Valuation Interview Questions and Answers

Valuation Interview Questions and Answers What are the 3 major valuation methodologies? Public Company Comparables (Public Comps), Precedent Transactions and the Discounted Cash Flow Analysis. Public Comps and Precedent Transactions are examples of relative valuation (based on market values) while the DCF is intrinsic valuation (based on cash flows.) Can you walk me through how you use Public Comps and Precedent Transactions? First you select the companies and transactions based on criteria such as industry, financial metrics and geography. Then you determine the appropriate metrics and multiples for each set - for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples - and you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile and maximum for each valuation multiple in the set. Finally you apply those numbers to the financial metrics for the company you're analyzing to estimate the potential range for its valuation. For example, if the company you're valuing has $100 in EBITDA and the median EBITDA multiple of the set is 7x its implied Enterprise Value is $700 million based on that. You would then calculate its value at other multiples in this range. How do you select Comparable Companies or Precedent Transactions? The 3 main criteria for selecting companies and transactions: 1. Industry Classification 2. Financial Criteria (Revenue, EBITDA, etc.) 3. Geography For precedent transactions, you also limit the set based on date and often focus on transactions within the past 1-2 years. The most important factor is industry. Ex: Oil and gas producers with market caps over $5 billion Digital media companies with over $100 million in revenue Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue. Retail M&A transactions over the past year For Public Comps, you calculate Equity Value and Enterprise Value for use in multiples based on companies' share prices and share counts...what about Precedent Transactions? How do you calculate multiples there? They should be based on the purchase price of the company at the time of the deal announcement. For example, a sellers current share price is $40.00 and it has 10 million shares outstanding. The buyer announces that it will pay $50.00 per share. The seller's Equity Value in this case would be $500 million. And then you would calculate its Enterprise Value the normal way: subtract cash, add debt and so on. You only care about what the offer price was at the initial deal announcement. How would you value an apple tree? The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the present value of the apple tree's cash flows (intrinsic valuation) When is a DCF useful? When is it not so useful? A DCF is best when the company is large, mature and has stable and predictable cash flows. Your far in the future assumptions will generally be more accurate there. A DCF is not as useful if the company has unstable or unpredictable cash flows (tech-start up _ or when Debt and Operating Assets and Liabilities serve fundamentally different roles (Ex: banks and insurance firms) What other Valuation methodologies are there? Liquidation Valuation: Valuing a company's Assets, assuming they are sold off and then subtracting Liabilities to determine how much capital, if any, equity investors receive LBO analysis: Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range Sum of the Parts - Valuing each division of a company separately and adding them together at the end. M&A Premiums Analysis: Analyzing M&A deals and figuring out the premium that each buyer paid and using this to establish what your company is worth. Future Share Price Analysis: projecting a company's share price based on the P/E multiples of the public company comparables and then discounting it back to its present value. When is a Liquidation Valuation useful? It's most common in bankruptcy scenarios and is used to se whether or not shareholders will receive anything after the company's Liabilities have been paid off with the proceeds from selling all its assets. It is often used to advise struggling businesses on whether it's better to sell off Assets separately or to sell 100% of the company. When would you use a Sum of the Parts valuation? This is used when a company has completely different, unrealted divisions like General Electric. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead you should use different sets for each division, value each one separately, and then add them together to calculate the Total Value. When do you use an LBO Analysis as part of your valuation? Clearly, you use this whenever you're analyzing a Leveraged Buyout - but it is also used to "set a floor" on the company's value and determine the minimum amount that a PE firm could pay to achieve its targeted returns. You often see it used when both strategics (normal companies) and financial sponsors (PE Firms) are competing to buy the same company and you want to determine the potential price if a PE firm were to acquire the company. How do you apply the valuation methodologies to value a company/ You would present everything in a "football field" graph. To do this you need to calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each set and then multiply by the relevant metrics for the company you're analyzing. Example: if the median EBITDA multiple from your set of Precedent Transactions is 8x and your company's EBITDA is $500 million, the implied Enterprise Value would be $4 billion. For public companies, you will also work backwards to calculate the Equity Value and the Implied per share price based on this. Can you walk me through how to calculate EBIT and EBITDA? How are they different? EBIT is just a company's Operating Income on its Income Statement; it includes not only COGS and Operating Expenses but also non-cash charges such as Depreciation & Amortization and therefore reflects, at least indirectly, the company's Capital Expenditures. EBITDA is defined as EBIT plus D&A. The idea is to move closer to a company's "cash flow" since D&A are non cash expenses, the problem is that you're also excluding CapEx altogether. What about how you calculate Unlevered FCF( Free Cash Flow to Firm) and Levered FCF (Free Cash Flow to Equity)? Unlevered FCF = EBIT * (1-Tax Rate) + Non-cash Charges - Change in operating Assets and Liabilities - Capex. With unlevered FCF, you're excluding interest income and expenses as well as mandatory debt repayments. Levered FCF = Net Income + Non-cash charges - change in operating assets and liabilities - capex -mandatory repayments With levered FCF, you're including interest income, interest expense and required principal repayments on the debt. What are the most common Valuation multiples? And what do they mean? Enterprise Value/Revenue: How valuable is a company in relation to its overall sales Enterprise Value/EBTIDA: How valuable is a company in relation to its approximate cash flow Enterprise Value/EBIT: How valuable is a company in relation to the pre-tax profit it earns from its core business operations Price Per Share/Earnings Per Share (P/E): How valuable is a company in relation to its after tax profits inclusive of interest income and expense and other non-core business activities Other multiples include P/BV, Enterprise Value/Unlevered FCF, Equity Value/Levered FCF P/BV is not terribly meaningful for most companies, EV/Unlevered FCF is closer to true cash flow than EV/EBITDA but takes more work to calculate and Equity Value/Levered FCF is even closer but it's influenced by the company's capital structure and takes even more time to calculate. How are the key operating metrics and valuation multiples correlated? What might explain a higher or lower EV/EBITDA multiple? Usually there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well. Math also plays role: sometimes companies with extremely high EBITDA margins may have lower EBITDA multiples because EBITDA itself is much higher Plenty of other non-financial factors explain higher or lower multiples Why can't you use Equity Value/EBITDA as a multiple rather than Enterprise Value/EBITDA? If the metric includes interest income and expense, you use Equity value, if it excludes them you use Enterprise Value. EBITDA is available to all investors in the company. Similarly, Enterprise Value is also available to all investors since it includes Equity and Debt so you pair them together. Calculating Equity Value/EBITDA is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only what is available to common shareholders. What would you use with Free Cash Flow multiples - Equity Value or Enterprise Value? For unlevered FCF (Free cash flow to firm) you would use Enterprise value but for levered Free Cash Flow (free cash flow to equity) you would use Equity Value. Unlevered Free Cash Flow excludes interest (and mandatory debt repayments) and thus represents money available to all investors whereas levered FCF already includes the effects of Interest expense and the money is therefore only available to equity investors. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples? He dislikes EBITDA because it hides the Capital expenditures companies make and disguises how much cash they require to finance their operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is capital intensive and asset heavy for example will show a big disparity. EBIT itself does not include Capital Expenditures but it does include depreciation and that is directly linked to CapEx. If a company has a high Depreciation expense, chances are it has high CapEx spending as well. What are some problems with EBITDA and EBITDA multiple? And if there are so many problems why do we still use it? It hides the amount of debt principal and interest that a company is paying each year, which can be very large and may make the company cash flow-negative, it also hides CapEx spending, which can be huge. EBITDA ignores working capital requirements (e.g. Accounts Receivable, Inventory, Accounts Payable ) which can be very large for some companies. Finally, companies like to "add back" many charges and expenses to EBITDA so you never really know what it represents unless you dig into it in depth. IN many cases EBITDA is not even close to true cash flow - widely used because to its convenience and because it has become a standard over time. Another argument for EBITDA is that although it's not close to cash flow, its better for comparing the cash generated by a company's core business operations than other metrics so you could say it is more about comparability than cash flow approximation. EV/EBIT, EV/EBITDA and P/E multiples all measure a company's profitability. What's the difference between them and when do you use each one? P/E depends on the company's capital structure whereas EV/EBIT and EV/EBITDa are capital structure neutral. Therefore you use P/E for banks, insurance firms and other companies where interest is critical and where capital structures tend to be similar. EV/EBIT includes D&A whereas EV/EBITDA excludes it - you're more likely to use EV/EBIT in industries where D&A is large and where CapEx and fixed assets are important (e.g. manufacturing) and EV/EBITDA in industires where fixed assets are less important. Could EV/EBITDA ever be higher than EV/EBIT for the same company? No. By definition, EBITDA must be greater than or equal to EBIT because to calculate it you take EBIT and then add D&A neither of which can be negative. Since EBITDA is always greater than or equal to EBIT, EV/EBITDA must be always less than or equal to EV/EBI for a single company What are some examples of industry-specific mutiples? Technology (Internet): EV/Unique Visitors, EV/Pageviews Retail/Airlines: EV/EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) Oil & Gas: EV/EBITDAX (Earnings before interest, taxes, Depreciation, Amortization & Exploration Expense) EV/Production, EV/Proved Reserves Real Estate Investment Trusts: Price/FFO per share, Price/AFFo per share (Funds from operations, adjusted funds from operations) Technology and Oil& Gas are straightfoward - website traffic and energy reserves as value drivers rather than revenue or profit. For retail and airlines you add back rent because some companies own their own buildings and capitalize the expense whereas other rent and therefore have a rental expense. This one is about comparability. EBITDAX is about comparability too - some firms capitalize their exploration expenses and some expense them. When you're looking at an industry-specific multiple like EV/Proved Reserves or EV/Subscribers, why do you use Enterprise Value rather than Equity Value? You use Enterprise Value because those Proved Reserves or Subscribers are "available" to all the investors (both debt and equity) in a company. This is almost always the case unless the metric includes interest income and expense (FFO and AFFO) Rank the 3 main valuation methodologies from highest to lowest expected value Trick question - no ranking that always holds up. In general - Precedent Transactions will be higher than Comps due to the control premium in acquisitions DCF could go either way - more variable than other methodologies. Often it produces the highest value but it can produce the lowest value as well depending on your assumptions. Would an LBO or DCF produce a higher valuation? Technically it could go either way, but in most cases the LBO will give you a lower valuation. With an LBO, you do not get any value from the cash flows of a company in between year 1 and the final year - you only get "value" out of its final year. With a DCF you're taking into account both the company's cash flows in the period itself and its terminal value so values tend to be higher. An LBO model by itself does not give a specific valuation. You set a desired IRR and back-solve for how much you could pay for the company based on that When would a Liquidation Valuation produce the highest value? Could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason. As a result, the comps or precedent transactions would likely produce lower values as well - and if its assets were valued highly enough, liquidation valuation might give a higher value then other methodologies. Why are Public comps and Precedent Transactions sometimes viewed as being "more reliable" than a DCF? Because they're based on actual market data as opposed to assumptions far into the future. You still do make future assumptions with these for forward multiples Sometimes you don't have good or truly comparable data and a DCF may produce better results. What are the flaws with Public OCmps No company is 100% comparable to another company The stock market is "emotional"- your multiples might be dramatically higher or lower on certain dates depending on market movements Share prices for small companies with thinly traded stocks may not reflect their full value Precedent Transactions usually produce a higher value than Public Comps - can you think of a situation where this is not the case? When there is a substantial mismatch between the M&A market and the public markets. For example, no public companies have been acquired recently but lots of small private companies have been acquired at low valuations. For the most part this generalization is true but there are exceptions to almost every rule in finance. What are some flaws with Precedent Transactions Past transactions are rarely 100% comparable - the transaction structure, size of the company and market sentiment all make a huge impact Data on precedent transactions is generally more difficult to find than it is for public company comparables especially for acquisitions of small, private companies HOw would you present these valuation methodologies to a company or its investors? and what do you use it for? Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number You could use a valuation for: Pitch Books and Client Presentations - when you provide updates and tell them what you think they're worth Parts of other models - defense analyses, merger models, LBO models, DCFs and almost everything else in finance will incorporate a Valuation in some way Fairness opinions- right before a deal with a public seller closes, its financial advisor creates a fairness opinion that justifies the acquisition price and directly estimates the company's valuation Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium? Number of reasons: The company has reported earnings well above expectations and its stock price has risen in response It has some type of competitive advantage not reflected in its financials such as a key patent or other intellectual property It has just won a favorable ruling in a major lawsuit It is the market leader in an industry and has greater market share than its competitors How do you take into account a company's competitive advantage in a valuation? 1. Highlight the 75th percentile or higher for the multiples rather than the median 2. add in a premium to some of the multiples 3. Use more aggressive projections for the company Do you always use the median multiple of a set of public company comparables or precedent transactions? No you almost always show a range. And you may make the median the center of that range but you don't have to - you could focus on the 75th percentile, 25th percentile or anything else if the company is outperforming or underperforming for some reason. Two companies have the exact same financial profiles (revenue, growth and profits) and are purchased by the same acquirer but the EBITDA multiple for one is twice the multiple of the other - how could this happen? One process was more competitive and had a lot more companies bidding on the target One company had recent bad news or a depressed stock price so it was acquired at a discount They were in industries with different median multiples The two companies have different accounting standards and have added back different items when calculating EBITDA If you were buying a vending machine business, would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated normally or one in which the machines were leased? The Depreciation expense and the lease expense are the same dollar amounts and everything else is held constant. You would pay a higher multiple for the one with leased machines if all else is equal. The Purchase enterprise value would be the same but depreciation is excluded from EBITDA so EBITDA is higher and the EV/EBITDA multiple is lower for the one that owns its own machines. For the company with leased machines, the leased expense would show up in Operating Expenses making EBITDA lower and the multiple higher. In this case it would be more meaningful to use EBIT or EBITDAR multiple to compare the two potential acquisitions. How would you value a company that has no profit and no revenue? 1. You could use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews (for internet start-up) rather than EV/Revenue or EV/EBITDA 2. You could use a "far in the future" DCF and project a company's financials out until it actually earns revenue and profit Method 1 is better for Internet start ups or anything else that is truly unpredictble, method 2 is more common for biotech and pharmaceutical companies where you can more predictably estimate the potential market size and prices for new drugs. The S&P 500 index has a median P/E multiple of 20x. A manufacturing company you're analyzing has earnings of $1 million. How much is the company worth? It depends on how it's performing relative to the index and relative to companies in its own industry. If it has higher growth and/or higher earnings you may assign a higher multiple to it - maybe25x or even 30x, and therefore assume that its Equity Value equals $25 million or $30 million. If its on par with everyone else then maybe its valuation is just $20 million. Qualitative factors such as management team and market position also come into play and may determine the appropriate multiple to use. A company's current stock price is $20.00 per share, and its P/E multiple is 20x so its EPS is $1.00. it has 10 million shares outstanding. Now it does a 2-for-1 stock split- how do its P/E multiple and valuation change? They dont. The company now has 20 million shares outstanding but its equity value has stayed the same so its share price falls to $10.00 EPS falls to $.50 but its share price has also fallen to $10 so the P/E multiple remains 20x. Splitting the stock into fewer units doesnt by itself make a company worth less. however, in practice often a stock split is viewed as a positive sign by the market so in many cases a company's value will go up and its share price won't necessarily be cut in half, so P/E could increase.