# Walk Me Through a DCF in 5 Steps – The Ultimate Guide (2021 Updated)

Learn how to answer the interview question, **‘Walk Me Through a DCF’** like a pro and land your dream job in **Investment Banking**, **Private Equity**, or **Investment Management**. We’ll break everything down with a simple **5 Step Framework **as well as tips on how to avoid **common pitfalls**.

Estimated reading time: 17 minutes

**TL;DR**

- Initially, keep your answer
**high-level**for**‘Walk Me Through a DCF’**…and let the interviewer pull you into the details. - You need to understand the
**underlying concepts**to master this question…just memorizing formulas is a recipe for disaster. - You can answer this question in just
**5 simple steps**which we’ve listed below.

**A Little Context on…‘Walk Me Through a DCF’**

One of the **most common Investment Banking Interview questions** is **‘Walk Me Through a DCF’**. It is easily one of the **Top 10 Investment Banking Interview Questions** and can be quite intimidating to tackle for newcomers.

**Many students aiming for top-tier Finance simply memorize the DCF formulas to answer this question**. **But they quickly find themselves in a jam when they can’t explain the underlying concepts.**

You can make it easy with the simple **Framework** and **Plain English** explanations we share here. First though, just a few points on ** why** this question is asked to begin with.

**What is Discounted Cash Flow (DCF) and Why Does it Matter?**

A common (and fair!) question is, “** What is the point of a DCF in the first place?**“.

**Discounted Cash Flow Analysis** (or **DCF**) is *the* core method of **Business Valuation** used across the **Finance** world (**Investment Banking**, **Private Equity**, **Investment Management**, and **Corporate M&A**).

It’s one of the **Three Primary Methods** of Business Valuation. In fact, the other two methods of **Business Valuation** (**Trading** **and Transaction Comparables**) are ‘shorthand’ analyses that are underpinned by the **DCF** approach. We discuss these connections in more detail in our Launchpad Valuation Course (currently available to site **Members** only).

For now, the short story is that the **DCF method** is ** central** to

**Business Valuation**. As a result, interviewers ask this question a

**to gauge whether prospective employees**

__LOT__**truly ‘get it’**.

**The Big Picture & Common Pitfalls: ‘Walk Me Through a DCF’**

Before we get into the **5 Step Framework**, let’s first address the approach to take when answering this question. As is the case when answering most Finance interview questions, you want to **keep your answer very high-level** at first. You can use the **5 Step Framework** we provide below to help keep you on track.

This avoids two common mistakes:

**Mistake #1: Seeming Long-Winded**– If you give a long answer to the question it can seem like you don’t understand the concept and/or can’t give a succinct answer. Neither of those things reflect well on a prospective candidate.**Mistake #2: Trying to Show off Your Knowledge**– Let’s face it, the person sitting on the other side of the table in an interview has a huge leg up on you in most cases. They have likely been on the job for years and can run circles around you. If you try to show off how much you know, they will just take it to the next level. It’s nearly impossible to win this game.

By keeping it simple at the start, you can **avoid these common mistakes**. With that out of the way, let’s dive in here!

**Quick Note: Levered vs Unlevered DCF**

As a matter of technicality, when an interviewer asks you to walk through a **DCF** **Valuation**, they could be asking you to take one of two approaches: an **Unlevered DCF (excludes Debt impact)** or a **Levered DCF (includes Debt impact)**.

On the job, the ** vast majority** of

**Discounted Cash Flow**analyses are

**Unlevered DCFs**. As a result, the framework below focuses on just the

**Unlevered DCF**approach.

**‘Walk Me Through a DCF’ in 5 Steps**

With that clarified, let’s now look at our **5 Step Framework**.

To answer this question most effectively, you can break a **Discounted Cash Flow** analysis down into 5 easy Steps.

**How to Answer ‘Walk Me Through a DCF’ in 5 Steps**

**Project Future Cash Flows**Make detailed financial projections (usually for 5-10) years until the Business reaches maturity (i.e. GDP-level growth).

**Calculate Terminal Value**Use either the Perpetuity Growth or Exit Multiple method to calculate Terminal Value.

**Discount Projected Cash Flows and Terminal Value at WACC**Discount your Projected Cash Flows and Terminal Value at the Weighted Average Cost of Capital (WACC) to arrive at Enterprise Value.

**Work from Enterprise Value to Equity Value**Subtract Debt and add Cash to arrive at the value attributable to the owners of the business (i.e. Equity Value).

**Calculate Price Per Share**Divide the Equity Value by the Company’s total Share Count to arrive at Price Per Share.

**In the sections below**, we’ll walk through **each of these steps** in **extensive detail**. We’ll **also explain** the **underlying idea** behind each step.

**‘Walk Me Through a DCF’ Step #1: Project Future Cash Flows**

In Step 1, we create **explicit projections** for to calculate the **Cash Flows** of the Business **until the business hits a ‘steady state’** level of growth (

**typically 5-10 years**into the future). This period of projections is referred to as

**of the**

*‘Stage 1’***DCF**analysis.

**Calculating Unlevered Free Cash Flow**

Because this is an **Unlevered DCF** analysis, we ignore the impact of the **Capital Structure** (i.e. the level of **Debt**). As such, we do ** not** incorporate deductions for

**Interest Expense**or

**Principal**payments for

**Debt**in our

**Cash Flow**calculations.

To be more specific, we are calculating the **Cash** **Flow **generated by the business, after paying **Taxes** and accounting for reinvestments in **Capital Expenditures** and **Working Capital**.

The formal name for this type of **Cash Flow** is **Unlevered Free Cash Flow** (or **UFCF**). Again, it’s **‘Unlevered’ **because we don’t take into account the impact of **Debt **(a.k.a. **Leverage**). In the diagram below, we illustrate the calculation step-by-step in **Plain English**:

One **quick note **here. **EBIT **includes a **deduction for Depreciation and Amortization **(D&A). We deduct **D&A** because it **lowers our taxes**. This process is referred to as the **Depreciation Tax Shield**, which is a **common Interview Question topic**. For a** deeper dive** check out our article on the **Depreciation Tax Shield**.

The **goal with the calculations** above is to **continue these projections** **until** the business hits a **‘Steady State’** level of growth in line with the overall economy (i.e. GDP Growth).

Now, let’s move on to **Step 2**.

**Walk Me Through a DCF Step #2: Calculate Terminal Value**

In Step 2, we will calculate all of the value that exists ** beyond** the

**Stage 1**

**Cash Flows**.

We refer to the phase beyond **Stage 1** as **Stage 2**. And we call the * value* that exists in

**Stage 2**our

**Terminal Value**.

There are two common methods used to calculate **Terminal Value**: The **Perpetuity Growth Method** and The **Exit Multiple Method**.

**Terminal Value Calculation Method #1 – Perpetuity Growth Method**

If we wanted to value the **Cash Flows** that exist beyond **Stage 1**, we could make **100 years of projections**…but that would be a **TON** of work.

Fortunately, we have a well-established formula to help. The **Perpetuity Growth Formula** takes our final year of **Cash Flow** from **Stage 1**, projects out all future **Cash Flows **(**beyond Stage 1**) at a **constant growth rate (to infinity)**, and then **Discounts those Cash Flows** back to the ** final period** of

**Stage 1**.

The formula, which we’ve illustrated below, is called the **Perpetuity Growth** **Formula**. For more on the math behind this formula, check out this **link**.

One thing to note is that the **Long-Term Growth (or ‘g’)** should generally be **in line with GDP growth**. Otherwise, the business would outgrow the overall economy…which is probably not a reasonable assumption!

**CRITICAL POINT: Terminal Value = Enterprise Value at the end of Stage 1**

Before we dive into the second method, there’s a **critical** point that’s important to grasp here.

The present value of all the future **Unlevered Free Cash Flows** of a business **Discounted** back to any point in time, reflects the **Purchase Price** (i.e. **Enterprise Value**) of the business.

When we calculate **Terminal Value** using the **Perpetuity Growth Method**, we are simply doing a **DCF** of all **Cash Flows** beyond **Stage 1**.

As a result, you can also think of **Terminal Value** as the **Enterprise Value** of the business at the end of **Stage 1**.

**Terminal Value Calculation Method #2 – Exit Multiple Method**

Because **Terminal Value** represents the **Enterprise Value** of the Business at the end of **Stage 1**, we can take a shortcut here. To do that, we simply use **Peer Valuation Multiples **(typically **EV/EBITDA**) which we multiply by the appropriate **Valuation Metric** (in this case **Year 5 EBITDA**) to calculate our **Terminal Value**.

Now that we’ve calculated our **Stage 1** and **Stage 2** values for our **Unlevered DCF**, we need to pull the __future__**Cash Flows** back to ** today** using

**Discounting**.

**Walk Me Through a DCF Step #3: Discount Cash Flows and Terminal Value by WACC**

In Step 3, we calculate the **Weighted Average Cost of Capital** (or **WACC**). **WACC **is the **Discount Rate** we use to **Discount** our **Cash Flows** back to today.

The general idea here is to find a **Discount Rat**e that **reflects the risk** of the **Cash Flows** stream being valued.

Once we’ve calculated **WACC**, we’ll show you how to **calculate Discounted Cash Flow **at the end of Step 3.

**What’s the Big Idea Behind WACC?**

The problem is that most businesses have __multiple__**capital providers** (i.e. **Lenders** and **Investors**) with different risk profiles.

Their risk profiles differ because **Lenders** are typically ** paid first** in a

**Sale**or

**Bankruptcy**. So,

**Lenders**take

**less risk**than

**Investors**.

**Investors**take a

**higher level of risk**because they are paid only after all the money owed to

**Lenders**has been repaid.

As a result, **Lenders** and **Investors** have **different expected rates of return**. So, using either of their individual expected rates of return would incorrectly value the Business.

To solve this issue, we take a **‘Weighted Average’** of their expected returns. This **Weighted Average** reflects the **blended average return** for ** all providers of capital** to the company. We call this blended average return the

**Weighted Average Cost of Capital.**

**The WACC Formula in Plain English**

Below we’ve laid out the formula for the **Weighted Average Cost of Capital** and explanations for each component.

**Weighted Average Cost of Capital (WACC) Components**

**Debt / (Debt + Equity)**– the value of Debt (**typically Book Value**) relative to the total value of Debt + Equity.**Cost of Debt (Kd)**– the current**blended return**expected by**Lenders**to the Company. Typically calculated as the weighted average**Yield to Maturity**for all components of the Company’s Debt. Note that we look at the**Cost of Debt**on an**after-tax basis**because**Interest is tax-deductible**, which**lowers**the true**Cost of Debt**.**Debt / (Debt + Equity)**– the value of Equity (__always__**Market Value**) relative to the total value of Debt + Equity.**Cost of Equity (Ke)**– the level of**Return expected by Investors**in the Business which is calculated using the**Capital Asset Pricing Model**(or**‘CAPM’**) formula.

**The Cost of Equity Formula (or CAPM)…also in Plain English!**

Calculating the **expected return of our Lenders** is **fairly simple**. We look at the **Interest Rate** that they would charge to lend to the company…and that’s basically it.

Determining the expected rate of return required by **Investors** is **a bit trickier** because it’s not explicitly stated anywhere. Fortunately, there’s a well-established theory called the **Capital Asset Pricing Model (or ‘CAPM’) **to help us. The **CAPM **formula helps us to figure out what return Investors will expect.

Below are the components of the formula along with explanations for what each component represents:

**Cost of Equity (or CAPM) Formula Components**

**Risk-Free Rate (Rf)**– sets a**baseline for the level of return**an Investor should expect if they take**zero**risk. The most common benchmark rate for**Rf**is the**10 Year US Treasury Note.****Beta (β)**– expressesby showing how a*‘Risk’***Stock**moves**relative to the Market****(i.e. how Volatile it is)**. A Beta of 1 reflects the average**Risk**of the market. As this number increases, it reflects increasing**Risk**and thus results in a higher expected return for investors (and vice versa).**Equity/Market Risk Premium (ERP or MRP)**– shows theInvestors have earned in the past for investing in*‘Reward’***Stocks (vs Risk-Free Bonds)**.

In short, this formula **begins with a baseline return** for a **Risk-Free investment**. It then **ratchets up** the Return (the ** Reward** or

**ERP/MRP**) expected by

**Investors**based on the level of

**(**

*Risk***) that the**

*Beta***Investor**is taking by investing in a particular

**Business**.

**What about Preferred Stock in WACC?**

In some instances, you’ll see other components like **Preferred Stock** creep into the **WACC** formula. This is a common source of confusion for **newcomers** **to** **Finance**.

Remember that at the beginning of this section we said that we have to reflect the **blended average** **Expected Returns** of **ALL **providers of capital to the business? Well, if a company has **Preferred Stock** (or any other form of **Debt** or **Equity**), we have to incorporate that into **our WACC calculation** as well**.**

**How to Discount Cash Flows**

Once we’ve calculated our **WACC**, we then use the **WACC** to **Discount **our **Stage 1** **Cash Flows** and **Stage 2** (**Terminal Value**) back to today.

In substance, the sum of all of our **Discounted Cash Flows **represents the price we would pay for the right to those future **Cash Flows**, or the **Purchase Price** to buy the entire business which we call **Enterprise Value**.

In Step 4, we’ll work from (**Enterprise Value**) to the value attributable only to the **Business** **Owners** (**Equity Value**).

**‘Walk Me Through a DCF’ Step #4: From Enterprise Value to Equity Value**

To calculate **Equity Value**, we need to incorporate both **Debt** and **Cash**.

Let’s begin with **Debt**. Most businesses are funded with some level of **Debt**. And if the Business were ever sold, the **Lenders** need to be **repaid before the Owners** can collect any proceeds. As a result, we have to **subtract Debt** to get to the value attributable to the owners of the Business.

In addition, most Businesses will **generate Excess Cash** that accumulates in the company bank account over time. If an Owner sells their Business, they will typically **keep the Excess Cash**. As such, we **add Excess Cash** to reflect the fact that the **Cash belongs to the Owner of the Business**.

So, in short: **Equity Value = Enterprise Value – Debt + Cash**

After these completing these calculations, we arrive at the ** total** value to the

**Owners (i.e.**S

**hareholders)**of a

**Business**. But we’re not quite done though.

Most Businesses slice their **Equity Value** into numerous **Shares** so they can have a large number of **Owners**. In the next step, we’ll walk through how to calculate the value attributable to a single **Share**.

**‘Walk Me Through a DCF’ Step #5: Calculating Price Per Share**

As discussed in our **Stocks vs Bonds**** explainer video**, most businesses divide their ownership into many **Shares**. So, our final step is to calculate the value attributable to an **individual Share**.

Before we begin, note that we listed this last step as **optional**. In many cases, you can just calculate to **Equity Value** and stop. But sometimes the Interviewer might want you to work to **Price Per Share** in which case you can use this explanation.

To calculate the **Price Per Share**, we need to divide the **Equity Value** by the **Number of Shares** issued by the company. The problem is that companies have **two **distinct share counts:

**Basic Shares**– reflects the number of**Shares**that are**currently Outstanding**.**Fully Diluted Shares**– current shares**plus all potential Shares**from employee**Stock**O**ption exercises**,**Restricted Stock**, and any securities that are**Convertible**into additional shares. We calculate the number of potential shares with the**Treasury Stock Method**.

In short, we divide **Equity Value** by the **Fully Diluted Share** **Count** of the Business. This wraps up our fifth and last step in the DCF process.

**Wrap-Up**

Having a **solid answer** to **‘Walk Me Through a DCF’** is a **core **part of prepping for **Technical Interview Questions** for **Investment Banking**, **Private Equity** or **Investment Management**.

Hopefully, after reading through this, you have a much better understanding of both the **5 Step approach** **AND** the **underlying ideas** behind the Question, ‘**Walk Me Through a DCF’.**

If you follow the approach laid out above and truly grasp the underlying concepts behind each step, you’ll be in great shape!

Let us know if you have any comments or questions below.

**Interview Question Video: Walk Me Through a DCF**

- If you’d like a video overview of this topic, check out our
**Walk Me Through a DCF**video from our Founder,**Mike Kimpel**, with a full walkthrough of how to answer the question. - Also check out our
**YouTube channel****Walk Me Through an LBO**,**How does $10 of Depreciation Flow Through the 3 Statements**, and**When to use EV/Revenue Multiples**.

**Frequently Asked Questions**

*How to calculate Discounted Cash Flow?*The 5 steps to the Discounted Cash Flow process are:

1) Project Future Cash Flows.

2) Calculate Terminal Value.

3) Discount Cash Flows and Terminal Value by the Weighted Average Cost of Capital (or WACC).

4) Work from Enterprise Value to Equity Value.

5) Calculate Price Per Share.

*What is DCF?*DCF stands for ‘Discounted Cash Flow.’ In a DCF analysis, you value a Business based on its estimated future Cash Flows, which are discounted to reflect the Time Value of Money.

*What is a DCF in Investment Banking?*Discounted Cash Flow Analysis (or DCF) is a core valuation method in Investment Banking. With a DCF, you discount the future values of a business to arrive at its Intrinsic Value. This Intrinsic approach is then weighed against other market-oriented approaches like Trading and Transaction comparables.

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