Valuation
Interview Questions

Which methods of valuing a company do you know?

There are three main valuation methods.

  • Discounted Cash Flow (intrinsic value)
  • Precedent Transaction Multiples (relative valuation)
  • Trading Multiples (relative valuation)

Walk me through a DCF.

The discounted cash flow method values a company by discounting projected future cash flows as well as the terminal value. Let’s assume we want to calculate the Enterprise Value (“EV”) of a company. We first need to project the free cash flow to firm (“FCFF”) or unlevered free cash flow (“UFCF”), which is defined as follows:

  EBIT
– Tax
= EBIAT/NOPAT
+ Depreciation & Amortization
– Capex
– Changes in Working Capital
– Investments
= FCFF

The usual projection period for the FCFF is between 5 and 10 years, depending on when the company reaches a steady state.

Following that period, a terminal value (“TV”) has to be calculated, which represents the residual value of the company at the end of the projection period. There are two methods to calculate the TV, (i) by using a multiple on the final year’s EBITDA, or (ii) by using a perpetual growth formula (“Gordon Growth Method”). Note: As DCFs are supposed to calculate the intrinsic value of a company, not the market value, we would recommend using the perpetual growth formula.

Both the FCFF as well as the TV have to be discounted back to today’s time value by using a weighted average cost of capital (“WACC”).

The EV is the sum of the discounted FCFF plus the discounted TV.

What are precedent transaction multiples? Name a few.

The precedent transaction multiples or “transaction comps” value a company by looking at historic transaction of similar companies. It is a relative valuation method that will come up with a market price (as opposed to an intrinsic value).

Common transaction comps are EV/Sales, EV/EBITDA, EV/EBIT.

What are trading multiples? Name a few.

Trading multiples or “trading comps” value a company based on how similar companies are currently traded on a stock exchange. It is a relative valuation method based on current market data and financials, and will come up with a market price (as opposed to an intrinsic value).

Common trading comps are Price to Earnings (PE), Price to Book Value (PB), EV/EBITDA

In general, how do you find the right companies to use in your multiple valuation?

Whether you use trading or transaction comps, you value your company relatively to other companies. As there are no two identical companies, you must look for companies that are as similar as possible to yours. In other words, similar in sector, products/services, size, geographies, customers, distribution channels, capital structure and other business and financial factors.

What exactly is EBITDA?

EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. It shows the profit of a company’s core operations and is widely used in valuation methods as it is independent of the impacts of e.g. different tax rates, depreciation methods, one-offs etc.

Who can pay higher purchase prices - financial or strategic investors? Why?

The keyword here is synergies.

Imagine a strategic and a financial player bidding for an asset that has a fair purchase price (based on future cash flows to be generated) of €10m, so both parties would usually be able to pay a price of up to €10m. However, as the strategic buyer can generate synergies, let’s assume 30%, he would be able to pay up to €13m. In normal circumstances a strategic buyer would only partially pay for possible synergies, but nevertheless has the possibility to pay beyond what is possible for financial investors.

For the sake of completion, it should be mentioned that through financial investors that make a bolt-on purchase to their current holdings and therefore realize synergies themselves, as well as through a large portion of dry powder available (at least pre-Corona), the margin of what’s possible in terms of purchase price between strategic and financial investors keeps shrinking.

Which of the valuation methods usually comes up with the highest value?

In most of the cases the transaction comps come with the highest value as they include a so-called control premium. An average control premium is in the area of 20%.

What discount rate would you use in a DCF?

When calculating an Enterprise Value by using the free cash flow to firm / unlevered free cash flow, a weighted average cost of capital (“WACC”) will be used. The WACC is calculated based on the share of equity of the company times cost of equity plus the share of debt times cost of debt times 1 – tax rate.

WACC = D/D+E * cost of debt *(1-tax) + E/D+E * cost of equity

How can you lower the impact of the terminal value in a DCF?

That is possible by prolonging the period of forecasted cash flows and pushing the TV further back. Let’s assume a 10% discount rate. By pushing back the TV from the end of a 5-year FCF forecast to the end of a 10-year forecast period, the discount factor decreases from 0.62 (=1/(1+10%)^5) to 0.39 (=1/(1+10%)^10).

How would you calculate the cost of equity?

The cost of equity is calculated by using the Capital Asset Pricing Model. The formula looks as follows:

Cost of equity = risk free rate + Beta * MRP

MRP = Market Risk Premium = expected market return – risk free rate

What is a beta and how are they usually determined?

The beta factor represents the systematic risk of a company. It is calculated via a regression analysis of a company compared to its relevant market (often a stock index).

A beta factor of 1 means that the company’s stock price is moving in line with the market price. A beta below 1 means that the stock is less heavily moving than the market, while a beta factor above 1 means that the stock is moving above market average. A negative beta would mean that the stock is moving anticyclic to the market.

Why is EBITDA such a ubiquitous financial metric? Why not look at net income when comparing companies?

EBITDA shows the profit before the impact of interest, taxes, depreciation and amortization.

Image you want two compare two companies, which are operating in different countries. These companies might therefore have different tax rates, different capital structures with different interest rates, as well as different depreciation and amortization methods.

If we now assume that these companies have the exact same EBITDA, their net income would differ through the differences in the aforementioned treatments, e.g. lower tax rate, lower depreciation, but also non-operational income/expenses or “one-offs”.

To make companies comparable, a metric should be used that is independent of these differences, i.e. EBITDA.

Why does it make sense for some companies to issue debt for an acquisition?

There are two main reasons here.

  1. Debt is usually cheaper than equity
  2. Tax Shield: Debt lowers the taxable income of a company, resulting in less taxes to be paid. This is what is represented by the ‘cost of debt *(1-tax)’ in the WACC formula, effectively resulting in a lower WACC.

However, high amounts of debt drastically increase the interest + principal payments and therefore increase the risk of the company going bankrupt.

What is the advantage for companies of buying back shares?

  • Cost of equity is usually more expensive than cost of debt, therefore buying back shares and replacing the “lost” liquidity by debt might be more cost-effective
  • Buying back share increases the value of the remaining shareholders. Imagine a dividend of €100 divided by 100 shares outstanding equals Earnings per share (“EPS”) of 1. If the company now buys back 10 shares, the dividend of €100 divided by 90 shares outstanding equals an EPS of €1.11, so 11% higher, and that without increasing the dividend.

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