Walk me through a DCF
Answer
This is the most popular question by far and you will likely see it in every single recruiting process you are involved in. As a result, you should know it forwards and backwards.
Defining a DCF
Give the definition of a DCF: “A DCF values a company based on the present value of both forecasted cash flows and a forecasted Terminal Value”
Step 1: Projection of Financials and Calculating Unlevered Free Cash Flow
First, you’ll want to roll through how you’d forecast the Income Statement from top to bottom. I would use loose / relaxed verbiage like the below; when you do this it sounds less rehearsed:
“So step one is obviously, forecasting revenue using revenue growth as this will drive the rest of our assumptions. I normally like to err a bit on the side of conservatism, so if a company had on average, 20% Revenue growth over the last few years, I’ll usually knock it down to 15%-19%”
“Once we have our forecasted Revenue numbers, I’ll use COGS as a % of Revenue to forecast COGS. Normally, I’ll have this taper a couple tenths of a percent a year due to presumed economies of scale”
“From here on out, I would forecast all operating expenses and working capital items using a fairly stable % of Revenue unless I have any reason to edit them”
“Now I’ll be calculating Unlevered Free Cash flow assuming this is an M&A transaction and then also calculate Terminal Value using the Gordon Growth Method or Multiples method”
The Multiples Method is simply multiplying the last year’s EBITDA by a multiple that’s reasonable for the type of business. Ex. If a business has $10 of EBITDA and similar businesses trade at 10.0x EBITDA, we would calculate a Terminal Value of $100
“The next thing I would do is discount both the Unlevered Free Cash Flows and the Terminal Value back to Present Value using a discount rate, typically the WACC”
“Once we have the present values of the Unlevered FCFs and Terminal Value, we will add both together to determine a company’s Enterprise Value”
Bonus
“Usually after this, I’ll give my work a sanity check by dividing Enterprise Value by EBITDA, and seeing how this multiple compares to comparable public companies”
You don’t need to provide this much detail, but it would be an absolute standout answer and would earn you a lot of critical thinking points
Why this matters to bankers
DCFs are a key method when bankers value a business and you would do this analysis frequently. But honestly, most of this question is just to check if you’ve actually done your homework. It’s the easiest filter to tell if somebody cares enough about recruiting for banking to learn the answer cold.