How a DCF works, start to finish
“Walk me through a DCF.”
It's the most common valuation question. Interviewers want a clean four-step structure first, then proof you understand why each step exists.
A business is worth the cash it will generate, converted into today's dollars. Forecast the near years, estimate everything after, discount both, add them up.
Why discount at all?
Would you rather have $100 today or $100 in five years? Today, because you could invest it, and because the future is uncertain. A DCF applies that logic to a whole company: each future dollar is shrunk by a discount rate that reflects the return investors demand for waiting and for risk.
Step 1: project free cash flow
Forecast unlevered free cash flow, the cash the business produces before paying lenders or shareholders, for roughly five to ten years, until the company looks mature and steady.
Step 2: estimate a terminal value
The company doesn't stop existing in year five. The terminal value captures everything after the forecast, either by growing the final cash flow at a modest rate forever or by applying an exit multiple. It's usually the majority of the value.
Step 3: discount, then add up
Discount each year's cash flow and the terminal value back to today at the WACC, the blended return that lenders and shareholders require. The sum is enterprise value.
Dashed: cash flow that year. Filled: what it's worth today. The further out, the more it shrinks.
Step 4: bridge to a share price
- 1Enterprise value = 520 + 1,180 = $1,700.
- 2Equity value = 1,700 − 400 + 100 = $1,400.
- 3Implied share price = 1,400 ÷ 60 ≈ $23.33.
A DCF is only as good as its inputs. Bankers always show a sensitivity table (WACC vs terminal growth) and compare the result with trading and deal multiples.
Say it like this
A DCF values a business on the cash it will generate in the future. I'd project unlevered free cash flow for five to ten years, then calculate a terminal value for the years after that using either a perpetuity growth rate or an exit multiple. I'd discount the projected cash flows and the terminal value back to today using WACC and add them to get enterprise value. Then I'd subtract net debt and other claims to get equity value and divide by diluted shares for an implied share price.
Traps to avoid
- ✕Forgetting to discount the terminal value. It's as of the end of the forecast, not today.
- ✕Saying the result is equity value. An unlevered DCF gives enterprise value.
- ✕Using cost of equity to discount unlevered cash flows. Unlevered cash flow goes with WACC.
What they'll ask next
›What's the biggest weakness of a DCF?
Sensitivity: small changes in WACC, growth or the terminal assumptions swing the value a lot, and the terminal value is usually most of it.
›When wouldn't you use a DCF?
When cash flows can't be forecast credibly, like an early-stage company, or for banks, where debt is part of operations; use equity-based methods instead.
›If 80% of the value is terminal value, what do you do?
That's common, but sanity-check it: compare the implied exit multiple and implied growth rate to peers and the economy, and consider a longer forecast so more value comes from explicit years.
Check yourself
Sum the discounted projected cash flows plus the discounted terminal value in an unlevered DCF. What number do you get?
Put it all together
Build a full five-year DCF and decide if the stock is cheap.