Introduction

DCF valuation method is probably the most well-known valuation methodology, and you are almost 100% certain to get a question on this topic.

Typically, interviewers will probe your understanding of DCF by asking you to walk through the entire process, from forecasting future cash flows to calculating terminal value. They might challenge you on how to determine the appropriate discount rate using the Weighted Average Cost of Capital (WACC) or quiz you on the differences between the Gordon Growth Model and the Exit Multiple Approach for terminal value calculation.

Additionally, expect questions that test your ability to perform sensitivity analysis and scenario modeling to understand the robustness of your DCF valuation.

What is a DCF

DCF is an intrinsic valuation methodology that estimates the value of an investment using its expected future cash flows. DCF analysis attempts to determine the value of an investment today based on projections of how much money that investment will generate in the future. This method helps in making informed decisions about acquisitions, investments, and capital projects.

Key Takeaway: DCF analysis helps to determine the intrinsic value of an investment based on its future cash flows, accounting for the time value of money.

Walk me through a DCF

The process of conducting a DCF analysis involves several steps:

1. Forecasting Future Cash Flows: Estimate the company’s revenue, expenses, and capital expenditures to derive free cash flows for each year in the forecasting period.
2. Discount Rate Calculation: Calculate the Weighted Average Cost of Capital (WACC) based on the target capital structure, the cost of debt and cost of equity (calculated using CAPM).‍
3. Discounting Future Cash Flows: Apply the WACC to discount both the forecasted cash flows and the terminal value to their present values.‍
4. Terminal Value Calculation: Use either the perpetuity growth method or the exit multiple method.‍
5. Summing the Present Values: Add the present values of the forecasted cash flows and the terminal value to determine the company’s intrinsic value.
6. Sensitivity Analysis and Scenario Modelling: Sensitize your DCF valuation by understanding the potential valuation impact of changes in inputs to achieve a more comprehensive and outcome valuation.

Forecasting Future Cash Flows

Projecting future cash flows is the first step in DCF analysis. This involves estimating operating cash flows and free cash flows over a specified period, typically between 5-10 years.

The accuracy and consistency of these projections are critical as they form the foundation of the valuation.

• Operating Cash Flows: Cash generated from the company’s core business operations.

• Free Cash Flows (FCF): Operating cash flows minus capital expenditures . FCF represents the cash available for distribution to all investors, including debt and equity holders.

Key Takeaway: Accurate forecasting of future cash flows is crucial for a reliable DCF valuation.

Discount Rate Calculation

The WACC represents the company's cost of capital i.e., the weighted after-tax cost of debt and equity. Alternatively, you can also think of the WACC as the average rate of return a company anticipates paying to secure financing for its operations.

Formula: WACC = (D / V) x rD x (1 - t) + (E / V) × rE ​

• E = Market value of the firm´s equity.

• D = Market value of the firm´s equity.

• V = E + D.

• rD = Cost of debt.

• rE = Cost of equity, calculated with CAPM (see below).

• t = Corporate tax rate.

Limitations of WACC:‍

• ‍Highly dependent on assumptions: The WACC formula is quite complex in naturee due to the variability of its components, such as the cost of equity, which can differ significantly depending on the assumptions taken.

• Assumes a constant capital structure: WACC assumes the current debt and equity proportions will remain unchanged, which is unrealistic as firms may adjust their capital structure over time.

• Implies a constant cost of capital: It presumes the costs of debt and equity remain constant, ignoring potential fluctuations due to changes in interest rates, risk premiums, and market conditions.

• Ignores project-specific risk: Unless it is done on a project by project basis (like in some cases for infrastructure projects) WACC is based on the overall firm risk, not accounting for the varying risk levels of different projects, which can lead to inaccurate NPV estimates and poor investment decisions.

Key Takeaway: WACC is the discount rate used to discount future cash flows in a DCF analysis.

Discounting Future Cash Flows

The present value (PV) of future cash flows is calculated to account for the time value of money (TVM).

The discount rate used is WACC, which reflects the return required by investors.

Formula: PV = FCF /  (1 + r) ^ T

• FCF = Free Cash Flow in the last forecasted year.

• r = Discount rate (WACC).

• T = Time period.

Terminal Value Calculation

The terminal value represents the value of the company beyond the explicit forecasting period. There are two common methods to calculate terminal value: Gordon Growth Model and Exit Multiple Approach.

Gordon Growth Model

Assumes the company will grow at a stable rate indefinitely.

Formula: TV = FCF × (1 + g) / (r - g)​

• FCF = Free Cash Flow in the last forecasted year

• g = Perpetuity growth rate

• r = Discount rate (WACC)

Advantages:

• Simple to apply if the company is expected to grow at a steady rate.

• Ideal for stable companies with predictable growth rates.

Disadvantages:

• Sensitive to the growth rate assumption.

• May not be appropriate for companies with fluctuating or uncertain growth rates.

Key Takeaway: As a rule of thumb the growth rate, g, is typically above inflation rate, otherwise you would be assuming no or negative real growth despite nominal growth.

Exit Multiple Approach

Applies a multiple to a financial metric (e.g., EBITDA) based on comparable companies.

Formula: TV = Metric x Multiple

Advantages:

• Reflects market conditions and comparable company valuations.

• Can be more flexible in accounting for industry-specific trends and company performance.

Disadvantages:

• Requires careful selection of an appropriate multiple, which can be subjective.

• May be less reliable if comparable companies are not readily available or if the industry is experiencing volatility.

Key Takeaway: Terminal value accounts for a significant portion of a company’s total value in DCF analysis. Even when the Gordon Growth Model is the chosen method, is customary to calculate the implied exit multiple as a "sanity check" .

Sensitivity Analysis and Scenario Modelling

Sensitivity analysis involves varying key assumptions (e.g., growth rates, discount rates) to assess their impact on the DCF valuation. Scenario modelling examines different future states of the world (e.g., best-case, worst-case scenarios) to understand potential valuation outcomes under various conditions.

• Stress Testing: Varying assumptions to see how sensitive the valuation is to changes in key inputs.

• Scenario Modelling: Creating different scenarios (e.g., optimistic, pessimistic) to understand potential outcomes.

Key Takeaway: Valuation is more an art than a science. Sensitivity analysis and scenario modelling help in understanding the range of possible valuations and the robustness of the DCF model.

CAPM

The Capital Asset Pricing Model (CAPM) is used to estimate the expected return on equity by considering the risk-free rate, the equity market risk premium, and the company’s beta. Each component of CAPM plays a crucial role in determining the discount rate for DCF analysis.

• Risk-Free Rate (Rf): Represents the theoretical return on an investment with zero risk, typically associated with government bonds e.g., US Treasury Yield.

• Market Risk Premium (MRP): Represents the additional return expected by investors for taking on the risk associated with the overall market, above the risk-free rate.

• Beta (β): Measures the sensitivity of an investment's returns to overall market movements.

Formula: Expected Return = Risk-Free Rate (Rf) + Beta × Market Risk Premium (MRP)

Interpreting Beta:

• Beta = 1: The investment's returns move in line with the market.

• Beta > 1: The investment is more volatile than the market (higher risk, higher potential return).

• Beta < 1: The investment is less volatile than the market (lower risk, lower potential return).

Key Takeaway: CAPM helps in determining the appropriate discount rate by considering its expected risk-adjusted return.

Limitations

While DCF is a powerful valuation tool, it has limitations that must be considered:

• Forecasting Uncertainty: The accuracy of DCF depends heavily on the reliability of future cash flow projections.

• Discount Rate Sensitivity: Estimating the correct discount rate (WACC) can be challenging and significantly affects the valuation.

• Complexity: DCF requires detailed financial analysis and assumptions, making it complex and time-consuming.

Recognizing the limitations of DCF is essential for effective application and interpretation of results.

Conclusion

In the context of investment banking interviews, understanding the DCF valuation is a must. Knowing how to forecast cash flows, calculate present values, and consider terminal values will enable you to confidently discuss DCF concepts and tackle valuation questions.