Question 1

How would you build a DCF model from scratch?

Accepted Answer

Building a DCF (Discounted Cash Flow) model from scratch involves several key steps: First, I analyze historical financial statements (3-5 years) to understand the company's performance trends. Next, I forecast future performance, typically projecting 5-10 years of free cash flows based on revenue growth assumptions, margin projections, working capital requirements, and capital expenditure needs. I calculate the terminal value using either the perpetuity growth method or exit multiple approach to capture value beyond the explicit forecast period. Then I determine the appropriate discount rate (WACC) by analyzing the company's capital structure, cost of debt, cost of equity (using CAPM), and tax considerations. I discount all projected cash flows and the terminal value back to present value using the WACC. Finally, I add any non-operating assets, subtract debt and other liabilities, and divide by shares outstanding to arrive at an equity value per share. Throughout this process, I conduct sensitivity analyses on key assumptions and compare my valuation to trading multiples of comparable companies as a sanity check.

Question 2

How do the three financial statements link together?

Accepted Answer

The three financial statements—income statement, balance sheet, and cash flow statement—are interconnected through several key linkages: The income statement's net income flows to the balance sheet by increasing retained earnings in the equity section, and also serves as the starting point for the cash flow statement's indirect method. Depreciation and amortization appear as expenses on the income statement, reducing net income, but since they're non-cash expenses, they're added back in the operating section of the cash flow statement. Meanwhile, these expenses accumulate as contra-assets on the balance sheet, reducing the book value of long-term assets. Changes in working capital accounts (accounts receivable, inventory, accounts payable) on the balance sheet are reflected in the operating section of the cash flow statement. Capital expenditures shown in the investing section of the cash flow statement increase PP&E on the balance sheet. Financing activities like debt issuance or repayment and equity issuance or buybacks appear in the financing section of the cash flow statement and directly affect the corresponding liability and equity accounts on the balance sheet. The cash flow statement's ending cash balance must equal the cash and cash equivalents on the balance sheet. This three-statement linkage ensures accounting consistency and provides different perspectives on a company's financial health—profitability (income statement), financial position (balance sheet), and liquidity (cash flow statement).

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