DCF Interview Questions

Politely decline to name a stock to buy, and offer to walk through how you would evaluate one instead. Recommending stocks is usually the job of equity research analysts (people who publish buy, hold, or sell ratings for investors) and the buy-side (firms such as hedge funds and mutual funds that invest money). Investment bankers advise companies on deals, and banks keep that work separate from stock recommendations. Then show your judgment with a pitch framework: the business, the thesis, valuation, catalysts, and risks.

Value usually goes up. A lower tax rate increases after-tax free cash flow, the cash the business generates for all investors after taxes and reinvestment. It also pushes WACC up slightly, because the interest tax shield (the tax saved by deducting interest) shrinks and after-tax debt gets more expensive. For a profitable company, the cash flow gain is much larger than the small rise in the discount rate, so the net effect is a higher valuation.

The discount rate turns money you expect to get later into what it is worth today. It combines three things: the time value of money (a dollar today is worth more than a dollar next year), a risk premium (extra return demanded because each year's payoff is uncertain, either $100 or $0, to the extent that risk can't be diversified away), and opportunity cost (the return the client gives up by not putting the $100 into another investment of similar risk). Skip it and you treat $50 expected in year 10 as equal to $50 in hand today. That overstates the coin's value.

CapEx down 10 has the biggest impact: free cash flow rises by the full 10. At a 25% tax rate, revenue up 10 adds only 7.50 after tax. Depreciation down 10 lowers free cash flow by 2.50, because the business loses a tax deduction.

You subtract the increase in net working capital because NOPAT, the after-tax operating profit FCFF starts from, is an accrual number. It records revenue when earned and costs when incurred, regardless of when cash changes hands. Net working capital (NWC) is operating current assets, such as receivables and inventory, minus operating current liabilities, such as payables. When NWC rises, the business has cash tied up that earnings never showed. FCFF is the cash available to both debt and equity holders, so it takes that amount out. When NWC falls, the same line adds cash back.

WACC is the weighted average cost of capital: the blended annual return a company has to earn to satisfy everyone who funds it. It is the rate you discount unlevered free cash flow at in a DCF. You build it by weighting the cost of equity and the after-tax cost of debt by each one's share of total capital, measured at market value: WACC = E/(D+E) x cost of equity + D/(D+E) x cost of debt x (1 - t). Cost of equity comes out of CAPM. Cost of debt is the yield the company pays on its debt today, and it gets tax-affected because interest is deductible. The equity term does not.

You usually get the cost of equity from the Capital Asset Pricing Model (CAPM): cost of equity = risk-free rate + beta × equity risk premium. The risk-free rate is typically a long-term government bond yield. Beta is how much a stock moves relative to the overall market. The equity risk premium is the extra return investors expect for holding stocks over risk-free bonds.

The cost of equity is 17%. WACC (weighted average cost of capital, the blended return a company's lenders and shareholders require) is 50% × cost of equity + 50% × 7%, and that has to equal 12%. The 7% is already after tax, so the 30% tax rate does not get applied again. Debt contributes 3.5%, equity has to contribute the remaining 8.5%, and 8.5% ÷ 0.50 = 17%.

Assuming the same discount rate, enterprise value is the same for both. A's equity value (the part of the company that belongs to shareholders) is most likely lower by A's net debt, a figure these numbers do not give you. Enterprise value (the value of the whole business to lenders and shareholders together) comes from unlevered free cash flow, the cash the operations produce before any payment to lenders. Both companies produce 100. The 5 gap to levered free cash flow (the cash left for shareholders after paying lenders) is money going to A's lenders, so A carries debt. Equity value equals enterprise value minus net debt (debt minus cash), so A's shareholders own less by the debt balance, not by the 5.

A DCF (discounted cash flow) analysis values a company as the present value of the cash it will generate in the future. Present value is what future money is worth today. You project the company's unlevered free cash flow for about five to ten years and estimate a terminal value for all the years after that. Then you discount both back to today at the weighted average cost of capital (WACC) to get enterprise value. Last, you bridge from enterprise value to equity value and divide by diluted shares to get an implied share price.

WACC (weighted average cost of capital, the blended return a company's shareholders and lenders require) is roughly two percentage points higher than in 2021 for a typical large US company. Almost all of the increase comes from interest rates. The risk-free rate (the 10-year Treasury yield) rose from about 1.5% to around 4 to 4.5%. That lifted the cost of equity and pushed investment-grade (highly rated) borrowing costs from about 2 to 2.5% to around 5%. The equity risk premium (the extra return investors demand for owning stocks) was flat to slightly lower, credit spreads (the extra yield a company pays over Treasuries) stayed about as tight as in 2021, and the corporate tax rate did not change.

Raise debt, assuming the company can use the interest deduction and has room to borrow at 10%. The 10% is pre-tax. Interest is tax-deductible, so at a 25% tax rate the after-tax cost is 10% × (1 − 25%) = 7.5%. A 10x P/E gives an earnings yield (earnings divided by share price, the inverse of P/E) of 1/10 = 10%, a rough stand-in for the cost of equity. Debt at 7.5% beats equity at roughly 10%.