DCF Valuation Explained: The Ultimate Guide for IB Interviews

If you're preparing for investment banking interviews, you will be asked about the discounted cash flow model. Not might be asked – will be asked. The DCF is the backbone of intrinsic valuation and one of the most tested concepts across every bank, from Goldman Sachs to Lazard to Rothschild.

The good news: once you understand the logic, the DCF is surprisingly intuitive. This guide covers everything you need to know to nail DCF questions in your interview – no fluff, no 200-page textbook, just the actual content that gets offers.

What Is a DCF and Why Does It Matter?

A discounted cash flow analysis values a company based on the present value of its future free cash flows. The core idea is simple: a pound today is worth more than a pound tomorrow. So if a company is going to generate cash over the next 5, 10, or 20 years, we need to discount those future cash flows back to what they're worth right now.

The DCF is the only valuation method that tries to calculate intrinsic value – what a company is actually worth based on its fundamentals, independent of what the market thinks. Comparable company analysis and precedent transactions tell you what the market is paying. The DCF tells you what the company should be worth.

The DCF Step by Step

There are six steps to a DCF. Learn these in order and you can walk through the entire model from memory.

Step 1: Project Unlevered Free Cash Flow

Unlevered Free Cash Flow (UFCF) is the cash a company generates from its core operations before any payments to debt or equity holders. The formula is:

UFCF = EBIT × (1 - t) + D&A - CapEx - ΔNWC

We start with EBIT (Earnings Before Interest and Tax) because we want cash flow to the entire firm, not just equity holders. We tax it because tax is a real cash outflow. We add back D&A because it's a non-cash charge that reduced EBIT but didn't cost anything. We subtract CapEx because that's actual cash spent on maintaining and growing assets. And we adjust for working capital changes because increases in inventory or receivables tie up cash, while increases in payables free it up.

You typically project UFCF for 5 to 10 years, depending on how far into the future you have visibility on the company's performance. Most interview DCFs use a 5-year projection period.

Step 2: Calculate WACC (The Discount Rate)

The Weighted Average Cost of Capital (WACC) is the rate we use to discount future cash flows. It represents the blended return that all of the company's capital providers – both debt and equity – expect to earn.

WACC = (E/V) × Re + (D/V) × Rd × (1 - t)

Where E = market value of equity, D = market value of debt, and V = E + D (total enterprise value of the firm's capital structure).

The Cost of Equity is calculated using the Capital Asset Pricing Model (CAPM):

Re = Rf + β × ERP

The risk-free rate is typically the 10-year government bond yield. Beta measures how volatile the stock is relative to the market. The equity risk premium is the extra return investors demand for holding stocks instead of risk-free bonds, usually around 5-7%.

The Cost of Debt is the interest rate the company pays on its borrowings, tax-adjusted. We multiply by (1 – Tax Rate) because interest payments are tax-deductible, creating a 'tax shield' that makes debt cheaper than its face interest rate.

For most companies, WACC falls somewhere between 8% and 14%. Higher for riskier businesses, lower for stable cash-generating ones.

Step 3: Discount the Projected Cash Flows

Once you have your projected UFCF and WACC, you discount each year's cash flow back to present value:

PV = UFCF / (1 + WACC)^N

So if WACC is 10% and Year 3 UFCF is £100m, the present value is £100m / (1.10)^3 = £75.1m. Cash flows further in the future are worth less today because of the time value of money.

Step 4: Calculate Terminal Value

The projection period only covers 5–10 years, but a company doesn't stop generating cash after that. Terminal Value captures the value of all cash flows beyond the projection period. It typically accounts for 60–80% of total DCF value, which is why interviewers love asking about it.

There are two methods:

Gordon Growth Model (Perpetuity Growth)

Terminal Value = Final Year FCF × (1 + g) / (WACC – g), where g is the long-term growth rate. This growth rate should be roughly in line with long-term GDP growth or inflation – typically 2–3%. If g is too close to WACC, the terminal value explodes, which means your assumptions are unrealistic.

Exit Multiple Method

Terminal Value = Final Year EBITDA × Exit EV/EBITDA Multiple. You apply a trading multiple (based on where comparable companies trade) to the terminal year's EBITDA. This is more commonly used in practice because it's anchored in market data rather than a theoretical growth rate.

Remember to discount the Terminal Value back to present value just like any other cash flow: PV of TV = TV / (1 + WACC)^N.

Step 5: Sum Everything to Get Enterprise Value

EV = Σ PV(FCF) + PV(TV)

That's it. Add up all the discounted cash flows from the projection period and the discounted terminal value. This gives you the Enterprise Value of the company.

Step 6: Bridge to Equity Value and Share Price

To get from Enterprise Value to Equity Value (which is what shareholders care about):

Equity Value = EV - Net Debt - MI - Preferred + Associates

Then divide by diluted shares outstanding to get the implied share price. Compare this to the current market price to determine if the stock is overvalued or undervalued.

How to Answer 'Walk Me Through a DCF' in 90 Seconds

This is the single most important DCF question. Here's a tight answer:

A DCF values a company by calculating the present value of its future free cash flows. First, you project unlevered free cash flow for 5–10 years using assumptions about revenue growth, margins, CapEx, and working capital. Second, you calculate a discount rate – the WACC – which blends the cost of equity and after-tax cost of debt. Third, you discount each year's cash flow back to present value. Fourth, you calculate terminal value, either using the Gordon Growth Model or an exit multiple, to capture value beyond the projection period. You discount that back too. Fifth, you sum the present values of the projected cash flows and terminal value to get Enterprise Value. Finally, you subtract net debt and other claims to bridge to Equity Value and divide by diluted shares to get the implied share price.

Key Sensitivities You Must Know

Interviewers will almost always follow up with: 'What are the key assumptions in a DCF?' or 'What drives the output the most?'

The answer: terminal value assumptions and the discount rate. Small changes in WACC or the perpetuity growth rate create large swings in valuation because terminal value represents such a huge portion of total value. A 1% change in WACC can shift the valuation by 15–25%. That's why analysts always run sensitivity tables showing how the implied share price changes across different WACC and growth rate assumptions.

Other key sensitivities include revenue growth rates, EBITDA margins, and the exit multiple (if using the exit multiple method for terminal value).

Common DCF Interview Questions

Q: What's the most important assumption in a DCF? A: The discount rate (WACC) and terminal value assumptions, because they drive the majority of the valuation output.

Q: When does a DCF not work well? A: When cash flows are highly unpredictable – early-stage companies with no revenue, distressed businesses, or cyclical firms at a peak/trough. Also financial institutions, which require different valuation approaches.

Q: Why use unlevered free cash flow? A: Because we're valuing the enterprise, not just equity. The capital structure impact is captured in WACC through the cost of debt and the debt/equity weighting.

Q: What discount rate do you use for levered free cash flow? A: Cost of equity, not WACC. If you're using levered FCF (which already deducts interest), you only discount at the equity rate to avoid double-counting.

Q: Does a DCF give you Enterprise Value or Equity Value? A: Enterprise Value if you're discounting unlevered FCF at WACC. Equity Value if you're discounting levered FCF at cost of equity.

Quick Reference: DCF at a Glance

Step	What You Do
1. Project UFCF	EBIT(1-t) + D&A – CapEx – ΔNWC for 5–10 years
2. Calculate WACC	(E/V)(Re) + (D/V)(Rd)(1-t) where Re = Rf + β(ERP)
3. Discount FCFs	PV = FCF / (1+WACC)^n for each year
4. Terminal Value	Gordon Growth: FCF(1+g)/(WACC-g) OR Exit Multiple: EBITDA × Multiple
5. Enterprise Value	Sum of PV of projected FCFs + PV of Terminal Value
6. Equity Value	EV – Net Debt – MI – Preferred + Associates. Divide by diluted shares for share price.