If you’re preparing for investment banking interviews, DCF analysis can feel bigger than it really is.
Yes, there are formulas. Yes, there are forecast periods, terminal values, discount rates, and free cash flow definitions. But the core idea is simple: you’re trying to figure out what a company should be worth based on the cash flow it can generate, and then compare that implied value to where the company is valued today.
That’s the part interviewers care about. They don’t want you to recite a definition and stop. They want to know whether you understand why the model works, what belongs in free cash flow, and what absolutely does not.
The big idea behind a DCF
The simplest valuation formula is:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate)
That formula only works if the cash flow growth rate is lower than the discount rate. It also assumes the company’s growth rate and discount rate stay the same forever.
That’s a useful starting point, but it’s not real life.
A company might grow quickly when it’s smaller, then slow down as it matures. Its discount rate might also be very high early on, then fall as the business becomes less risky and its potential returns decline. So instead of pretending growth and risk are fixed forever, a DCF breaks the problem into two pieces.
Project the company’s cash flows in detail for a near-term period, such as the next 5, 10, or 15 years.
Assume the company reaches a steadier state after that, then value the terminal period using a more simplified approach.
You discount the values from both periods back to today and add them together. That gives you the company’s implied value.
This is why DCF analysis is often called intrinsic valuation. You’re valuing the company based on its own cash flows rather than relying only on how other companies are trading.
DCF vs. relative valuation
The other major approach is relative valuation.
Instead of projecting detailed cash flows, you collect comparable companies or comparable M&A transactions, calculate valuation multiples, and apply those multiples to the company you’re analyzing.
For example, if similar companies trade at EV / EBITDA multiples between 10x and 12x, and your company has EBITDA of $200, its implied enterprise value would be between $2,000 and $2,400.
A DCF might produce a different number. Suppose you project 10 years of cash flows and find that their present value is $1,200. Then suppose the present value of the terminal period is $1,500. The company’s implied value would be $2,700.
Now compare those outputs to the company’s current enterprise value. If its current enterprise value is $2,000, the DCF suggests the company is undervalued. The comparable companies analysis suggests a range of $2,000 to $2,400, which is less aggressive but still provides useful context.
That’s the real point of valuation work: comparing implied value to current value.
In banking, that analysis can help advise a board on the price the company might receive in a sale. On the investing side, it can support the view that a company is undervalued and may be attractive if the stock price increases.
The DCF forecast starts with unlevered free cash flow
The first step in a DCF is projecting cash flows during the explicit forecast period.
The explicit forecast period usually means the next 5 to 10 years. For some companies and industries, it could be 15 to 20 years or more.
In almost all DCF analyses, you should use Unlevered Free Cash Flow.
That means you’re projecting the recurring business cash flow available to all investors, not just equity investors or debt investors. This is why the word “unlevered” matters: the cash flow is before the effects of capital structure items such as interest expense.
To project Unlevered Free Cash Flow, you need the following items:
Revenue
COGS and operating expenses
Taxes
Depreciation and amortization, and sometimes other recurring non-cash add-backs
The change in working capital
Capital expenditures
A compact version of the formula is:
Unlevered Free Cash Flow = NOPAT + non-cash adjustments and change in working capital from the cash flow statement – CapEx
NOPAT corresponds to revenue, COGS, operating expenses, and taxes. The change in working capital and CapEx come from the cash flow statement.
Notice what’s missing: interest expense, other income and expense, most non-cash adjustments, the financing section of the cash flow statement, and most of the investing section.
You leave those out because they’re either non-recurring or they relate only to specific investor groups rather than all investors.
What you ignore in a DCF, and why
This is where a lot of interview answers get sloppy.
You don’t project every line item just because it appears in the financial statements. A DCF is not a mechanical copy-and-paste exercise. You’re trying to isolate the company’s recurring operating cash flow.
For the income statement, that means you project the operating items: revenue, COGS, and operating expenses. You also project taxes, but for Unlevered Free Cash Flow, taxes are based on EBIT rather than pre-tax income.
You should not include items such as impairments, write-downs, gains, and losses in projected free cash flow. They’re non-recurring, so they don’t belong in the recurring cash flow profile of the business.
You also leave out items related to debt investors and non-core business assets. Net interest expense and other income or expense are not part of Unlevered Free Cash Flow because they don’t represent operating cash flow available to all investors.
On the cash flow statement, you use NOPAT rather than net income. You always project depreciation and amortization. You include the working capital line items. You include CapEx.
But you do not blindly add back every “non-cash” item.
Why stock-based compensation should not be added back
Stock-based compensation is the non-cash adjustment that trips people up.
It’s recurring for many companies, and it appears as a non-cash adjustment on the cash flow statement. So the tempting answer is: “Add it back.”
Don’t do that for Unlevered Free Cash Flow.
Stock-based compensation is not a real non-cash expense in the same way depreciation and amortization are. It creates additional shares and dilutes existing investors.
Think about a simple house example. You own a house worth $10 million, and you hire someone to manage it. Instead of paying that person a cash salary of $100,000 per year for five years, you give them a 1% ownership stake in the house each year.
After five years, that person owns 5% of the house. If you sell the house, you receive only $9.5 million rather than $10.0 million because someone else now owns part of it.
You didn’t pay cash compensation, but the person still cost you money because your ownership was reduced.
That’s the issue with stock-based compensation. If you add it back as if it were a free non-cash expense, you’re ignoring both the cash cost you avoided and the additional shares that were created.
For interview purposes, the clean answer is: do not add back stock-based compensation when calculating Unlevered Free Cash Flow.
Deferred taxes are the one awkward exception
Deferred taxes are trickier.
You can include deferred taxes, but they should decline over time as book versus cash-tax timing differences reverse.
For example, if deferred taxes initially represent 20% of total income taxes, you should not keep them at 20% throughout the entire forecast period. They should fall to a much lower percentage, such as 3% to 5%, by the end.
That distinction matters because it shows you understand the logic of the forecast. You’re not just extending historical percentages forever. You’re thinking about what happens as temporary timing differences unwind.
How to answer this in an interview
If someone asks you to walk through a DCF, don’t start by naming every tab in a model. Start with the purpose.
A DCF values a company based on the present value of its projected cash flows and terminal value. It’s intrinsic valuation because it relies on the company’s own cash flow generation rather than just peer multiples.
Then move into the cash flow definition:
In most DCFs, I would use Unlevered Free Cash Flow because it represents recurring business cash flow available to all investors. I’d project revenue, operating expenses, taxes based on EBIT, D&A, working capital, and CapEx, while excluding interest expense, non-core items, financing cash flows, and non-recurring gains or losses.
And if they push you on stock-based compensation:
I would not add back stock-based compensation because it dilutes existing shareholders. It is not “free” in the same way as depreciation and amortization.
That answer is much stronger than memorizing a formula without context. A good DCF interview answer shows that you understand what the model is trying to measure: recurring operating cash flow, available to all investors, discounted back to today and compared against current value.