A discounted cash flow, or DCF, sounds intimidating the first time an interviewer asks you to walk through one. In practice, every DCF — no matter how many tabs it has in a banker's Excel model — boils down to the same three mechanical steps: project a company's future cash flow, discount each year of that cash flow back to today's dollars, and sum the results into a single number called Enterprise Value.
Why discounting exists in the first place
A dollar promised to you three years from now is worth less than a dollar in your hand today. That's not just inflation — it's the opportunity cost of not being able to invest that dollar somewhere else in the meantime, plus the risk that the future cash flow might not show up exactly as projected. The discount rate (usually the Weighted Average Cost of Capital, or WACC) captures both of those ideas in a single percentage. If you want to see exactly how that rate is built from a company's cost of equity and cost of debt, Case 36: WACC: The Building Blocks walks through the CAPM and after-tax cost of debt inputs that go into it.
Step 1: Project the cash flow
Every DCF starts with an estimate of the free cash flow a business will generate in future years — the cash left over after operating expenses, taxes, and reinvestment in the business (CapEx and working capital). In a simplified teaching example, this might just be three years of given free cash flow figures. In a real banking model, it's a multi-year build from a revenue forecast down through EBIT, taxes, D&A, CapEx, and working capital changes.
Step 2: Discount each year back to today
Once you have a cash flow figure for each future year, you divide it by (1 + r)^n, where r is the discount rate and n is the number of years until that cash flow arrives. A cash flow five years out gets discounted more heavily than one arriving next year, because more time has passed and more uncertainty has accumulated.
Step 3: Sum the present values into Enterprise Value
Add up every year's present value, and the result is the Enterprise Value of the business — what the operating business is worth today, independent of how it happens to be financed with debt or equity. In a full model, this sum also includes the present value of a Terminal Value, which captures every year of cash flow beyond the explicit forecast period. Case 37: Terminal Value: Gordon Growth covers exactly how that Terminal Value is calculated and why it often ends up being the majority of a company's total valuation.
Seeing the three steps in isolation
Because Terminal Value, WACC construction, and multi-year revenue builds can each turn into a rabbit hole on their own, it helps to first see the three-step logic — project, discount, sum — with none of those complications attached. Case 38: Simple DCF: Three Steps does exactly that: three years of given free cash flow, a single discount rate, and nothing else, so you can isolate the mechanical core of a DCF before adding back the layers of complexity a real valuation requires.
Why interviewers ask about this
DCF questions show up constantly in investment banking, equity research, and private equity interviews because they test more than plug-and-chug math. An interviewer wants to know whether you understand why later cash flows are worth less, why the discount rate matters as much as the cash flow forecast itself, and what a DCF actually represents (the value of a business's future cash generation, in today's dollars). Once you can explain the three-step logic cleanly, the rest of the DCF — WACC, Terminal Value, sensitivity tables — are just additional layers on the same foundation.