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Investment Banking Valuation Questions

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Investment Banking Valuation Questions and Answers

Last month, we published a quick guide to answering most frequently asked accounting questions during the finance interviews, and in this issue are sharing our thoughts on how to answer valuation questions, which make up the meat of the technical questions students can be expected to answer. Stay tuned for M&A help coming next week!

All students who want to successfully complete the finance recruiting process must demonstrate their basic understanding of valuation. Such questions are typically not hard – if one takes the time to prepare and understand the basic valuation concepts. Below we have selected the most common valuation interview questions you should expect to see during the recruiting process.

Q. How do you value a company?

This question, or variations of it, should be answered by talking about 2 primary valuation methodologies:

  1. Intrinsic value (discounted cash flow valuation)
  2. Relative valuation (comparables/multiples valuation)
Intrinsic value (DCF)

This approach is the more academically respected approach. The DCF says that the value of a productive asset equals the present value of its cash flows. The answer should run along the line of “project free cash flows for 5-20 years, depending on the availability and reliability of information, and then calculate a terminal value.  Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of equity for levered DCF).  In an unlevered DCF (the more common approach) this will yield the company’s enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at equity value.  Divide equity value by diluted shares outstanding to arrive at equity value per share.-

Relative valuation (Multiples)

The second approach involves determining a comparable peer group – companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics.  Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation.

Q. What is the appropriate discount rate to use in an unlevered DCF analysis?

Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company’s cash flows as if it had no debt – so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity). The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate.  Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP’s DCF module for a detailed analysis of calculating the cost of equity).

Q. Which is typically higher – the cost of debt or the cost of equity?

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.

Q. How do you calculate the cost of equity?

There are several competing models for estimating the cost of equity, however, the capital asset pricing model (CAPM) is predominantly used on the street.  The CAPM links the expected return of a security to its sensitivity the overall market basket (often proxied using the S&P 500).  The formula is:

Cost of equity (re) = Risk free rate (rf) + β x Equity risk premium (rm-rf)

  • Risk free rate: The risk free rate should theoretically reflect yield to maturity of a default-free government bonds of equivalent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the preferred proxy for the risk-free rate for US companies.
  • Equity Risk Premium: The equity risk premium (rm-rf) represents the excess returns of investing in stocks over the risk free rate. Practitioners often use the historical excess returns method, and compare historical spreads between S&P 500 returns and the yield on 10 year treasury bonds.
  • Beta (β): Beta provides a method to estimate the degree of an asset’s systematic (non-diversifiable) risk. Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market. A company whose equity has a beta of 1.0 is “as risky” as the overall stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the stock market. A company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop twice as fast as the overall market.

Q. How would you calculate beta for a company?

Calculating raw betas from historical returns and even projected betas is an imprecise measurement of future beta because of estimation errors (i.e. standard errors create a large potential range for beta).  As a result, it is recommended that we use an industry beta. Of course, since the betas of comparable companies are distorted because of different rates of leverage, we should unlever the betas of these comparable companies as such:

  • β Unlevered = β (Levered) / (1+ (Debt/Equity) (1-T))

Then, once an average unlevered beta is calculated, relever this beta at the target company’s capital structure:

  • β Levered = β(Unlevered) x [1+(Debt/Equity) (1-T)]

Q. How do you calculate unlevered free cash flows for DCF analysis?

Free cash flows = Operating profit (EBIT) * (1 –tax rate) + depreciation & amortization – changes in net working capitalcapital expenditures

Q. What is the appropriate numerator for a revenue multiple?

The answer is enterprise value. The question tests whether you understand the difference between equity value and enterprise value and their relevance to multiples.  Equity value = Enterprise value – Net Debt (where net debt = gross debt and debt equivalents – excess cash).

EBIT, EBITDA, unlevered cash flow, and revenue multiples all have enterprise value as the numerator because the denominator is an unlevered (pre-debt) measure of profitability.  Conversely, EPS, after-tax cash flows, and book value of equity all have equity value as the numerator because the denominator is levered – or post-debt.

Q. How would you value a company with negative historical cash flows?

Given that negative profitability will make most multiples analyses meaningless, a DCF valuation approach is appropriate here.

Q. When should you value a company using a revenue multiple vs. EBITDA?

Companies with negative profits and EBITDA will have meaningless EBITDA multiples.  As a result, Revenue multiples are more insightful.

Q. Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk.  Company A is trading at a 15 P/E multiple, while the other trades at 10 P/E. Which would you prefer as an investment?

10 P/E: A rational investor would rather pay less per unit of ownership.

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