“Walk me through a DCF.”
This question was asked by Morgan Stanley’s New York office in a recent 1st round interview.
For those who are not familiar, DCF stands for discounted cash flow.
This is one of the most popular topics that investment bankers like to test candidates on during interviews.
There are a lot of variations in which interviewers can test your knowledge on when it comes to DCF. For example, you have to know:
- How to calculate free cash flow (“FCF”)
- How to calculate terminal value
- How to calculate the discount rate, also known as “WACC” or weighted average cost of capital
- How to calculate cost of equity, which includes things like CAPM and Beta
So when a banker asks you to walk them through a DCF, it’s really a question with a bunch of different concepts all rolled up into one. And that’s what makes it tricky.
But don’t worry, here’s how a DCF works – simplified so you can tackle any form of the topic that gets thrown at you during an interview.
What is DCF?
Simply put, a DCF is a way to value a business or figure out how much it’s worth.
This is done by calculating all of the future cash flows that it will generate, and discounting it back to present value.
But what does it mean to discount something back to present value?
Well, let’s say I want to give you some money, and I gave you two options to choose from:
- Option #1: I will give you $100 today.
- Option #2: I will give you $10 a year for the next 10 years.
In both options, I’m giving you $100 in total. Most people would choose to have $100 today of course.
But why?
Time value of money
The answer has to do with a concept called the time value of money, which basically states that a dollar today is worth more than a dollar tomorrow.
If you go with option #1 and took $100 today, you can go and invest that $100 and earn a return on it.
Let’s assume you pick something very safe and just put it in the bank, and you earn a very low interest rate of just 2% per year.
After year 1, your $100 would be $102.
After year two, your $102 would become $104.04.
After year three, it grows to $106.12.
And so on so forth.
At the beginning of year 10, you would have gotten $121.90.
So that’s option #1.
Now if you had gone with option #2, by the beginning of year 10 you would have just gotten your final payment of $10.
At this point you would only have $100, which is less than the $121.90.
So if you stay with this logic, it begs to reason that the cash flows you would receive in the future are worth less than cash flows you can receive today, right?
And the further out the cash flow is, the less that cash flow is worth.
So $100 today is worth more than $100 a year from now, but $100 a year from now is worth more than $100 two years from now.
This is why when you value a business using a DCF, you have to take all of their future cash flows, and discount each cash flow back to its present value, which is just a fancy way of saying – how much would that cash flow be worth today?
Then by adding up all of the present values of each future cash flow that’s coming in, that gives you the enterprise value of the business, or how much the business is worth.
Applying DCF to the real world
When actually working on a DCF, you will typically project out the free cash flow of the business for the next 5 to 10 years.
You want to project out the cash flows until the business reaches steady state, which means the business is growing at a stable and predictable rate and it’s now a mature business.
At the same time, you typically don’t want to go more than 10 years because the further out you have to make projections, the harder it becomes to be accurate with your projections.
But what is this “free cash flow” number that you’re projecting?
Conceptually, when a business sells something and generates cash, there are a few different uses for that cash.
Some of the cash will be used to pay your employees’ salaries, pay for the office rent, plus any other expenses needed to operate the business.
Since we are calculating the actual cash that’s flowing into or out of the business, we want to make sure to only include actual cash expenses while leaving out non-cash expenses like depreciation and amortization.
Some of the cash will be used to pay taxes, because the government is going to make sure to get theirs.
Some of the cash might be used to pay for working capital, or in other words the day-to-day expenses of the business.
For example:
- You have to pay for inventory so that you have something to sell
- You have to pay for the invoices you owe your vendors, also known as accounts payable
- You have to keep the lights on while you’re waiting to be paid by your customers, also known as accounts receivables
All these items require cash — this makes up your working capital.
Last but not least, some of the cash will be reinvested back into the business, e.g. by purchasing new equipment, also known as “capex” or capital expenditures.
Once all of that is taken care of, any remaining cash can then go to the company’s investors.
And that’s how you derive the free cash flow formula:
FCF = EBIT x (1-tax rate) + D&A +/- changes in working capital – capex.
This FCF is what helps determine what the company is worth from the investor’s point of view, because this is the cash that they can get their hands on.
For example, if you invested in the equity of the business, the free cash flow can be paid out to you in the form of dividends.
On the other hand, if you invested in the debt of the business, the free cash flow can be used to pay you interest and also repay the original principal that you loaned the business.
That’s why if you take the future free cash flow of the business, and you discount these cash flows back to their present value, you can calculate how much this business is worth to its investors.
Now that we understand that, you might be wondering, what about the cash flows generated by the business after those first 5 to 10 years of your projection period?
This is a great question, and that’s where terminal value comes in.
Terminal Value
Terminal value is an approximation of all the future cash flows of the business beyond the first 5 to 10 years, once it’s reached its steady state and has become a mature business.
This will usually represent 60-80% of the company’s value.
This approximation is used because it would be silly to try to forecast what will happen that far out into the future, with any sort of accuracy.
There are two ways to calculate the terminal value:
1. Exit multiple method — where you apply a reasonable multiple to the last year of the forecast period, usually using a measure of profit such as EBIT or EBITDA.
For example, if the company’s EBITDA is $100 million in year 10, and the EBITDA multiple for similar companies is 10x, then the terminal value would be $100 million x 10 or $1 billion.
You would then discount the $1 billion by 10 years to get back to its present value today.
This is typically the more practical way to do it, and what most investment bankers do when they need to calculate terminal value.
2. Gordon Growth method, also known as the perpetuity growth method.
This is more academic in nature, but there’s a formula that says
terminal value = [FCFn x (1+g)] / [(WACC – g)]
For now, these two methodologies would reach roughly similar terminal value figures.
They won’t be exactly the same, but they should give you an approximate range for what the terminal value would reasonably be.
Finding the Present Value
Now that you have 1) your free cash flow for the first 5 to 10 years projected out, 2) your terminal value that represents all of the future cash flows beyond that initial projection period, all you have to do is discount these cash flows back to the present value:
Present Value = Future Value / (1+Discount Rate)^(Number of Periods).
For example:
Let’s say a company has a 10% discount rate, and expects future cash flows of $10, $10, and $20 for the next 3 years.
In this case:
The present value of the year 1 cash flow would be calculated as $10/(1+10%)^1 = $10/1.1 = $9.09.
The present value of the year 2 cash flow would be calculated as $10/(1+10%)^2 = $10/1.21 = $8.26.
The present value of the year 3 cash flow would be calculated as $20/(1+10%)^3 = $20/1.33 = $15.04.
The total present value of the next 3 year’s cash flows would be $9.09 + $8.26 + $15.04 = $32.39, which is less than the $40 you would get if you just added $10 + $10 + $20.
In other words, getting the 3 payments that add up to $40 over 3 years is just as good as getting $32.39 today, assuming you can invest that money today and earn a 10% annual return on your money.
Discount Rates
Thus that explains what discount rate represents – the return your investors would expect to get if they were to invest their capital elsewhere, instead of investing in the business we’re trying to value.
In other words, it’s the opportunity cost that they’re foregoing, which is why we use it as the discount rate to discount our future cash flows back to their present values.
This discount rate is calculated using WACC, which stands for weighted average cost of capital.
Similar to the terminal value, there’s a lot that goes into calculating the WACC, and it deserves its own separate article which I will try to create in the near future.
But for now, you have a high-level understanding of how a discounted cash flow works.
The next time you get asked this question in an interview, hopefully you’ll ace it.
If you would like more hands-on and personalized coaching with your investment banking or private equity interviews from our team of coaches that includes the former global heads of recruiting at top investment banks like Goldman Sachs, Credit Suisse, UBS, and Lehman Brothers, please don’t hesitate to reach out to our team.
And as always – remember – nothing worthwhile comes easy, and nothing is more important than your future.
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