Walk Me Through a DCF - Investment Banking Interview Question

hey guys mike with financiable here today we're going to tackle one of the most common interview questions in finance which is walk me through a dcf this question often trips people up because they get lost in the weeds of the question and we're gonna give you a simple framework to nail the question and get the job by the way if you like these interview question reviews and you find them helpful definitely hit subscribe down below we have a lot more coming let's hop in here so when people try to answer this question one of the

biggest pitfalls is getting lost in the weeds and what you need is a big picture framework and we have a five step framework here for answering this question so that that doesn't happen to you we're going to go through the five steps at a very high level we're then going to walk through all the bits and pieces in detail one by one and then we'll come back and recap exactly how you'd answer this in an interview let's walk through the five steps briefly here and then we'll dive into the details so you begin with calculating

your stage one cash flows you then calculate terminal value which is your stage two value you then discount back stage one and stage two at your weighted average cost of capital which gives you enterprise value and then you can work from enterprise value to equity value by subtracting debt and adding cash and if you're asked to calculate to a price per share you would then take that equity value and divide by the number of shares at that point so those are the five steps and what we're going to do is now walk through each of

those steps in a little bit more detail and again when you answer the question you want to stay high level but we want you to have some of the nuts and bolts in case you are dragged down into the details so let's take a look so before we go through the five steps just a quick note we're doing a standard dcf where we start with unlevered free cash flow which is cash flow not affected by debt work to enterprise value and then ultimately to equity value and that type of approach the unlevered approach is what

is most common in interviews there is another approach using levered free cash flow it's not nearly as common i will make a video on that down the road but for now we're going to stick with the most common question in step one what we're going to calculate is our stage 1 cash flows and what we mean by cash flow is the money generated by the business after paying taxes and accounting for reinvestments and in particular we're calculating unlevered free cash flow so we're not going to incorporate the impact of any type of debt to walk

through this step by step we're going to start with ebit which is the profit of the business we then take out taxes because we have to pay our taxes we add back non-cash charges which is really just depreciation amortization in most cases because those are not cash expenditures but we needed to include them in ebit to calculate our taxes appropriately we then deduct capital expenditures or reinvestment in the business and then we adjust for changes in networking capital which is a longer conversation that we're going to cover in a future video but the short story

is it's another form of reinvestment in things like inventory let's imagine you're starting a pizza shop and you need to set it up you're going to need to buy inventory for that pizza shop which ties up cash and that's what we're talking about with changes in networking capital so in short when we calculate all those things out we work to unlevered free cash flow which again is the excess cash flow generated by the business after taking into account taxes and reinvestments now before we move on i want to make a quick note about stage 1

versus stage 2. so down below i've drawn out a little diagram which shows revenue and time so most businesses and you guys may have seen this in another video most businesses start small they inflect in their growth at some point they mature and level out and we can use that to explain what stage one means so when we calculate stage one what we're doing is we're calculating to the point of maturity for the business now the standard answer for the question of how long you project out for stage one versus stage two is five to

ten years which is fine but really what you're doing is projecting until the business hits maturity or some sort of steady state and then you project your stage two with simplifying assumptions beyond that point just wanna make sure that point is clear as an aside we have another video on stage one versus stage two if you wanna check that out so now in step two we're gonna calculate our terminal value terminal value reflects the value beyond stage one and there are two ways to calculate terminal value the first way is the perpetuity growth method over

on the left here and what we do there is we take all the cash flows out beyond our stage one and then bring them back today at a constant growth rate and that creates our terminal value the way we do that mechanically is we take our cash flow at the final period of stage one which is typically the fifth year which is why we're using five here and what we do is we then multiply that cash flow by one plus our terminal growth rate or our perpetual growth rate which is typically around gdp because businesses

can't outgrow gdp perpetually and then we divide by our discount rate which is our whack which we'll get to in a second minus our growth rate and what that does is it takes our cash flows as of year 5 carries them out into infinity and then brings them back to today and that gives us our terminal value now if you think about that in substance what we've done is we've taken all our cash flows out into the future and brought them back to the end of stage one and really what that represents is the value

of the business beyond stage one that leads me to the second method which is the exit multiple method and the short really a shortcut method but honestly the most common in practice in my experience um so with the exit multiple method what we do is we say okay well if that's the value of the business beyond stage one we can just use a multiple based approach to value the business at the end of our stage 1 and that will suffice instead of using the perpetuity growth formula the most common way of doing that is taking

ebitda and then multiplying it by our evde multiple based on pure valuations and that gets us to terminal value now there's an important thing i want you to understand here though which is both of these methods get you to the same place so it's not as if there one is an alternative to the other if you use the perpetuity growth method you're making an implicit assumption about the exit multiple method and vice versa it's really two different ways of doing the same thing whichever method you choose you end up with terminal value which is again

the value beyond stage one now that we have our stage one and stage two values calculated out the next step is to discount those values back to today using our weighted average cost of capital or whack so before we move ahead i want to make a quick note on whack because this often throws people for a loop so the short story here is whack is just a discount rate and any discount rate really just reflects the cost or riskiness of a particular set of cash flows the thing is most businesses have multiple capital providers so

they'll have lenders and investors at the very least sometimes more and those capital providers have different risk profiles and thus different expected rates of return so for example if i have a lender that gets paid before my investors they are taking less risk and let's have a lower cost of capital than my investor who gets paid second and is going to have a higher cost of capital or expected return the problem here is that we can't discount back by the lender's cost of capital because they're taking less risk and thus have a lower expected return

or discount rate and we also can't discount back at the investor's cost of capital because they're taking more risk and have a higher discount rate so what we do is we blend their expected returns to get to a weighted average cost of capital and that's where this whole concept comes from so now let's move down to the formula make this a little bit more complicated here for a second so the way that this works is we take our lender's expected rate of return the cost of debt or k sub d and we multiply by one

minus the tax rate because interest from a company's perspective is tax deductible so the true cost of the company is the after tax cost and then we just multiply by the proportion of debt relative to the total of debt plus equity and what we're saying here is what's the proportional cost of the debt in the capital structure we then take our investors expected return or the cost of equity and then multiply that by their proportional contribution to the total capital of the business the equity over debt plus equity and that gets us a blended expected

return or cost of capital for the business now i jumped over cost of equity fairly quickly we actually have a whole separate video that walks through the concept of cost of equity in quite a bit of detail if you want to check it out now we can wrap up this step and to do that what we're going to do is take all the cash flows we projected out for stage 1 as well as our terminal value and we're going to discount them back at one plus our discount rate which is whack in this case raised

to the number of periods and when we do that what we're really doing is pulling the cash flows all the way across the board along with the terminal value back to time zero let me get rid of all these and when we pull those cash flows back what we're really showing is the price we would pay for the right to all the future cash flows of the business which is just the purchase price of the entire business which we call enterprise value enterprise value is just a fancy term for purchase price of the entire business

so now we have the enterprise value and we can move on to the next step now in step four we're going to work from enterprise value to equity value and as i said in the last step enterprise value is the price to buy the entire business equity value on the other hand is what the owner owns the value to the owner so to get to equity value what we're going to do is we're going to start with enterprise value so the value of the business then think of this as we're selling the business we're then

going to subtract out debt because if we sold the business we'd have to pay the lenders first we're going to add cash because let's imagine you owned a business and you sold it if there were excess cash in the company's bank account that would be your money and that gets you to equity value which again is just really what the owner owns of the business so their ownership stake in the business at a given point in time now in step five we have our final and potentially optional step so in a lot of cases you

aren't asked to calculate the price per share but if you are this is what you would do and it's a fairly simple exercise so to calculate the price per share what we're going to do is we're going to take the equity value that you just calculated and divide by the fully diluted share count of the business to get to price per share now you'll notice in the drawing that i just said number of shares as opposed to the fully deleted share count and that was actually intentional when you're explaining this an interview i would just

say we take equity value and we divide by the number of shares to get the price per share if you say fully deluded share account they'll drag you into that calculation discussion and it becomes much more complicated so i'd start with that and if they drag you into the weeds of that then you can discuss fully diluted shares which is really just your basic shares plus any potential shares from options restricted stock and convertible debt or any type of convertible instrument but i would try to avoid that altogether by just saying divide by the number

of shares now that we've walked through the steps in detail let's talk about how you'd answer this in an interview so short story is you're going to keep it super high level and should you have to discuss all of the nuts and bolts that we just went through you can discuss that and we just went through it for you but you really want to keep it high level and stick to these five steps here so if someone says to me walk me through a dcf my answer is going to be we start by calculating our

stage one cash flows for the business we then calculate the value beyond that which is our terminal value or stage two we then take our discount rate and discount back both our stage one cash flows and our terminal value which gets us to enterprise value and then we can work from enterprise value to equity value by subtracting debt and adding cash and if they ask you for the price per share calculation it's we then take equity value and divide by the number of shares to get to a price per share simple as that and again

if they pull you into the weeds you've got the bits and pieces to answer that now after this video but keep it super high level and let them pull you into those details so hopefully how you'd answer walk me through a dcf in an interview setting makes a little bit more sense now if you found this answer helpful definitely hit subscribe down below we have a lot more of these videos coming and we hope to hear from you soon take care you