DCF Analysis Interview Questions & Walkthrough
Step-by-step explanation, real interview questions, model answers at different levels, and AI-scored practice.
Quick answer
A Discounted Cash Flow (DCF) analysis values a company by projecting its future free cash flows and discounting them back to present value using the Weighted Average Cost of Capital (WACC). The five core steps are: project revenue, calculate free cash flow, determine WACC, calculate terminal value, and discount everything to present value.
Step 1
What is a DCF analysis?
A Discounted Cash Flow analysis is an intrinsic valuation method that values a company based on the cash it is expected to generate in the future. Unlike relative valuation methods (comparable companies, precedent transactions), a DCF derives value from fundamentals rather than market pricing.
The core principle is the time value of money: £1 received today is worth more than £1 received next year, because today's £1 can be invested to earn a return. A DCF systematically accounts for this by discounting future cash flows using an appropriate rate.
Step 2
Step 1 — Project free cash flows
Start with revenue projections, typically 5-10 years into the future. Use a combination of top-down (market size × market share) and bottom-up (units × price) approaches. Apply operating margins to get EBITDA, then subtract D&A to get EBIT.
From EBIT, subtract taxes (using the marginal tax rate), add back depreciation and amortisation (non-cash), subtract capital expenditures, and adjust for changes in working capital. The result is Unlevered Free Cash Flow (UFCF) — the cash available to all capital providers.
Key formula: UFCF = EBIT × (1 - Tax Rate) + D&A - CapEx - Change in Working Capital
Step 3
Step 2 — Calculate WACC
WACC (Weighted Average Cost of Capital) is the discount rate used to bring future cash flows to present value. It represents the blended required return across all capital providers — both debt and equity.
WACC = (E/V × Re) + (D/V × Rd × (1-T)), where E = equity value, D = debt value, V = total (E+D), Re = cost of equity, Rd = cost of debt, T = tax rate. Cost of equity is typically derived from CAPM: Re = Rf + β × (Rm - Rf).
Example WACC ranges (vary by company and market conditions): typically 8-12% for mature companies, 12-20% for growth companies, 5-8% for utilities. The exact WACC significantly impacts valuation — a 1% change in WACC can shift the output by 15-25%.
Step 4
Step 3 — Calculate terminal value
Terminal value captures the value of all cash flows beyond the explicit projection period. It typically represents 60-80% of total DCF value, which is why it requires careful treatment.
Two methods: (1) Gordon Growth Model — TV = FCF_final × (1+g) / (WACC-g), where g is the perpetual growth rate (typically 2-3%, not exceeding long-term GDP growth); (2) Exit Multiple Method — TV = EBITDA_final × Exit Multiple (derived from comparable company trading multiples).
Best practice is to calculate terminal value using both methods and compare. If they diverge significantly, scrutinise your assumptions.
Step 5
Step 4 — Discount to present value
Discount each year's projected free cash flow and the terminal value back to present using WACC. The formula for each year: PV = CF / (1+WACC)^n, where n is the number of years into the future.
Sum all discounted cash flows plus the discounted terminal value to get Enterprise Value. Bridge from Enterprise Value to Equity Value by subtracting net debt (total debt minus cash), minority interest, and preferred stock. Divide Equity Value by diluted shares outstanding to get implied share price.
Always run a sensitivity analysis on key assumptions: WACC (±1-2%), terminal growth rate (±0.5-1%), and revenue growth (±2-3%). Present results as a range, not a point estimate.
Questions
DCF Analysis interview questions
- 1Walk me through a DCF analysis.
- 2What are the key inputs and assumptions in a DCF?
- 3How do you calculate free cash flow?
- 4What discount rate would you use and why?
- 5How do you calculate terminal value? Which method do you prefer?
- 6Why does terminal value typically represent 60-80% of DCF value?
- 7What is WACC and how do you calculate it?
- 8Walk me through the bridge from enterprise value to equity value.
- 9What perpetual growth rate would you use and why?
- 10How would a 1% increase in WACC affect the DCF output?
- 11What are the limitations of a DCF analysis?
- 12When would a DCF not be appropriate?
- 13How do you handle negative free cash flows in a DCF?
- 14What is the difference between levered and unlevered free cash flow?
Model answers
Example answers at different levels
Click a level to see the expected answer depth.
Question
Walk me through a DCF.
Answer
A DCF values a company by projecting its future cash flows and discounting them back to today's value. You project revenue and costs for 5-10 years to get free cash flow each year. Then you calculate a terminal value for everything beyond that period. You discount all of those cash flows using WACC — the company's blended cost of capital — to get enterprise value. Subtract net debt to get equity value, then divide by shares to get a share price.
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Follow-ups
Common follow-up questions
What if I told you the terminal growth rate should be 5%? Walk me through why that might be a problem.
The company has negative free cash flows for the first 3 years. How does that change your approach?
How would you adjust your DCF if the company has significant operating leases?
Walk me through how a change in working capital affects FCF — give me a specific example.
If WACC increases by 2%, what happens to the valuation? Is the impact linear?
When would you use UFCF vs levered free cash flow in a DCF?
How would you think about a terminal value for a company that's growing at 30% per year?
Avoid
Common mistakes on dcf analysis questions
Using a terminal growth rate above long-term GDP growth (2-3%). A 5% perpetual growth rate implies the company eventually becomes larger than the entire economy.
Forgetting to subtract capital expenditures from free cash flow. This is the single most common calculation error in interview DCF walkthroughs.
Using levered free cash flow with WACC. WACC is an unlevered discount rate — it should be used with unlevered free cash flow. Levered FCF uses cost of equity.
Not running a sensitivity analysis. Presenting a single DCF output without a range signals that you don't understand the inherent uncertainty in the model.
Confusing enterprise value and equity value. Know the bridge: EV = Equity Value + Net Debt + Minority Interest + Preferred Stock - Associates.
Ignoring changes in working capital. For many companies, working capital changes are material and can significantly impact free cash flow year to year.
Firms
Which firms ask dcf analysis questions?
Tested at assessment centre stage. Expect follow-up probes on assumptions and sensitivity.
Core technical question in all IB interviews. Especially detailed for M&A roles.
Tested at second round. Often combined with a discussion of a recent deal.
As a pure advisory firm, Lazard tests DCF knowledge more rigorously than bulge brackets.
Technical excellence expected. DCF walkthroughs tested from day one of interviews.
Strong focus on valuation methodology. DCF is a staple of their interview process.
FAQ
DCF Analysis FAQs
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