Valuation
Technical Interview
Questions.
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Q1. How do you value a company? 01
A. This question is very much asked in valuation as well as
finance interview and the answer should be answered
revolving around two methodologies primarily. They are:
A. Intrinsic Valuation (Discounted Cash Flow):
DCF says that the value of the company or the productive
asset is equal to the present value of the potential future
cash flows that the asset will generate assuming it as a
going concern entity.
1. Future Cash Flows: We should first Project the future
free cash flows (FCFF) of the company for 5-20 years
(Mostly 5 or 10 years is preferred) depending on the
availability and reliability of the data and then Calculate
the terminal value at the last year.
2. Discounting FCFF and Terminal Cash Flow: We have to
Bring the FCFF and TV at the present value terms using a
discount rate (PVF). Use Weighted Average Cost of
Capital (WACC) for Unlevered Cash Flows (Cash flows
before financial payments) and Cost of Equity for Levered
Cash Flows (Cash Flows after payment of financial
obligations).
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3. Enterprise Value and Equity Value: With the Unlevered
Cash Flows you will arrive at the Enterprise Value
(Company’s value or Transaction Value) but with Levered
Cash Flow we arrive at Equity value. Divide the equity
value with the number of diluted equity shares outstanding
to get equity value per share. Basically with Intrinsic
Valuation (DCF) we calculate the value of the firm in
today’s time based on its future capability of generating
cash flows.
B. Relative Valuation (Multiples Approach):
Here we have to Find a universe or the industry of the
company in which they operate determining a comparable
peer group with companies who are in same sector with
similar operations, growth, risk, return, etc. We have to
find not the exact replica but a comparable company with
a reasonable similar traits. Calculate the industry multiples
and find the median of the group. Apply that median on
the relevant operating metric of the target company to
arrive at a valuation.
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Common multiples are Revenue/EBITDA, EV/EBITDA, P/E,
P/S, P/B, etc. Some industries give more weightage to
some ratios and some prefer different valuation metric
altogether. It depends on the industry and the business in
which they are. The numbers are used to analysis the pros
and cons of the valuation of the target and determine
whether it is undervalued or overvalued.
Q2. What is the difference between Levered and
Unlevered Cash Flows?
The difference between them is the amount of cash to be
paid as financial obligations expenses such as Interest.
Levered cash flows shows the investors the amount of
money left with business for future capex or expansion
after interest payments while Unlevered cash flows is for
the whole firm. Levered cash flow is the amount of cash
a business has after it has met its financial obligations.
Unlevered free cash flow is the money the business has
before paying its financial obligations. The difference
between the levered and unlevered free cash flow is an
important indicator. The difference shows how many
financial obligations the business has and if the business is
overextended or operating with a healthy amount of debt.
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Investors mostly prefer to check the levered cash flows to
gauge the future potential of the company.
Q3. How do calculate Unlevered Free Cash Flows for DCF?
EBIT*(1-T) + Depreciation and Amortization - Capital
expenditure - Change in Working Capital = Free Cash Flow to
Firm (FCFF) - Interest (1-T) - Debt Repayment + Borrowings =
Free Cash Flow to Equity (FCFE).
Q4. How will you view negative levered cash flows and
also can it be negative ?
A. Yes absolutely, It is possible for a company to have a
negative levered cash flow If the financial expenses exceed
its earnings.
Although it shouldn’t have happened in the first place but if it i
a short term issue investors should not be worried.
Even if levered FCF is -ve, Then the company may not be
failing.
A company might have Substantial capital investments that
are soon to positively affect earnings in future.
Also, The money that the company has borrowed must have
been utilized somewhere productive in the business which wil
generate future cash flows.
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Q5. What is the appropriate discount rate to use in an
unlevered DCF analysis?
A. To arrive at a valuation through DCF We use a unlevered
cash flows and the cash flows used are pre debt which means
as if the company had no debt therefore paying no interest an
also foregoing the tax benefit from that interest (Tax Shield).
The cash flows we use are for both the debt lenders and the
equity shareholders, So we will use a discount rate that
represent both the capital providers and match their
respective risk and return expectations according to their
share in the capital structure (Weights).
We will Use Weighted Average Cost of Capital (WACC),
Which will represent all the capital providers.
Cost of Debt (Kd): The return the lender expects from the
company to give debt. The higher the risk the higher the ask.
Kd = 10 Year US Govt Bond Yield (Safest) + Default Spread of
that country + Default spread of that company (Add this part
only if Emerging Market).
Cost of Equity (Ke): The return the owner or the shareholders
expects before investing in your company. Higher than Kd
It is typically calculated using CAPM methodology (Tweaked)
which links expected ROE to its sensitivity to the market.
Ke = Risk Free Rate + Equity Risk Premium * Beta
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Q6. Which is typically higher - Cost of Debt or Cost of
Equity?
A. Cost of equity is higher than the Cost of debt because
Equity shareholders are taking more risk by investing in
the company and becoming the owners of the company.
Interest payments are fixed for the creditors and the
interest amount is tax deductible making the cost on
company less. The return the owner or the shareholders
expects is higher than Kd because the company isn’t
obligated to pay anything to the shareholders hence
they demand more (Ke). Shareholders are the last party
when the company dissolves. The higher the risk the
higher the ask.
Q7. How do you calculate the Cost of Equity (Ke)?
A. There are several methods to calculate the number but
CAPM is the most dominant one but there is an
adjustment that should be done for MRP but we will stick
to CAPM theory. CAPM links the expected return of the
security to its sensitivity to the overall market (S&P500,
NIFTY 50, etc). The formula is as follows: Ke = Rf +
Market Risk Premium (Rm - Rf) * Beta
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A) Risk Free Rate (Rf): It theoretically Reflects the yield to
maturity of a default free government bonds of equivalent
maturity to the duration of the cash flows being
discounted. Due to lack of liquidity in other long tenure
bonds the 10-Year US Govt Treasury Bond is taken as the
preferred proxy for the Rf for US companies. You should
deduct the default spread for the specific country from the
10 Year Govt Bond Yield of that country.
B) Market Risk Premium: The MRP (Rm - Rf) represents
the excess returns of investing in stocks over the risk free
rate. Historical Excess Return method is widely used where
we compare the historical spread between market
(S&P500/NIFTY50) and the yield on the 10 year govt bond.
C) Beta: It is an methodology to gauge the estimate the
degree of an asset’s systematic (non-diversifiable) risk.
Beta = Covariance between the expected returns on the
asset and the stock market overall / Variance of the
expected returns on the stock market. A stock with an
beta of 1 means that the volatility of the stock resembles
a lot like the overall market whereas a number of 2 means
if the market falls 1X the stock will fall 2X and vice versa.
Beta shows the volatility of that specific company stock
with the overall market.
Q8. How would you calculate Beta for a company? 08
The number of Beta tells us how much the company is
riskier in comparison with the overall stock market.
Calculating raw betas from historical returns and even
projected betas is an improper calculation of future betas
due to:
A. Standard Errors: Estimation errors caused by standard
errors creating a large potential range for beta.
B. Issue of Capital Structure: If the company has high
leverage > There is more risk to invest > investors will
demand high return > Beta will shoot.
C. Business Model: The work that the company used to do
in past is in no way predicts what they will do in future.
Companies expands, open new divisions, etc. Historical
Beta will be affected by the past without taking account
of future changes in the business strategy. For ex:
Reliance Industries was an Oil and Gas company but is it
now, No. Now it is a conglomerate with presence
everywhere. As a result Industry Beta is preferred, Since
the betas of comparable companies are distorted due to
different rates of leverage we should Un-Lever the betas
of the industry like following
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Beta Unlevered (industry)= Beta (levered) / [1 + (Debt/Equity)
(1 - Tax)]
And then Re-Lever it again with the target company’s capital
structure as follows
Beta Levered (Company)= Beta (Un-Levered) X [1 +
(Debt/Equity) * (1 - Tax)]
Q9. What is the appropriate numerator for a revenue
multiple?
Its is Enterprise Value.
The question tests the difference between the Enterprise
Value and Equity Value.
Enterprise value is the one because the Revenue is for the
both the parties i.e. Creditors and Shareholders and Revenue
is an unlevered (Pre-Debt) measure of profitability.
Equity Value = Enterprise Value - Net Debt where Net Debt =
Gross Debt and Equivalents - Excess Cash.
Enterprise Value Multiples: Revenue, EBITDA, EBIT, and
Unlevered CFs.
Equity Value Multiples: EPS, After Tax CFs, BV of Equity all
have equity vale as the numerator since the denominator is
levered (Post Debt).
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Q10. How would you value a company with negative
historical cash flows?
Given that negative profitability will make most multiples
analysis meaningless, A DCF approach should be
considered. Since DCF considers the cash flows as a
going concern and does give a growth to the cash flows
going forward so there is a chance at some point in the
future the cash flows will turn positive making the
valuation possible.
Q11. When should you value a company using a
Revenue multiple vs EBITDA?
We would use Revenue Multiple instead of the EBITDA
when the target company is pushing out negative EBITDA
and profits number. If the denominator in the EV/EBITDA is
negative, Then it doesn’t make sense to go further. Hence
revenue multiple should be preferred.
Q12. You are given a 2 Identical Companies in terms
of Earnings, Growth, Leverage, ROC, and Risk profile.
A is trading at 15 P/E while B is at 10. Where would
you investment?
Given everything same, I would go with B (Undervalued in
comparison with A). Why to pay 5 times of earnings more
when everything is same. PE Ratio tells for 1 Rs of Earning
(EPS) how much is the market paying (MPS)
