Walk me through a DCF.
Model answer
A DCF values a business by projecting the unlevered free cash flow it will generate, discounting those cash flows back to today, and adding a terminal value to capture the cash flows beyond the projection period.
Step one: project unlevered free cash flow for five to ten years. UFCF starts with EBIT, taxes EBIT at the marginal rate to get NOPAT, then adds back D&A, subtracts CapEx, and subtracts the change in net working capital. The result is the cash the business throws off before any decisions about how it's financed. The horizon is whatever it takes to get the business to a steady-state growth rate — for stable companies, five years; for growth or cyclical names, longer.
Step two: calculate the terminal value, which is typically 60-80% of total enterprise value, so you have to be careful with it. Two methods: Gordon Growth (Year N+1 UFCF / (WACC - perpetual growth rate)) or exit multiple (Year N EBITDA times an EV/EBITDA multiple from comps). I cross-check the two — if the implied perpetual growth from an exit multiple is 6%, that's a red flag for a mature company.
Step three: calculate WACC. Weight the cost of equity (CAPM: risk-free rate plus levered beta times equity risk premium) and the after-tax cost of debt by their target capital structure weights at market value. WACC for a typical large-cap is 7-10%.
Step four: discount each UFCF and the terminal value back to today using WACC. Sum them — that's enterprise value. Then bridge to equity value: subtract debt, add cash, subtract minority interest, add associates. Divide by diluted shares to get per-share value.
Finally, sensitize. WACC plus or minus 100 basis points and terminal growth plus or minus 50 basis points — a clean DCF always has the football.