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Here is a list of common technical valuation questions with answer explained. Technical valuation these days can be easily solved but this is a great way to study and practice the concepts and solve questions.
Q1- When do you perform an LBO analysis as part of a valuation?
Suggested Answer: Although this is obviously useful when looking at leveraged buyouts, it can also be used to determine how much a private equity firm might be willing to pay, which is typically less than what a company would be willing to pay. It is frequently used to establish a "baseline" for a possible valuation of the company you are considering purchasing or merging with.
Q2- How do you present the valuation methodologies to value a any company?
Suggested Answer:
When it comes to determining the value of a company as a going concern, there are three main valuation methods that industry practitioners use:
(1) DCF analysis,
(2) comparable company analysis, and
(3) precedent transactions
Q3- Could you explain how to calculate EBIT and EBITDA? What differentiates them?
Suggested Answer: When a company's operating income is reported on its income statement, it includes cost of goods sold (COGS), operating expenses, and non-cash charges such as depreciation and amortization. As a result, EBIT reflects the company's capital expenditures (depreciation and amortization) (indirectly) • EBITDA: EBIT plus Depreciation & Amortization (may sometimes add back other expenses as well)
The goal is to get closer to a company's "cash flow," which is difficult to achieve because D&A and other non-cash expenses are involved. However, you are also excluding capital expenditures from consideration.
Q4- Tell me what is unlevered FCF (free cash flow to the firm) and how to calculate?
Suggested Answer: Is the cash flow available to all sources of capital, including debt, equity, and hybrid sources of financing? A business or asset that generates more cash than it invests generates positive free cash flow (FCF), which can be used to pay interest and retire debt (service debt holders), as well as to pay dividends and buy back shares of stock (service equity holders)
Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure.
Q5- Why do you use enterprise value for unlevered free cash flow multiples but equity value for Levered free cash flow multiples?
Suggested Answer: These two measures of cash flow are similar, but Unlevered Free Cash Flow (Free Cash Flow to Firm) excludes interest income and interest expense (as well as mandatory debt repayments), whereas Levered Free Cash Flow includes interest income and interest expense (as well as mandatory debt repayments), implying that only Equity Investors are entitled to that cash flow in the first instance. As a result, you calculate Levered Free Cash Flow using Equity Value and Unlevered Free Cash Flow using Enterprise Value.
Q6- What is working capital? How is it used?
Suggested Answer: Working Capital = Current Assets - Current Liabilities.
If the result is positive, it indicates that a company has the ability to pay off its short-term liabilities with its short-term assets. It is frequently presented as a financial metric, and the magnitude and sign (positive or negative) of the metric tell you whether or not the organization is "sound."
The term "operating working capital" is used more frequently by bankers in models, and it is defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt).
Q7- Assume a company has 1000 shares outstanding at a $10 per share price. It also has 10 outstanding options with a $5 exercise price each. What is the diluted equity value of the company?
Suggested Answer: There is $1,000 in basic equity (100 * $10 = $1,000) in the company. To determine the dilutive effect of the options, you must first note that all of the options are "in-the-money," which means that their exercise price is less than the current share price of the company. When these options are exercised, a total of 10 new shares are issued, bringing the total number of shares to 110 rather than 100. That, however, does not tell the entire story of the situation. We had to "pay" the company $5 for each option we wanted to exercise in order to be able to do so (the exercise price). Therefore, it has received an additional $50, which it has used to purchase back 5 of the new shares that we issued as a result of this. Consequently, the fully diluted share count is 105, and the Diluted Equity Value is $1,050, as shown in the table above.
Q8- A company has a total of 1 million shares outstanding, each worth $10. It also includes convertible bonds worth $10 million with a par value of $100 and a conversion price of $5. How can you calculate diluted shares are outstanding?
Suggested Answer: Because the bonds are in the money, they should be counted as shares. Why? Although the share price is $100, the conversion price is $50. $10 million divided by $1,000 equals 10,000 convertible bonds (convertible bonds=combined value of bonds divided by par value of each bond). $1000/$50=20 shares per bond (shares per bond equals bond par value/conversion price).
So, since we discovered 10,000 convertible bonds with 20 shares per bond, we multiply 20 x 10,000 to find out how many shares are added to the 1 million outstanding, which is (20 x 10,000=200,000), so add 200,000+1 million to get the total diluted shares outstanding of 1.2 million.
Q9-When calculating the terminal value, what is a suitable growth rate to use?
Suggested Answer: Typically, you would use the country's long-term GDP growth rate, inflation rate, or something similarly conservative. A long-term growth rate of more than 5% would be quite aggressive for companies in developed countries.
Q10- When calculating terminal value, how did you select the suitable exit multiple?
Suggested Answer: Normally, you would look at the Public Comps and choose the set's median or something close to it. Rather than displaying a single number, you always show a range of exit multiples and what the Terminal Value looks like across that range. So, if the set's median EBITDA multiple was 8x, you could show a range of values ranging from 6x to 10x.
Q11- Which method of measuring terminal value will result in a higher valuation?
Suggested Answer: It's impossible to say because the assumptions could lead to either outcome. There is no general rule that applies all of the time, or even most of the time.
Q12-Can you give me a more full explanation of the Gordon Growth formula? What are the intuition behind it?
Suggested Answer: If you look at the Key Rules section above, you will see that we do have a complete derivation. The formula is as follows:
Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).
In addition, here's what the intuition behind it is:
Consider the following scenario: we know for certain that we will receive $100 every year indefinitely, and we are required to earn a 10 percent return on our investment.
In other words, we can "afford" to pay $1,000 now ($100 / 10%) in exchange for receiving $100 in year 1 and another $100 in every year after that for the rest of our lives.
For example, suppose that $100 stream continues to grow year after year; if this is the case, we will be able to invest significantly more than the initial $1,000 in our business venture.
Suppose we expect the $100 to grow by 5 percent per year for the next ten years. How much can we realistically expect to pay now to capture all of those future payments if our required return is 10%?
As a result of this growth, our effective return increases, allowing us to charge higher prices while still receiving the same 10 percent return.
We can make an educated guess by dividing $100 by 100. (10 percent - 5 percent ). Our required rate of return is 10%, and our required growth rate is 5% per year. As a result, in this case, $100 divided by (10 percent minus 5 percent) equals $2,000.
This is in accordance with the formula above: The Final Year Free Cash Flow * (1 + Growth Rate) is represented by $100, the Discount Rate is represented by 10%, and the Growth Rate is represented by 5%.
More money can be paid upfront if expected growth is higher than it is currently expected to be. If the expected growth equals the required return, we can theoretically pay an infinite amount (which results in a divide by zero error in the equation) to obtain the required return.
You can check this for yourself by entering the following data into a spreadsheet: Enter $100, make it grow by 5 percent each year, and then use NPV(10 percent, Area With All The Numbers) to see how it approaches $2,000 as you add more to it: Enter $100, make it grow by 5 percent each year, and then use NPV(10 percent, Area With All The Numbers) to see how it approaches $2,000 as you add more to it:
Q13-What are the disadvantage with basing the Terminal Multiple on what the Public Comps are trading at and Why?
Suggested Answer: It is possible that the median multiples will change significantly over the next 5-10 years, and that they will no longer be accurate by the end of the period you are considering. In order to determine how these variables affect the valuation, you should examine a wide range of multiples and perform sensitivity analyses on the data.
Q14-Tell me what is risk sensitive in WACC?
Suggested Answer: When the risk appreciation line is above the expected return line, the expected return exceeds the WACC. When the risk appropriate line is below the expected return line, the expected return is less than the WACC.
Q15-In the Cost of Equity Calculation, how do you compute Beta?
Suggested Answer: First and foremost, keep in mind that you are not required to calculate anything; you could simply use the company's Historical Beta, which is based on its stock performance relative to the relevant index. Instead, you would typically generate a new estimate for Beta using the same set of public comparable that you are using to value the company elsewhere in the Valuation, with the assumption that your new estimate will be more accurate. Take the Beta of each Comparable Company (usually found on Bloomberg), unlevered each one, take the median of the set and then lever that median based on the capital structure of the company. Then you can use this Levered Beta in the Cost of Equity calculation to determine your return on equity.
Q16-When you calculate Beta based on the comps, why do you have to un-lever and re-lever it?
Suggested Answer: As a result, when you look up the Betas on Bloomberg, Thomson Reuters, Capital IQ, or any other source, they will already be leveraged because a company's previous stock price movements reflect the Debt that they have taken on. However, each company's capital structure is unique, and we are interested in determining how "risky" a company is regardless of how much debt or equity it possesses in total. Each time we un-lever Beta, we are able to accomplish this. The inherent business risk that each company possesses, as opposed to the risk created by debt, is what we are seeking to identify. Nonetheless, at the conclusion of the calculation, we must re-lever the median Unlevered Beta of that set in order for the Beta used in the Cost of Equity calculation to accurately reflect the total risk of our company, taking into consideration its capital structure this time as well.
Q17-With unlevered free cash flow, why would you use Levered Beta?
Suggested Answer: They are two entirely different concepts (yes, the names get very confusing here). You always use Levered Beta in conjunction with Cost of Equity because debt increases the risk associated with a company's stock for everyone involved. Moreover, you always use the same Cost of Equity number for both Levered Free Cash Flow, in which the Cost of Equity is the Discount Rate in itself, and Unlevered Free Cash Flow, in which the Cost of Equity is a component of the Discount Rate (WACC).
Q18-In the calculations for Beta, how do you treat Preferred Stock?
Suggested Answer: Because Preferred Dividends are not tax deductible, in contrast to interest paid on debt, it should be included in the calculation of equity.
Q19-Is it possible for Beta will be negative? What exactly does that indicate?
Suggested Answer: Theoretically, Beta could be negative for certain assets, and this is something to consider. If the beta of an asset is -1, for example, it means that the asset moves in the opposite direction of the market as a whole, and vice versa. The value of this asset would decrease by 10% if the market increased by 10%. In practice, it is rare, if ever, to see negative Betas for publicly traded companies. It is possible for something to be labelled as "counter-cyclical" to still track the overall market; for example, a "counter-cyclical" company might have a Beta of 0.5 or 0.7, but not one of -1.
Q20-Would you expect a manufacturing company to have a greater Beta than a technological one?
Suggested Answer: A technology company, because the technology industry is considered to be "riskier" than the manufacturing industry.
Q21-Tell me how can I go from Enterprise Value to Estimated Per Share Value in a DCF if I'm dealing with a public company?
Suggested Answer: Having determined Enterprise Value, add Cash to the total and then SUBTRACT debt, preferred stock, and noncontrolling interests (as well as any other debt-like items) from the total to arrive at Equity Value. The implied per-share price is calculated by dividing the implied per-share price by the company's share count (after accounting for all dilutive securities).
Q22-Let's suppose we do analysis and come up with a $10.00 Implied per Share Value. The current share price of the company is $5.00. What does all this mean?
Suggested Answer: This isn't very important on its own. You need to look at a lot more than just one number from a DCF. In this way, you would be able to see what the Implied per Share Value would be if you changed the Discount Rate, the growth in revenue, the margins, and so on.
If you always find that it's more than the company's current share price, then the analysis might say that the company is undervalued. If it's always less than the current share price, the analysis might say that the company is worth more than it is.
Q23-When calculating FCF, is it always correct to leave out the most of the CFI section and the whole CFF section?
Suggested Answer: This isn't very important on its own. You need to look at a lot more than just one number from a DCF. In this way, you would be able to see what the Implied per Share Value would be if you changed the Discount Rate, the growth in revenue, the margins, and so on.
If you always find that it's more than the company's current share price, then the analysis might say that the company is undervalued. If it's always less than the current share price, the analysis might say that the company is worth more than it is.
Q24-What is an other way to calculate Unlevered Free Cash Flow?
Suggested Answer:
Unlevered FCF = EBIT X (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx
Unlevered FCF = Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx
Unlevered FCF = Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx
The difference between these two is that the tax numbers will be slightly different as a result of excluding the interest from the calculations.
Q25-What about calculating Levered FCF in a different way?
Suggested Answer:
Levered FCF = (EBIT - Net Interest Expense) X (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments
Levered FCF = Cash Flow from Operations - CapEx - Mandatory Debt Repayments
Levered FCF = Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments
Q26-Do you think it's acceptable to utilize EBITA-Changes in Operating Assets and Liabilities - Capex to estimate Unlevered FCF as a rough approximation?
Suggested Answer:
It is inaccurate because it does not include any taxes at all.
Better to use EBITDA - Taxes - Changes in Operating Assets and Liabilities - CapEx
Q27-What is the purpose of the section on "Changes in Operating Assets and Liabilities"? What would that indicate?
Suggested Answer:
Assets growing faster than liabilities indicates that the company is spending cash and thus decreasing its available cash flow (cash on hand).
If the increase in liabilities exceeds the increase in assets, the company is increasing its cash flow.
Q28-What is the basic concept of a Discounted Cash Flow analysis?
Suggested Answer 1-:
Essentially, you are valuing a company based on the present value of its Free Cash Flows that will be generated far into the future.
You divide the future into two periods: a "near future" period of 5-10 years, during which you calculate, project, discount, and add up those Free Cash Flows; and a "far future" period for everything beyond that, which you can't estimate as precisely but which you can approximate using various approaches to estimate.
Because money today is worth more than money tomorrow, you must discount everything back to its present value in order to account for inflation.
Suggested Answer 2-:
The DCF analysis represents the net present value (NPV) of projected cash flows that are available to all sources of capital, minus the cash required to be invested in order to generate the anticipated growth.
It is based on the principle that, in order for a business or asset to be valued, it must first and foremost be able to generate cash flows for the benefit of lenders and other investors (intrinsic valuation)
In contrast to public market factors or historical precedents, it places a greater emphasis on the fundamental expectations of the business (theoretical approach, relies heavily on numerous assumptions)
DCF calculates the total value of a business (enterprise value), which includes both debt and equity, as well as the amount of debt and equity.
Q29-Could you explain how you go from revenue to free cash flow in your projections?
Suggested Answer: To calculate operating income, subtract cost of goods sold and operating expenses from total revenue (EBIT). Afterwards, multiply the result by (1 - Tax Rate), subtract Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital from the total.
As a result, you have Unlevered Free Cash Flow, rather than EBIT, because you have switched from EBT to EBIT. Maybe you should double-check with the interviewer that this is what they're looking for.
💡 Hint: As a result, you have Unlevered Free Cash Flow, rather than EBIT, because you have switched from EBT to EBIT. Maybe you should double-check with the interviewer that this is what they're looking for.
Q30-When would a Sum of the Parts value be appropriate?
Suggested Answer: When different valuation metrics are applied to separate business operations, the sum of the parts valuation method is used to determine the value of the whole. In this example, the copper mining operations might be valued using discounted cash flow or EV/EBITDA, whereas the financial services division would most likely be valued using a multiple of its book value.
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