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Its all about Valuation Getting at the Heart of the Finance Interviews!

Posted on October 31, 2011 by Ark | 3 Comments

By Arkady Libman, Managing Director, Wall Street Prep Last month, we published a quick guide to answering most frequently asked accounting questions during the finance interv iews, and in this issue are sharing our thoughts on how to answer v aluation questions, which make up the meat of the technical questions students can be ex pected to answer. Stay tuned for M&A help coming nex t week! Th in kin g o f g e t t in g fin a n c ia l a n d v a lu a t io n m o d e lin g s kill s e t a h e a d o f in t e r v ie w s ? Bring us to y our campus: http://www.wallstreetprep.com/training/univ ersity _training.php or call 61 7 31 4-7 685 ex t. 7 22; or check out our interactiv e self-study programs: http://www.wallstreetprep.com/programs/self_study / NOW ON TO V A LUA TI ON QUESTI ONS All students who want to successfully complete the finance recruiting process must demonstrate their basic understanding of v aluation. Such questions are

ty pically not hard if one takes the time to prepare and understand the basic v aluation concepts. Below we hav e selected most common v aluation questions y ou should ex pect to see during the recruiting process. 1. Ho w d o y o u v a lu e a c o m p a n y ?

This question, or v ariations of it, should be answered by talking about 2 primary v aluation methodologies: 1 . Intrinsic v alue (discounted cash flow v aluation) 2. Relativ e v aluation (comparables/multiples v aluation) I n t rin s ic v a lu e (DCF) This approach is the more academically respected approach. The DCF say s that the v alue of a productiv e asset equals the present v alue of its cash flows. The answer should run along the line of project free cash flows for 5-20 y ears, depending on the av ailability and reliability of information, and then calculate a terminal v alue. Discount both the free cash flow projections and terminal v alue by an appropriate cost of capital (weighted av erage cost of capital for unlev ered DCF and cost of equity for lev ered DCF). In an unlev ered DCF (the more common approach) this will y ield the company s enterprise v alue (aka firm and transaction v alue), from which we need to subtract net debt to arriv e at equity v alue. Div ide equity v alue by diluted shares outstanding to arriv e at equity v alue per share.Re la t iv e v a lu a t io n (Mu lt ip le s ) The second approach inv olv es 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 ex ist, but y ou should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these multiples on the relev ant operating metric of the target company to arriv e at a v aluation. 2. Wh a t is t h e a p p r o p r ia t e d is c o u n t r a t e t o u s e in a n u n le v e r e d DCF a n a ly s is ?

Since the free cash flows in an unlev ered DCF analy sis are pre-debt (i.e. a helpful way to think about this is to think of unlev ered cash flows as the company s cash flows as if it had no debt so no interest ex pense, and no tax benefit from that interest ex pense), the cost of the cash flows relate to both the lenders and the equity prov iders of capital. Thus, the discount rate is the weighted av erage cost of capital to all prov iders of capital (both debt and equity ). The cost of debt is readily observ able in the market as the y ield on debt with equiv alent risk, while the cost of equity is more difficult to estimate. Cost of equity is ty pically estimated using the capital asset pricing model (CAPM), which links the ex pected return of equity to its sensitiv ity to the ov erall market (see WSPs

DCF module for a detailed analy sis of calculating the cost of equity ). 3. Wh a t is t y p ic a lly h ig h e r t h e c o s t o f d e b t o r t h e c o s t o f e q u it y ?

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest ex pense) is tax deductible, creating a tax shield. Additionally , the cost of equity is ty pically higher because unlike lenders, equity inv estors are not guaranteed fix ed pay ments, and are last in line at liquidation. 4. Ho w d o y o u c a lc u la t e t h e c o s t o f e q u it y ?

There are sev eral competing models for estimating the cost of equity , howev er, the capital asset pricing model (CAPM) is predominantly used on the street. The CAPM links the ex pected return of a security to its sensitiv ity the ov erall market basket (often prox ied using the S&P 500). The formula is: Cost of equity (re) = Risk free rate (rf) + x Market risk premium (rm-rf) Ris k fr e e r a t e : The risk free rate should theoretically reflect y ield to maturity of a default-free gov ernment bonds of equiv alent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity in long term bonds hav e made the current y ield on 1 0-y ear U.S. Treasury bonds as the preferred prox y for the risk-free rate for US companies. Ma r ke t r is k p r e m iu m : The market risk premium (rm-rf) represents the ex cess returns of inv esting in stocks ov er the risk free rate. Practitioners often use the historical ex cess returns method, and compare historical spreads between S&P 500 returns and the y ield on 1 0 y ear treasury bonds. Be t a ( ): Beta prov ides a method to estimate the degree of an assets sy stematic (non-div ersifiable) risk. Beta equals the cov ariance between ex pected returns on the asset and on the stock market, div ided by the v ariance of ex pected returns on the stock market. A company whose equity has a beta of 1 .0 is as risky as the ov erall stock market and should therefore be ex pected to prov ide returns to inv estors 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 ov erall market. 5. Ho w w o u ld y o u c a lc u la t e b e t a fo r a c o m p a n y ?

Calculating raw betas from historical returns and ev en 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 lev erage, we should unlev er the betas of these comparable companies as such:

 Unlev ered =

(Lev ered) / (1 + (Debt/Equity ) (1 -T))

Then, once an av erage unlev ered beta is calculated, relev er this beta at the target company s capital structure: Lev ered = (Unlev ered) x [1 +(Debt/Equity ) (1 -T)] 6. Ho w d o y o u c a lc u la t e u n le v e r e d fr e e c a s h flo w s fo r DCF a n a ly s is ?

Free cash flows = Operating profit (EBIT) * (1 tax rate) + depreciation & amortization changes in net working capital capital ex penditures 7. Wh a t is t h e a p p r o p r ia t e n u m e r a t o r fo r a r e v e n u e m u lt ip le ?

The answer is enterprise v alue. The question tests whether y ou understand the difference between equity v alue and enterprise v alue and their relev ance to multiples. Equity v alue = Enterprise v alue Net Debt (where net debt = gross debt and debt equiv alents ex cess cash). For more on this equation see WSPs article at www.wallstreetprep.com/blog/. EBIT, EBITDA, unlev ered cash flow, and rev enue multiples all hav e enterprise v alue as the numerator because the denominator is an unlev ered (pre-debt) measure of profitability . Conv ersely , EPS, after-tax cash flows, and book v alue of equity all hav e equity v alue as the numerator because the denominator is lev ered or post-debt. 8. Ho w w o u ld y o u v a lu e a c o m p a n y w it h n e g a t iv e h is t o r ic a l c a s h flo w s ?

Giv en that negativ e profitability will make most multiples analy ses meaningless, a DCF v aluation approach is appropriate here. 9. Wh e n s h o u ld y o u v a lu e a c o m p a n y u s in g a r e v e n u e m u lt ip le v s . EBI TDA ?

Companies with negativ e profits and EBITDA will hav e meaningless EBITDA multiples. As a result, Rev enue multiples are more insightful. 1 0 . Tw o c o m p a n ie s a r e id e n t ic a l in e a r n in g s , g r o w t h p r o s p e c t s , le v e r a g e , r e t u r n s o n c a p it a l, a n d r is k. Co m p a n y A is t r a d in g a t a 1 5 P/ E m u lt ip le , w h ile t h e o t h e r t r a d e s a t 1 0 P/ E. Wh ic h w o u ld y o u p r e fe r a s a n in v e s t m e n t ? 1 0 P/E: A rational inv estor would rather pay less per unit of ownership.

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This entry was posted in Inv estment Banking Interv iew Prep and tagged accounting, finance interv iew, financial modeling, interv iew prep, inv estment banking, v aluation. Bookmark the permalink.

3 RE S P ONS E S TO ITS A LL A B OUT VA LUATION GE TTING AT THE HE A RT OF THE FINA NCE INTE RV IE W S !
Pingback: Investment Banking InterviewThe Prospectus Musings on Investment Banking

rachana | January 10, 2012 at 9:08 pm | Reply

ex cellent interv iewing Qs and answers. there are some of the qs in this where i actually had goofed up when i was interv iewed by top ranking IB firm. now i realise why ?

WI N WI N MAW(MS.) | February 17, 2012 at 4:38 am | Reply

Thank y ou.

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