A strong answer to "walk me through a DCF" explains, in about two minutes, that you forecast a company's unlevered free cash flows, estimate a terminal value, discount both at the weighted average cost of capital (WACC) to get enterprise value, and then bridge to equity value per share. To avoid sounding scripted, show that you understand the judgement behind each step and be ready for follow-ups. Reciting a memorised paragraph isn't enough.
Why do interviewers still ask this?
It's a foundational investment banking and private equity technical question. It tests whether you understand valuation logic, the link between the three financial statements and cash flow, and the sensitivity of value to assumptions. Because almost every candidate has memorised an answer, interviewers listen for depth and probe with follow-ups.
What's the core structure of a good answer?
1. Purpose
"A DCF values a business based on the present value of the cash flows it will generate for all capital providers."
2. Forecast unlevered free cash flow
"I'd project the business over typically five to ten years, long enough to reach a steady state. Unlevered free cash flow is EBIT, less taxes on EBIT, plus depreciation and amortisation, less capital expenditure, less the increase in net working capital."
3. Terminal value
"Then I'd estimate value beyond the forecast using either a perpetuity growth method, with a long-term growth rate below the economy's nominal growth, or an exit multiple, such as EV/EBITDA based on comparable companies. I'd cross-check one against the other."
4. Discount rate
"I'd discount both the forecast cash flows and the terminal value at WACC: the cost of equity, typically from CAPM, and the after-tax cost of debt, weighted by target capital structure."
5. Enterprise to equity value
"Summing the present values gives enterprise value. To get equity value, subtract net debt and other claims such as preferred shares, minority interests and certain pension deficits, then divide by diluted shares for a per-share value."
6. A judgement comment
"In practice, the terminal value often accounts for most of the total value, so I'd run sensitivities on WACC and terminal growth or the exit multiple, and I'd treat a DCF as one input alongside comparables and precedent transactions."
That final sentence turns the answer from recitation into judgement.
How do you avoid sounding scripted?
- Use your own words. Explain it as you would to a smart friend, not as a textbook would.
- Pause at the decision points. For example: "the forecast period depends on when the business reaches steady state."
- Reference a real example where appropriate. "For a high-growth software company, I'd probably use a longer forecast period because it's far from steady state."
- Keep it to about 90 seconds to two minutes. Let the interviewer pull you into detail.
What follow-up questions should you expect?
"Why unlevered free cash flow?"
Because we're valuing the whole enterprise, available to both debt and equity holders, so we use cash flows before interest and discount at a rate reflecting both.
"How do you calculate the cost of equity?"
Usually CAPM: risk-free rate + beta × equity risk premium. You might discuss levering and unlevering beta from comparables.
"What happens to the DCF if WACC rises?"
Present values fall, so valuation falls. Terminal value is especially sensitive.
"When would a DCF be inappropriate?"
For businesses with highly unpredictable or negative cash flows (early-stage start-ups), or for banks and insurers, where debt is operational and other methods such as dividend discount models are usually used.
"Why might perpetuity growth and exit multiple methods give different results?"
Because the implied multiple from the growth method may not match market multiples, which signals inconsistent assumptions. Reconciling the two is a good sanity check.
"Walk me through how a £10 increase in depreciation affects the DCF."
Higher D&A lowers EBIT and therefore taxes. D&A is added back, so unlevered free cash flow rises by the tax saving (£10 × tax rate), assuming the depreciation is tax-deductible and nothing else changes. Valuation rises slightly.
How is DCF knowledge tested in a superday or PE interview?
In banking superdays, DCF questions are usually conversational. In private equity, interviewers are often more interested in how you'd underwrite a business: cash conversion, capex intensity and downside cases. They may ask you to compare a DCF to an LBO analysis. The LBO tells you what a financial buyer could pay to hit a target return, while the DCF estimates intrinsic value.
How should you practise?
- Explain a DCF out loud five times, each time to a different imagined audience (a fellow student, a managing director, a non-finance relative).
- Build a simple DCF in Excel for a real company from public filings.
- Practise answering follow-ups out loud under time pressure. AI practice tools, including caize.ai's interviewer for finance-style questions, can fire follow-ups at you so you hear where your understanding gets thin. Use them alongside, not instead of, technical study guides and modelling practice.
FAQ
How long should my answer be?
About 90 seconds to two minutes for the overview, then go deeper as prompted.
Do I need to know the formula for WACC?
Yes: WACC = (E/V × cost of equity) + (D/V × cost of debt × (1 − tax rate)).
Should I mention mid-year convention?
Only if asked or if it fits naturally. It shows depth but isn't essential in the core answer.
What's the most common mistake?
Mixing levered and unlevered concepts, for example discounting levered free cash flow at WACC.
