DCF
Discounted Cash Flow. A valuation method that projects a company’s future free cash flows and discounts them to present value at the weighted average cost of capital, plus a terminal value for cash flows beyond the explicit forecast.
Why DCF matters in interviews
The DCF is the valuation method interviewers use to test whether you understand value at all, rather than whether you can read a comps table. It is also the method with the most places to go wrong, so "walk me through a DCF" is really a request for a five-minute demonstration that you can hold a chain of logic together under pressure.
How it works in practice
The structure: project unlevered free cash flow for an explicit forecast period, usually five to ten years; discount each year back at the weighted average cost of capital; calculate a terminal value for everything beyond the forecast; discount that back too; sum to enterprise value; then bridge to equity value and per-share value.
Unlevered free cash flow is built as EBIT, less taxes on EBIT, plus depreciation and amortisation, less capital expenditure, less the increase in net working capital. It is unlevered — before interest — because you are valuing the whole business and the cost of debt is already reflected in the discount rate.
Terminal value dominates the answer. Under the perpetuity growth method, terminal value = final-year free cash flow x (1 + g) / (WACC − g). With final-year FCF of $500m, g of 2.5% and WACC of 9%, terminal value is $500m x 1.025 / 0.065 = $7.9bn — and on a typical ten-year forecast that will be 60-75% of total enterprise value.
What candidates get wrong
- Discounting levered cash flow at WACC. Unlevered FCF pairs with WACC and gives enterprise value; levered FCF pairs with cost of equity and gives equity value directly. Mixing them is the classic error.
- Using a perpetuity growth rate above long-run GDP growth. Anything much above 2-3% implies the company eventually becomes the entire economy.
- Forgetting to mid-year discount, or applying it inconsistently between the forecast period and terminal value.
- Treating the DCF output as a point estimate. Practitioners always present a sensitivity table across WACC and terminal growth, because the answer moves enormously.
DCF: frequently asked questions
Why is terminal value such a large share of a DCF?
Because a perpetuity captures every cash flow beyond the forecast window, which is an infinite series, while the explicit period captures only five to ten years. On a standard model, terminal value is typically 60-75% of enterprise value. That is not a flaw in the method, but it does mean the answer is highly sensitive to the growth rate and discount rate you assume.
When is a DCF the wrong tool?
When cash flows cannot be forecast with any confidence — early-stage companies, banks and insurers (where the capital structure is the business, so an unlevered DCF is meaningless), and deeply cyclical businesses near a turning point. Banks are usually valued on a dividend discount model or price-to-book instead.
What are the two ways to calculate terminal value?
The perpetuity growth method, which applies a long-run growth rate to final-year free cash flow, and the exit multiple method, which applies a terminal EV/EBITDA multiple to final-year EBITDA. Practitioners typically calculate both and check that the implied growth rate from the exit multiple is sane.
Go deeper
This term comes up constantly in valuation interviews and on the desk.
DCF interview questions guideRelated Valuation terms
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