Valuation interview questions

Valuation interview questions in Investment Banking interviews are tricky. There are a bunch of valuation methods to keep track of. Your interviewer has a lot more experience than you. There is little to no room for error. Having gone through the recruiting process and having worked in Investment Banking ourselves, we have compiled the core concepts you need to get a hold of if you want to succeed in an Investment Banking interview. Scroll down to read through the most common valuation interview questions.

Remember that valuation interview questions are just one part of Investment Banking interviews. You still need a basic understanding of accounting and have your fit questions sorted out.

The most common valuation interview questions

Enterprise value and equity value

What’s Enterprise Value and what does it mean?

Market Cap (or Equity Value) + Debt – Cash (more advanced: Market Cap + Debt + Preferred Stock + Minority Interest – Cash). It is a valuation available to both bond and equity holders as it includes Net Debt and can be derived using Sales or EBITDA multiples.

Why do we add Debt and subtract Cash?

When you purchase a company, you are also liable for its debt and own its cash balance. So, you adjust for its liabilities (money borrowed from future incomes) and cash at hand (money already earned from the past). The “Equity Value” is the purchase price you must pay.

Valuation methods

What valuation methods do you know? What are the most common valuation methods you know?

• Comparable company analysis – using trading multiples of similar companies to justify a valuation multiple

• Comparable transaction analysis – using valuation multiples of similar transactions to justify a valuation multiple

• DCF – using future free cash flows to value a company

• LBO – you are purchasing a company with debt to flip it and make your money back. So it’s entry price vs. exit price while considering potential cost & revenue synergies during the holding period to justify the entry valuation

Which valuation method yields the highest valuation?

It depends. But generally, Comparable Transactions > Comparable Companies. Comparable Transactions include the premium paid in a competitive bidding process. A DCF could yield higher valuations depending on the underlying business plan. An LBO usually yields a lower valuation as it is a leveraged buyout driven by IRR rather than a strategic transaction. Here is a more detailed answer to this question.

How would you value a company with negative cash flows?

If EBITDA is also negative, using an EBITDA multiple makes no sense. In that case, you could use a revenue multiple, such as with early-stage tech startups. The DCF analysis might also be a viable option for Capex heavy companies. However, with a DCF analysis, the underlying business plan will be scrutinized.

Who would pay more for a deal? A strategic investor or private equity investor?

In general, a strategic investor would likely pay more because they can realize more synergies. They operate in the same space and can expand products quicker or access each other’s clients. A financial investor can only grow the company, make it leaner and then flip it.

Why would a company rather use stocks vs. cash to fund the transaction?

The company uses stocks if (1) the company wants to take advantage of its high stock price or (2) it does not have enough cash and is unwilling to take out debt to finance the transaction.

What are synergies in a transaction?

There are two types of synergies: (1) Revenues synergies include access to each other’s clients (e.g., different geographies or target groups) or combining product portfolios. (2) Cost synergies include reducing overhead functions, such as combining facilities, reducing admin headcounts or gaining more bargaining power with suppliers.

What does it mean if a transaction is accretive?

A transaction is considered accretive if the combined new company has a higher Net Income post-merger. The negative impact from the acquisition (interest lost on cash, financing costs, post-merger integration) should be offset by additional Net Income. A transaction is considered dilutive if the acquisition causes Net Income to drop post-merger. Rule of thumb for stock transactions: If a P/E ratio is higher, the transaction is likely dilutive as you are paying more per earnings. If you add a company with a lower P/E ratio, you are adding a company with lower “costs per earning” and likely to be accretive.

Multiple valuation

What are the most common multiples you know?

• EV/Sales. Very crude as it only accounts for revenues. Mainly used for EBITDA and cashflow negative companies

• EV/EBITDA. The most used multiple. It is the quickest proxy for cash flow. However, it ignores Capex and D&A

• EV/EBIT. Better for Capex intensive sectors as it accounts for D&A

• P/E ratio. Most used equity multiple. “Price per earning” multiple

• Price/Book Value. Most widely used in valuing financial institutions because their assets (e.g., loans and deposits) drive their earnings

When would you use a revenue multiple vs. an EBITDA multiple?

If EBITDA is negative, multiplying it with an EBITDA multiple is meaningless. At that point, it would make more sense to look at revenues and use the revenue multiple. This is often the case for tech startups that already have revenues but are still EBITDA negative.

When would you use an EBIT multiple vs. an EBITDA multiple?

Using the EBIT multiple makes sense if D&A and Capex are significant factors. Companies in asset-heavy industries are more comparable with an EBIT multiple, such as telecommunications, industrials or airlines. D&A spreads out the Capex investment cycle and makes companies more comparable. Additionally, going with the EBIT multiple means that both lease expenses and D&A of equipment are both included. This makes a company that leases its entire fleet comparable to a company that owns (D&A) its entire fleet. Companies with leased equipment would have lower EBITDA multiple because rent expenses are included in EBITDA. On the other hand, companies that own their equipment would have a higher EBITDA multiple because D&A is excluded.

Estimate the Enterprise Value of a company. You have 3x LTM Sales and 10x LTM EBITDA and an LTM Income Statement

• Sales Multiple -> 3x * LTM Sales = Enterprise Value (Sales cancels out)

• EBITDA Multiple -> 10x * LTM EBITDA = Enterprise Value (EBITDA cancels out)

• Assuming that the multiples are derived from a comparable peer group

What are the advantages and disadvantages of using multiples from comparable companies?

Trading comps offer a quick way to estimate the valuation of a company (no business plan required). However, no two companies are identical. The rationale of your peer group will be under great scrutiny. Every. Single. Time. Even in the same sector, companies may have different growth rates and margins. This creates a problem justifying an exact multiple to be applied to your target company.

DCF

Walk me through a DCF

First, we would project the company’s P&L for 5 years and then derive the Unlevered Free Cash Flow, the cash flow available for both equity and debt investors.

Unlevered Free Cash Flow = EBITDA – Taxes +/ – Changes in Working Capital – Capex.

DCF = CF1/(1+r)+(CF2/(1+r)^2…..+(CF5/(1+r)^5+FCFN(1+g)/(R – g) (discount back to 5).

CF = Cash flow, R = Discount Rate, G = Long-Term Growth.

Alternatively, use an exit multiple to EBITDA for the terminal value and discount back. This is the short answer. Here is a more detailed answer.

What are the flaws of a DCF?

A DCF is best suited to value stable, predictable and cashflow positive companies. Companies with negative cash flows or exponential growth in the future can make the valuation more terminal value heavy (<70%). The quality of a DCF analysis depends on the underlying business plan for the next 5 years. Too aggressive assumptions will lead to an inflated valuation.

How do you calculate the discount rate?

• WACC = ((Cost of Debt*(Debt/(Debt + Equity))*(1 – Tax Rate))+(Cost of Equity*(Equity/(Debt + Equity))

• Cost of Equity = Risk-Free Rate + ((Beta * (Market Return – Risk Free Return))

  • Un-Levered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity)))

  • Levered Beta = Un-Levered Beta * (1+((1-Tax Rate)*(Total Debt/Equity))) 

• Cost of Debt = The interest rate at which the company borrows money

What is usually higher – cost of debt or cost of equity?

Cost of equity is usually higher than cost of debt because equity includes more risks compared to debt. Equity holders are not guaranteed a return. They only get a return if their venture succeeds. Plus, you would have to consider investing in passive alternatives vs. putting the money into a specific company. Equity investors are last in line at liquidation if a company goes bankrupt. On the other hand, debt holders are guaranteed a return regardless of how much the company makes. Plus, interest expenses are tax deductible. In case of bankruptcy, debt holders come before equity investors at liquidation.

Additional resources

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