If you are preparing for investment banking interviews, you will almost certainly encounter this question: “Walk me through a DCF.” It is one of the most popular technical questions asked at top banks — including Morgan Stanley, Goldman Sachs, JP Morgan, and every elite boutique on Wall Street.
DCF stands for discounted cash flow, and it is a method used to value a business. The reason interviewers love this question is that it tests multiple concepts at once — free cash flow, terminal value, the discount rate (WACC), and the time value of money. Getting this question right demonstrates that you truly understand how valuation works, not just that you memorized a textbook definition.
In this guide, we will break down how a DCF works step by step, so that you understand the logic behind it rather than relying on rote memorization. Once you understand the “why” behind each step, you will be able to handle any variation of this question that an interviewer throws at you.
What Is a DCF?
A DCF is a way to figure out how much a business is worth. The core idea is straightforward: a company’s value is equal to all the cash it will generate in the future, discounted back to what that cash would be worth today.
Why do we need to discount future cash flows? Because of a concept called the time value of money — a dollar today is worth more than a dollar tomorrow. If someone offered you $100 right now or $100 a year from now, you would take the $100 today every time. Why? Because you could invest that $100 today and earn a return on it. Even at a modest 2% annual interest rate, your $100 would grow to $102 after one year. The person who waited a year would still only have $100.
This logic extends further: the farther out a cash flow is, the less it is worth in today’s dollars. Cash you receive five years from now is worth less than cash you receive next year, which is worth less than cash you receive today. A DCF accounts for this by converting every future cash flow into its present value, and then summing them all up to arrive at the company’s enterprise value.
When performing a DCF, analysts typically project a company’s free cash flow for the next 5 to 10 years. The projection period should cover enough time for the business to reach a “steady state” — meaning it is growing at a stable and predictable rate. At the same time, projecting beyond 10 years becomes increasingly speculative, so analysts avoid going too far into the future.
Step 1: Calculate Free Cash Flow (FCF)
Free cash flow is the cash a business generates after covering all of its operating expenses, taxes, working capital needs, and capital expenditures. It represents the cash that is actually available to the company’s investors — both equity holders (shareholders) and debt holders (bondholders and lenders).
Here is the free cash flow formula:
FCF = EBIT x (1 – Tax Rate) + Depreciation & Amortization +/- Changes in Working Capital – Capital Expenditures
Let’s break down each component:
- EBIT (Earnings Before Interest and Taxes): This is the company’s operating profit — revenue minus all operating expenses. We start with EBIT rather than net income because we want a measure of profit that is available to all investors, not just equity holders.
- Tax adjustment (1 – Tax Rate): We apply the tax rate to EBIT to get the after-tax operating profit. The government always gets its share.
- Add back Depreciation & Amortization (D&A): D&A is a non-cash expense. Since we are calculating actual cash flow, we need to add back any expenses that did not involve real cash leaving the business.
- Working capital changes: Working capital covers the day-to-day cash needs of the business — inventory, accounts receivable (money customers owe you), and accounts payable (money you owe vendors). Changes in these items affect cash flow even though they do not show up on the income statement.
- Subtract Capital Expenditures (CapEx): This is the cash spent on long-term assets like equipment, property, or technology. These are real cash outflows that the business needs to maintain and grow its operations.
The resulting FCF number tells you how much cash the business is truly generating for its investors. If you own equity in the business, FCF can be paid out to you as dividends. If you own debt, FCF is what gets used to pay interest and repay principal.
Step 2: Calculate the Terminal Value
After projecting free cash flow for the first 5 to 10 years, you need to account for all the cash flows the business will generate beyond that projection period. This is where the terminal value comes in.
The terminal value is an approximation of the company’s value from the end of the projection period onward, assuming the business has reached a steady, mature growth rate. This is a critically important number — in most DCFs, the terminal value represents 60-80% of the company’s total enterprise value.
There are two common methods for calculating terminal value:
Method 1: Exit Multiple Method
This is the more practical approach and the one most investment bankers use in practice. You apply a reasonable valuation multiple (typically EV/EBITDA) to the company’s projected EBITDA in the final year of your forecast.
For example, if the company’s projected EBITDA in year 10 is $100 million and comparable companies trade at 10x EBITDA, then the terminal value would be $100 million x 10 = $1 billion. You would then discount that $1 billion back to its present value.
Method 2: Gordon Growth Method (Perpetuity Growth Method)
This method is more academic and uses the following formula:
Terminal Value = (FCF in Final Year x (1 + g)) / (WACC – g)
Where “g” is the long-term growth rate of the business (typically 2-3%, in line with long-term GDP or inflation) and WACC is the weighted average cost of capital (the discount rate).
Both methods should give you a roughly similar terminal value. If they are wildly different, that is a signal to revisit your assumptions. Most bankers will calculate both and use the exit multiple method as their primary approach, with the Gordon Growth method as a sanity check.
Step 3: Discount Everything Back to Present Value
Now that you have your projected free cash flows for years 1 through 10 (or however long your projection period is), plus your terminal value, you need to discount all of these cash flows back to their present value. This is the core mechanic of the entire DCF.
The present value formula is:
Present Value = Future Value / (1 + Discount Rate)^n
Where “n” is the number of years into the future that cash flow occurs.
Here is a simple example. Assume a company has a 10% discount rate and is expected to generate cash flows of $10, $10, and $20 over the next three years:
- Year 1: $10 / (1.10)^1 = $9.09
- Year 2: $10 / (1.10)^2 = $8.26
- Year 3: $20 / (1.10)^3 = $15.04
The total present value of those three years of cash flow is $9.09 + $8.26 + $15.04 = $32.39. Notice that this is less than the $40 you would get by simply adding up $10 + $10 + $20 without discounting. The difference reflects the time value of money — receiving $40 spread over three years is worth less than receiving $32.39 today (assuming you can invest at a 10% return).
You apply this same formula to each year’s projected free cash flow and to the terminal value. The sum of all these present values gives you the enterprise value of the business.
Step 4: The Discount Rate (WACC)
The discount rate used in a DCF is the WACC, or weighted average cost of capital. It represents the blended rate of return that the company’s investors (both equity and debt holders) expect to earn.
Think of it this way: if investors could put their money elsewhere and earn a 10% return, then they need to earn at least 10% from this investment to justify the risk. That expected return becomes the discount rate, because it represents the opportunity cost of investing in this company versus the next best alternative.
WACC is calculated by weighting the cost of equity and the cost of debt by their respective proportions in the company’s capital structure. Calculating WACC involves several sub-concepts including CAPM (the Capital Asset Pricing Model), beta, the risk-free rate, and the equity risk premium — each of which deserves its own detailed explanation. For a deeper dive into WACC, check out our related guides on investment banking technical interview questions.
Putting It All Together: The Complete DCF Framework
Here is the full DCF process summarized in five steps:
- Project the company’s free cash flow for the next 5 to 10 years, until it reaches a steady state.
- Calculate the terminal value to capture all cash flows beyond the projection period, using either the exit multiple method or the Gordon Growth method.
- Discount each year’s free cash flow and the terminal value back to their present values using the WACC as your discount rate.
- Sum up all the present values to arrive at the enterprise value of the business.
- To get equity value, subtract net debt (total debt minus cash) from the enterprise value. Divide by shares outstanding to get a per-share price.
Common DCF Interview Mistakes to Avoid
Having coached over 1,300 students who have collectively secured offers from every bulge bracket and elite boutique investment bank, we have seen the most common mistakes candidates make when answering DCF questions:
- Memorizing without understanding: Interviewers will follow up with “why?” questions. If you memorized the steps but do not understand the reasoning, you will get caught. Focus on understanding concepts like the time value of money — the rest flows naturally from there.
- Forgetting the terminal value: Some candidates walk through the free cash flow projection but forget to mention the terminal value. Given that it typically represents 60-80% of enterprise value, this is a critical omission.
- Confusing enterprise value and equity value: The DCF gives you enterprise value. To get to equity value (what equity investors care about), you need to subtract net debt.
- Not knowing both terminal value methods: You should be able to explain both the exit multiple method and the perpetuity growth method. Interviewers may ask you to compare the two or explain when you would use one over the other.
- Ignoring working capital and CapEx: When explaining free cash flow, some candidates only mention EBIT and taxes but forget working capital changes and capital expenditures. These are real cash flow items that matter.
How to Practice DCF Questions
The best way to prepare for DCF interview questions is to practice explaining the concept out loud, as if you were teaching it to someone who has never heard of it before. If you can explain it simply and clearly, you understand it well enough to handle any follow-up question.
Here are a few practice questions to test yourself:
- Walk me through a DCF.
- Why do we discount cash flows?
- What is free cash flow and how do you calculate it?
- What are the two ways to calculate terminal value?
- What discount rate do you use in a DCF and why?
- What drives the value in a DCF — the projection period or the terminal value?
- If I increase the discount rate, what happens to the valuation? Why?
If you can answer each of these confidently and explain the reasoning behind your answers, you will be well prepared for any DCF-related question in your investment banking interviews.
Want Personalized Interview Coaching?
At Wall Street Mastermind, we provide hands-on coaching for investment banking and private equity interviews. Our team includes former global heads of recruiting at top banks like Goldman Sachs, Credit Suisse, UBS, and Lehman Brothers. We have helped over 1,300 students secure offers from every single bulge bracket and elite boutique bank on Wall Street.
If you want personalized help preparing for your investment banking interviews, book a call with our team to learn how we can help you land your dream offer.
And if you found this guide helpful, check out our video version of this breakdown on our YouTube channel, where Sam walks through the entire DCF step by step with visual examples.
Watch the Full Video
This article is based on our popular YouTube video breaking down the DCF interview question step by step. Watch the full walkthrough below:
Watch: How to Nail Morgan Stanley’s DCF Interview Question
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