Walk Me Through a DCF: The Perfect Interview Answer (Step-by-Step)

"Walk me through a DCF" is the single most asked technical question in investment banking interviews. It's so common that interviewers can tell within 30 seconds whether you actually understand valuation or just memorized a script.

Here's how to answer it properly—with the depth that separates strong candidates from average ones.

The 60-Second Answer

For initial screens, you need a concise version:

"A DCF values a company based on the present value of its future cash flows.

First, I project unlevered free cash flows for 5-10 years. That's EBIT times one minus the tax rate, plus depreciation and amortization, minus capital expenditures, minus changes in net working capital.

Second, I calculate the terminal value—either using a perpetuity growth method or an exit multiple.

Third, I discount both the projected cash flows and terminal value back to present value using WACC.

Finally, I sum those present values to get enterprise value, then subtract net debt to get equity value."

That's your foundation. But interviewers will dig deeper.

The Full Framework (For Follow-Up Questions)

Step 1: Project Unlevered Free Cash Flows

The formula: UFCF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWC

Why unlevered? We use unlevered (debt-free) cash flows because we're valuing the entire enterprise, not just equity. Debt and interest are captured in the discount rate (WACC).

Projection period: Typically 5-10 years. Use 5 years for stable companies, longer for high-growth businesses that need more time to reach steady state.

Key drivers to model:

• Revenue growth rate
• EBITDA margins (or individual expense items)
• D&A as % of revenue or CapEx
• CapEx as % of revenue
• NWC as % of revenue

Step 2: Calculate Terminal Value

Two methods—know both:

Perpetuity Growth Method: TV = (Final Year FCF × (1 + g)) / (WACC - g)

Where g = long-term growth rate (typically 2-3%, roughly GDP growth)

Exit Multiple Method: TV = Final Year EBITDA × Exit Multiple

The exit multiple is usually based on current trading multiples for comparable companies.

Which to use? Most bankers calculate both and use them as a sanity check. If they give wildly different answers, reexamine your assumptions.

Step 3: Calculate WACC

The formula: WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1 - Tax))

Cost of Equity (via CAPM): Cost of Equity = Risk-Free Rate + β × Market Risk Premium

• Risk-free rate: 10-year Treasury yield
• Beta: Measure of stock volatility vs. market (levered beta from comps, unlever/relever as needed)
• Market risk premium: Typically 5-7%

Cost of Debt: The company's current borrowing rate, tax-affected since interest is deductible.

Step 4: Discount to Present Value

Formula: PV = CF / (1 + WACC)^n

Apply to each year's projected cash flow and to the terminal value.

Step 5: Bridge to Equity Value

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

Equity Value = Enterprise Value - Net Debt - Preferred Stock - Minority Interest + Cash

Implied Share Price = Equity Value / Diluted Shares Outstanding

Common Follow-Up Questions

"What discount rate do you use and why?"

"WACC, because we're discounting unlevered free cash flows which are available to all capital providers—both debt and equity. WACC weights each source of capital by its proportion in the capital structure and cost."

"What growth rate do you use for terminal value?"

"Typically 2-3%, roughly in line with long-term GDP growth. A company can't grow faster than the economy in perpetuity—if it did, it would eventually become the entire economy. For inflation-protected analysis, you might use 0-1% real growth."

"Why is terminal value often such a large percentage of total value?"

"Because we're projecting explicit cash flows for only 5-10 years, but the terminal value captures all value creation beyond that. For mature companies, terminal value often represents 60-80% of total DCF value. This is why terminal value assumptions are so critical and why we sensitize them."

"Walk me through how changes in working capital affect the DCF."

"Net working capital represents cash tied up in operations—inventory, receivables, payables. If NWC increases, that's cash being invested in operations, so we subtract it. If NWC decreases, cash is being released, so it's additive to free cash flow.

For example, if a company grows revenue but needs more inventory to support that growth, NWC increases and FCF decreases relative to EBITDA."

"What are the limitations of a DCF?"

"The DCF is highly sensitive to assumptions—small changes in discount rate or terminal growth can swing value significantly. It relies on accurate projections of future cash flows, which are inherently uncertain. It also doesn't capture real-time market sentiment, which is why we use DCF alongside trading comps and transaction comps for triangulation."

Sensitivity Analysis

Always be prepared to discuss sensitivity. Key sensitivities include:

• Terminal growth rate vs. WACC
• WACC vs. revenue growth
• EBITDA margin assumptions
• Exit multiple (if using exit method)

Understanding what drives value changes shows you truly understand the model, not just the mechanics.

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