“Walk me through a DCF.” Make every step count.

Give the structure before the detail

A compact answer could be: ‘I forecast unlevered free cash flow over an explicit period, estimate a terminal value, and discount both at WACC to get the value of the operating business. I then adjust for non-operating assets and claims ahead of common equity to reach equity value.’

Pause there. If asked to go deeper, explain the assumptions driving each stage rather than delivering a memorised list of formula names.

Build unlevered free cash flow

Start with operating profit after tax, add back non-cash depreciation and amortisation, then subtract capital expenditure and the increase in operating net working capital. Interest expense does not belong in this unlevered cash flow because financing is reflected in the discount rate.

For an original practice example, assume EBIT of 80, a 25% tax rate, D&A of 12, capital expenditure of 20 and an increase in operating working capital of 7. After-tax operating profit is 60; free cash flow is 45.

State the terminal value assumption

The perpetuity-growth approach assumes cash flow grows at a stable rate beyond the explicit forecast. The exit-multiple approach applies a chosen multiple to a terminal operating metric. Neither removes the need to justify what the business looks like at maturity.

Suppose year-five cash flow is 50, long-term growth is 2% and WACC is 10%. Terminal value at the end of year five is 50 × 1.02 / (0.10 − 0.02) = 637.5. Its present value under a year-end convention is approximately 395.8. That is only the terminal component; add the present value of the explicit forecast cash flows.

Close the bridge to equity

If the operating business is worth 500, with 80 of debt and 20 of excess cash, simplified equity value is 440. Other adjustments can include preferred equity, non-controlling interests and non-operating investments, depending on what your cash flow includes.

Be consistent about both scope and timing. Do not add cash already captured elsewhere in your valuation or subtract a claim twice.

Practise the follow-ups

A useful rehearsal is to change one assumption at a time. Higher WACC lowers present value if expected positive cash flows are unchanged. A higher perpetual growth rate raises terminal value in this model, but it must remain below WACC and be economically defensible.

• Why do you use unlevered cash flow?
• What changes if the business has negative near-term cash flow?
• Why can terminal value dominate the output?
• Which assumptions would you sensitise before trusting the result?