1. Would you expect a manufacturing company or a technology company to have a higher Beta in Cost of Equity calculation?

A technology company, because technology is viewed as a “riskier” industry than manufacturing.

2. Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).

3. If you use Levered Free Cash Flow, what should you use as the Discount Rate?

Cost of Equity since we’re not concerned with Debt or Preferred Stock as we’re calculating Equity Value, not Enterprise Value.

4. In which case would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

Only when there are no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples. 

5. What’s the flaw with basing terminal multiples on what public company comparables are trading at?

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

6. How do you know if your DCF is too dependent on future assumptions?

The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions.

In reality, almost all DCFs are “too dependent on future assumptions” – it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.

But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

7. Which has a greater impact on a company’s DCF valuation – a 10% change in revenue or a 1% change in the discount rate?

The to-go answer: “it depends”, but most of the time the 10% difference in revenue will have more of an impact.

That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

8. What about a 1% change in revenue vs. a 1% change in the discount rate?

Again, it should be “it depends”, but the discount rate is likely to have a bigger impact on the valuation.

9. How do you calculate WACC for a private company?

Just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

10. Why would you not use a DCF for a bank or other financial institution?

Banks use debt differently: they create products instead of reinvesting

Interest is a critical part of banks’ business models and working capital takes up a huge part of their Balance Sheets -> a DCF for a financial institution would not make much sense.

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