DCF Overview & Core Concepts
Frame discounted cash flow as an investor would: when it's powerful, when it breaks, and how to connect free cash flow, discount rates, and enterprise value into a coherent narrative instead of a mechanical exercise.
Interview Angle
By the end of this lesson you should be able to walk someone through DCF intuition in plain English, not just recite formulas.
What You'll Learn in This Lesson
1Where DCF Sits in the Valuation Toolkit
A DCF is one of several valuation tools you'll use as a banker. It is powerful because it is theoretically grounded: value equals the present value of all future cash flows. It is dangerous because every input is a judgment call — growth, margins, reinvestment, discount rate, terminal assumptions.
In practice, most buy-side and sell-side teams use DCFs to answer three questions:
Sanity Check
Does a theoretically grounded DCF support or contradict where comps are trading?
Narrative Tool
What story do our assumptions tell about growth, margins, and reinvestment?
Sensitivity Engine
How sensitive is value to key levers (growth, margin, WACC, exit multiple/TV g%)?
Interview framing tip: when asked “Walk me through a DCF,” start with a 10-second positioning: “We project free cash flows from the three-statement model, discount them at a risk-adjusted rate (WACC), add a terminal value, and reconcile from enterprise value to equity value and price per share.” Then go into mechanics.
How ibleet will make this concrete:
- Later in the module, you'll build a full DCF inside the grid and see how changing just WACC or exit multiple moves implied IRR and equity value.
- You'll also get scoring on whether your assumptions are internally consistent — something static textbooks never provide.
2Enterprise Value vs Equity Value — The Non-Textbook Version
A DCF built on unlevered free cash flow yields an enterprise value (EV). Investors, however, buy equity, not EV. You must be fluent in the bridge from EV → equity value → price per share.
Conceptual Definitions
- Enterprise Value: value of the entire business to all capital providers (debt, equity, preferred, minority interest).
- Equity Value: value attributable only to common shareholders — what you compare to market cap.
- Unlevered FCF: cash flows before interest (available to all capital providers) → discount at WACC → EV.
EV → Equity Bridge (Banker Format)
− Net Debt (Debt − Cash)
− Preferred Equity
− Minority Interest
± Other Adjustments (leases, pensions, NOLs)*
= Equity Value
÷ Diluted Shares Outstanding
= Implied Price per Share
Treatment of leases, pensions, and NOLs differs firm-to-firm. Later lessons and the modeling engine will show multiple “house views” and explain the trade-offs.
Worked Numeric Example
Step 1 — DCF Output:
PV of forecast period FCFs = $420M
PV of terminal value = $780M
Enterprise Value = $1,200M
Step 2 — EV → Equity:
Net Debt = $350M
Preferred Equity = $50M
Minority Interest = $30M
Equity Value = 1,200 − 350 − 50 − 30 = $770M
Diluted Shares = 77M
Implied Price/Share = 770 / 77 = $10.00
Common interview trap: saying “DCF gives you a target share price” without mentioning EV. A precise answer is: “An unlevered DCF produces enterprise value, which we then bridge to equity value and finally to an implied share price using diluted shares.”
3Unlevered vs Levered Free Cash Flow (FCFF vs FCFE)
In this module, you'll primarily model unlevered free cash flow (FCFF), also called free cash flow to the firm. But interviews frequently ask you to distinguish FCFF vs FCFE and when you might use each.
FCFF — Unlevered Free Cash Flow
Cash flows available to all capital providers (debt and equity), before interest expense.
+ D&A
− CapEx
− ΔNWC
Discount FCFF at WACC → Enterprise Value.
FCFE — Levered Free Cash Flow
Cash flows available only to common equity holders, after interest and debt flows.
+ D&A
− CapEx
− ΔNWC
− Mandatory Debt Repayments
+ Net New Debt Issuance
Discount FCFE at the cost of equity → Equity Value directly (no EV bridge).
Practical Comparison & Interview Angles
Why bankers prefer FCFF:
- Simpler to use with multiple capital structures / leverage cases.
- Lines up cleanly with EV-based multiples (EV/EBITDA, EV/EBIT).
- Less sensitive to specific debt repayment schedules.
When FCFE is useful:
- Financial institutions where debt is "raw material."
- Highly levered equity where equity behaves like a call option.
- Academic or hedge-fund contexts that focus on cost of equity modeling.
Interview sound-bite:
“In banking we almost always use an unlevered DCF: we project FCFF, discount at WACC to get enterprise value, and then reconcile to equity value. FCFE is conceptually similar but incorporates the capital structure explicitly and is discounted at the cost of equity.”
4Building a Clean Unlevered Free Cash Flow Bridge
A proper FCFF schedule begins with EBIT, applies a cash tax rate, and adjusts fornon-cash items, changes in working capital, andcapital expenditures. Most junior analysts get tripped up because they treat FCFF as a mechanical formula rather than a logical economic flow.
Core FCFF Structure
× (1 − Tax Rate)
= NOPAT (Net Operating Profit After Tax)
+ D&A
− CapEx
− ΔNWC
= Unlevered Free Cash Flow
Worked Example — Full FCFF Bridge
Operating Inputs
Revenue = 500M
EBIT margin = 18%
Tax rate (cash) = 25%
D&A = 20M
CapEx = 30M
ΔNWC = −5M (source)
Bridge Calculation
EBIT = 500 × 18% = 90M
NOPAT = 90 × (1 − 25%) = 67.5M
+ D&A = +20M
− CapEx = −30M
− ΔNWC = −(−5M) = +5M
FCFF = 67.5 + 20 − 30 + 5 = 62.5M
Analyst Insight:If EBIT margins rise but FCFF falls, your issue is almost always in CapEx or NWC. Free cash flow is more sensitive to reinvestment than to margins. This is why DCF is the best sanity check for capital intensity.
5Designing the Forecast Period — What Actually Drives Value
Most DCFs use a 5–10 year explicit forecast period. The point isn’t “how long,” it’s:what assumptions create the company’s economics?
Revenue Growth
Driver-based (volume × price, ARPU × subs, units × mix) is preferred.
Margins
Gross → EBITDA → EBIT; each tied to operational scaling logic.
Reinvestment
CapEx and NWC patterns should reflect business model, not noise.
Example – Proper Forecast Logic
Revenue Drivers
Units sold = 2.5M
Growth = 7% annually
Price / unit = $32
Margin Evolution
Gross margin expands 80bps/year
SG&A leverage reduces opex by 40bps/year
EBIT margin rises from 14% → 18%
Reinvestment Pattern
CapEx = 5.5% of revenue
ΔNWC = 1.5% of revenue (growing co.)
D&A ≈ CapEx for a steady-state business
Advanced modeling point: A company with 10% revenue growth but 12–15% reinvestment needs (CapEx + ΔNWC) can have lower FCFF than a slower-growing competitor. Growth is not “free” — reinvestment is the hidden lever that IB textbooks gloss over but real investors obsess over.
6WACC — The Real Intuition (Not the Textbook Version)
Most analysts “calculate” WACC but cannot explain what it means. Interviewers test if you understand that WACC blends the required return of all capital providers, weighted by their relative stake in the business.
WACC Formula (Banker Format)
+ (D / (D + E)) × Cost of Debt × (1 − Tax Rate)
Cost of Equity (CAPM)
Risk-free rate + β × Equity Risk Premium
Cost of Debt (Yield)
Estimated from market yields or credit spreads.
Capital Structure Weights
Target or market value basis (never book value).
Worked Example — WACC for a Mid-Market Company
Inputs
Risk-free rate = 4.0%
ERP = 5.5%
Beta = 1.25
Cost of debt = 7.0%
Tax rate = 25%
Target weights: 65% equity / 35% debt
Outputs
Cost of equity = 4.0% + 1.25 × 5.5% = 10.9%
After-tax cost of debt = 7.0% × (1 − 25%) = 5.25%
WACC = 0.65 × 10.9% + 0.35 × 5.25% = 8.9%
Buy-side tip:When WACC is above 10–11% for “normal” businesses, investors assume either structural risk, high leverage, or lack of competitive moat. WACC is always a story about risk, not just a number.
7Terminal Value — The Silent Giant (60–90% of Value)
The terminal value (TV) usually drives the majority of a DCF’s valuation. Understanding TV logic is one of the clearest ways to “sound senior” in interviews.
Perpetuity Growth Method
TV = (FCFFfinal year + 1) / (WACC − g)
g should rarely exceed long-term GDP growth (2–3% in developed markets).
Exit Multiple Method
TV = Exit Multiple × Final-Year Metric (EBITDA, EBIT, etc.)
Should anchor to current/broader comps, not arbitrarily inflated multiples.
Example — Perpetuity Method
g = 2.5%
WACC = 8.5%
FCFFt+1 = 75M × 1.025 = 76.9M
TV = 76.9 / (8.5% − 2.5%) = 1,281M
Senior banker framing:“Terminal value is not ‘everything after year 5.’ It is the present value of all future cash flows assuming the company reaches a steady state. The art is picking assumptions that are internally consistent with the explicit period — not magically higher.”
8Pulling It All Together — From FCF to Enterprise Value
Once FCFF, WACC, and terminal value are known, producing an enterprise value is straightforward — but interpretation is where junior analysts stand out.
Present Value Mechanics
PV(Terminal Value) = TV / (1 + WACC)T
Example — Pulling Together a 5-Year DCF
Forecast FCFFs
Year 1: 60M
Year 2: 65M
Year 3: 70M
Year 4: 74M
Year 5: 78M
Assumptions
WACC = 9.0%
Terminal method: Perpetuity
g = 2.5%
FCFFt+1 = 78M × 1.025 = 79.95M
TV = 79.95 / (0.09 − 0.025) = 1230M
PV Calculations
PV(FCFF1) = 60 / 1.09 = 55.0M
PV(FCFF2) = 65 / 1.09² = 54.7M
PV(FCFF3) = 70 / 1.09³ = 54.1M
PV(FCFF4) = 74 / 1.09⁴ = 52.4M
PV(FCFF5) = 78 / 1.09⁵ = 50.7M
PV(TV) = 1230 / 1.09⁵ = 800.2M
Enterprise Value = Sum(PV FCFs) + PV(TV)
= (55 + 54.7 + 54.1 + 52.4 + 50.7) + 800.2
= 1,067M
Interpretation skill:A strong analyst doesn’t stop at the EV. They compare: • DCF value vs trading comps • DCF value vs precedent transactions • DCF value vs management guidance and explain why the differences make sense.
9Mini Case Study — “Orion Tools Inc.”
This case mirrors the type of company used in your upcoming DCF practice problem (Problem 1). Mastering this example will make the modeling grid extremely intuitive.
Company Snapshot
- Industry: Light industrial tools
- Revenue: 550M
- EBIT margin: 16%
- CapEx intensity: 5% of revenue
- NWC: 10% of revenue, grows with sales
- Growth rate: 6–7%
FCFF Calculation
EBIT = 550 × 16% = 88M
NOPAT = 88 × (1 − 25%) = 66M
D&A = 24M
CapEx = 550 × 5% = 27.5M
ΔNWC ≈ 550 × 10% × 6.5% growth = 3.6M
FCFF = 66 + 24 − 27.5 − 3.6 = 58.9M
Enterprise Value Snapshot
- WACC = 9.2%
- g = 2.5%
- TV ≈ ~1.1B
- PV(FCFs) ≈ ~235M
- EV ≈ 1.335B
Why this matters:
This case gives you a mental model of how typical mid-market industrials behave. When you get to the modeling grid, your FCF schedule will feel familiar rather than abstract.
10Interview Prep — DCF Questions You Must Master
Walk me through a DCF.
Start with projecting unlevered free cash flows from EBIT, discount them at WACC, calculate terminal value using perpetuity or exit multiple, sum to enterprise value, then bridge to equity value and price per share.
What drives a DCF — growth, margins, or reinvestment?
Reinvestment is the hidden lever. Growth only creates value if ROIC exceeds the discount rate and the reinvestment burden does not consume the incremental cash flow.
Why does terminal value dominate a DCF?
Because most businesses reach a steady-state far beyond the explicit forecast. If the explicit period does not capture major structural changes, the long-run economics dominate.
When is a DCF not useful?
Hyper-cyclical businesses, unpredictable reinvestment, short product cycles, or unclear capital structure dynamics. Also when WACC and g are highly unstable.
What is WACC trying to reflect?
The opportunity cost of capital — the required return demanded by all capital providers given the business’s risk profile.
How do you sanity-check a DCF?
Compare against trading comps, precedents, IRR math, management guidance, and unit economics. Ensure assumptions are internally consistent.
11Key Takeaways
- 1. DCFs tell a story, not just a number.Every assumption signals what you believe about margins, growth, and reinvestment.
- 2. FCFF is the cleanest lens for valuation.Begin at EBIT, apply cash taxes, then adjust for non-cash and reinvestment.
- 3. WACC is about risk, not math.A high WACC means investors demand more return to compensate for uncertainty.
- 4. Terminal value must be internally consistent.TV assumptions must line up with explicit period economics.
- 5. Senior bankers evaluate assumptions before outputs.If your revenue and reinvestment logic makes sense, your EV will follow.