Walk me through a DCF: how to answer it step by step

In this article

1. Before you start
2. Why interviewers ask this
3. DCF from first principles
4. Worked example
5. Trade-offs and edge cases
6. How to answer it in an interview
7. Common mistakes
8. Follow-up questions
9. Sources

Before you start

For the wider set of investment banking questions, see the investment banking interview questions guide. For the model mechanics behind each line, see financial modeling interview questions. For how the same statements feed a model, see the three-statement walkthrough.

Why interviewers ask this

The DCF question tests whether a candidate understands what drives value, not whether they can recite a list. Candidates report it in technical rounds for investment banking and private equity roles.

A weak answer lists the steps in a flat line: "project cash flows, discount them, add terminal value." A strong answer says what each step produces, which cash flow matches which rate, and why the bridge to a per-share value subtracts net debt. A senior-level answer, the kind a senior banker gives, adds the judgement: the terminal value can carry most of the result, so the answer is a range that depends on the discount rate and the growth rate. Interviewers then probe exactly those two inputs. The investment banking technicals page shows the neighbouring questions that tend to follow.

DCF from first principles

Unlevered free cash flow

Unlevered free cash flow is the cash a business's operations generate after tax on operating profit and after reinvestment in equipment and working capital, measured before any interest payments, so it belongs to lenders and shareholders together. It equals earnings before interest and taxes (EBIT) × (1 − tax rate) + depreciation and amortization (D&A) − capital expenditure (CapEx) − the increase in net working capital.

Weighted average cost of capital (WACC)

The weighted average cost of capital is the blended return that a company's lenders and shareholders together require, weighting the after-tax cost of debt and the cost of equity by their shares of total market value. A DCF uses it to discount unlevered free cash flow, because that cash flow belongs to both groups.

Enterprise value (EV)

Enterprise value is the value of a company's operating business to all its capital providers, debt and equity together, before net debt is subtracted. A DCF produces enterprise value first; equity value is what remains for shareholders after net debt and similar claims are taken out.

In plain words

Think of pricing an orchard. You estimate the fruit it will sell each year. You shrink each future harvest, because waiting has a cost. You add what the orchard is worth after your forecast ends. Then you subtract the loan on it. The analogy breaks at risk: the orchard picture hides that a riskier harvest gets a higher discount rate. Each step in the next sections matches one of these moves, so keep the picture in mind as you read.

In one precise sentence, a DCF forecasts unlevered free cash flow, finds the discount rate, discounts the cash flows and adds a terminal value, then bridges enterprise value to equity value per share.

Step 1: Forecast unlevered free cash flow

The forecast turns the operating plan into one cash number per year. Start from EBIT and remove tax on it, which gives net operating profit after tax (NOPAT). Add back depreciation and amortization (D&A), because it is a charge that uses no cash. Subtract capital expenditure (CapEx), the cash spent on equipment and buildings. Subtract the increase in net working capital, the growth in short-term operating assets minus short-term operating liabilities, because growth ties up cash.

Input: a revenue and margin plan. Output: one cash flow for each forecast year. Interest is left out on purpose, so the value does not depend on how the company is financed. The forecast runs until the business reaches a steady growth rate; the worked example below uses five illustrative years. Damodaran's valuation lecture notes teach this forecast-then-terminal-value structure. You now have the numbers to discount, and the next step finds the rate.

Step 2: Find the discount rate (WACC)

The discount rate for these cash flows is the weighted average cost of capital, because the cash flows belong to lenders and shareholders together. WACC = equity weight × cost of equity + debt weight × cost of debt × (1 − tax rate). The cost of equity usually comes from the capital asset pricing model (CAPM): risk-free rate + beta × equity risk premium (ERP). Beta measures how strongly the stock moves with the market.

Read the risk-free rate from a government yield such as the Treasury par yield curve, and an equity risk premium from a published estimate such as Damodaran's implied premium data. Weights use market values, not book values. With illustrative inputs of a 4% risk-free rate, beta 1.1, a 5% premium, 6% pre-tax debt cost, a 25% tax rate and a 70/30 equity/debt split, the cost of equity is 9.5% and WACC is 8.0%.¹ The corporate finance interview questions cover the cost of capital in more depth.

Step 3: Discount the cash flows and add a terminal value

Discounting divides each year's cash flow by (1 + WACC) raised to the power of the year number. The terminal value then captures every year after the forecast. The Gordon growth formula is terminal value = final-year cash flow × (1 + g) / (WACC − g), where g is the long-run growth rate. The other method applies a market multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) to the final year. The growth rate must stay below WACC, and a common rule keeps it at or below the long-run growth of the economy.

Input: the cash flows and the rate. Output: enterprise value, the sum of the discounted cash flows and the discounted terminal value. This is the point interviewers press on. For a company that is still growing, the forecast years are few and the terminal value covers every later year, so it is often the larger part. In the illustrative worked example its present value is 79.6% of enterprise value.¹

Step 4: Bridge from enterprise value to value per share

Enterprise value belongs to lenders and shareholders together, so shareholders get what is left after the lenders. Subtract net debt, and also minority interest and preferred stock where they exist, and add non-operating assets such as equity investments, to reach equity value. Divide by the diluted share count to get value per share. Balance-sheet debt, cash and the share count come from the company's latest annual report, which the filing search on the Securities and Exchange Commission's website finds.

In the illustrative example, enterprise value of 1,553.9 million less net debt of 300.0 million gives equity value of 1,253.9 million; across 50.0 million diluted shares that is 25.1 per share.¹ Each step produces the input of the next step.

1 · Forecast2 · Rate3 · Discount4 · BridgeReplay

Step-by-step description

1. Forecast unlevered free cash flow for each year.
2. Find the discount rate, WACC.
3. Discount the cash flows and add a terminal value.
4. Subtract net debt and divide by shares.

• A DCF forecasts unlevered free cash flow, finds the discount rate, discounts the cash flows and adds a terminal value, then bridges enterprise value to equity value per share.
• Each step produces the input of the next step.

Worked example

The company below is invented and every input is illustrative, in millions of currency units. The table builds unlevered free cash flow for five years and discounts it at 8.0%.¹

The terminal value uses growth of 2.5% (illustrative): 97.50 × 1.025 / (0.080 − 0.025) is 1,817.0 in year 5, and discounting it gives a present value of 1,236.7.¹ The five forecast years add 317.2 together, so enterprise value is 1,553.9.¹

Text description of the diagram

• The present value of the terminal value is 1,236.7 of an enterprise value of 1,553.9.
• The five forecast years add 317.2 together.

The present value of the terminal value is 1,236.7 of an enterprise value of 1,553.9 (illustrative).¹

Now change the inputs slightly. The table shows the value per share for three discount rates and three growth rates, all illustrative.¹

At WACC 8% and growth 2.5% (illustrative) the value is 25.1 per share. The range across the grid runs from 18.6 to 36.3 per share, nearly double the low end.

Trade-offs and edge cases

A DCF trades market noise for assumption noise. It does not depend on what other companies trade at, but it depends heavily on the discount rate and the growth rate. The terminal value method is the biggest choice.

Use each as a check. With final-year EBITDA of 174 (EBIT 146 plus D&A 28, illustrative), the Gordon terminal value of 1,817.0 implies an exit multiple of 10.4 times EBITDA.¹ If that multiple looks far from where comparable companies trade, revisit the growth rate or the WACC.

Text description of the diagram

• Final-year EBITDA is 174.
• The Gordon terminal value of 1,817.0 implies an exit multiple of 10.4 times EBITDA.

Other cases matter. If cash arrives through the year, mid-year discounting treats each cash flow as arriving halfway through, which raises value slightly. If WACC is not above g, the formula breaks, so the rate and the growth rate must be sensible together. Currency and inflation must be consistent: nominal cash flows take a nominal rate. A company with negative cash flows needs a longer forecast before the terminal value makes sense. Banks are valued on cash flows to equity with the cost of equity, not on this enterprise version. The mergers and acquisitions page shows how a DCF sits beside other valuation methods in a deal.

How to answer it in an interview

The spoken structure: say the cash flow, then the rate, then the terminal value, then the bridge, and finish with the sensitivity.

Common mistakes

• "I discount the cash flows to equity at WACC." (wrong) Cash flows before interest belong to lenders and shareholders together. (right) "Unlevered cash flow goes with WACC; cash flow to equity goes with the cost of equity."
• "Enterprise value is the share price times shares." (wrong) That is equity value. (right) "I subtract net debt, and adjust for minority interest and preferred stock, to move from enterprise value to equity value."
• "I weight WACC with book values." (wrong) Book values are historical. (right) "I use market values for equity and debt."
• "I set terminal growth where I like." (wrong) It must stay below WACC and should not outgrow the economy. (right) "I keep it modest and cross-check with an exit multiple."
• "The DCF gives the value." (wrong) The grid above shows 18.6 to 36.3 per share for small input changes. (right) "It gives a range that depends on the assumptions."

Follow-up questions

How do you calculate unlevered free cash flow?

Take EBIT, multiply by one minus the tax rate, add depreciation and amortization, subtract capital expenditure, and subtract the increase in net working capital. The financial modeling interview questions walk through the line items.

Why do you discount the cash flows at WACC?

The cash flows are before interest, so they are available to lenders and shareholders together. WACC is the blended return those two groups require, so it is the matching rate.

How do you find beta for a private company?

Take the betas of comparable public companies, remove their leverage with βu = βL / (1 + (1 − t) × D/E), average them, then relever at the target's debt-to-equity ratio. Here βu is the unlevered beta, βL the observed beta, t the tax rate and D/E the debt-to-equity ratio.

What terminal growth rate should you use?

Use a modest rate that stays below WACC and does not exceed long-run growth of the economy. In the example, 2.5% is used for illustration only, and the sensitivity table shows how far the value moves if it changes.

Gordon growth or exit multiple?

Use one as the main method and the other as a check. Gordon growth rests on the growth assumption; the exit multiple rests on market pricing, and each exposes the other's weakness.

How sensitive is a DCF to its inputs?

Very sensitive. In the illustrative grid, moving WACC from 7% to 9% and growth from 3.0% to 2.0% moves the value from 36.3 to 18.6 per share. The investment banking technicals page covers related sensitivity questions.

Sources

1. Damodaran Online: valuation lecture notes and data — NYU Stern (Aswath Damodaran), 26 Oct 2026
2. Damodaran Online: implied equity risk premium data — NYU Stern (Aswath Damodaran), 26 Oct 2026
3. Daily Treasury Par Yield Curve Rates — U.S. Department of the Treasury, 26 Oct 2026