(courtesy of www.wallstreetprep.com)

With the start of a new academic year, we know that finance interviews are again at the forefront of many of your minds. This article is part of a series on the most frequently asked technical finance interview questions and answers across a variety of topics.

This question, or variations of it, should be answered by talking about 2 primary valuation methodologies: Intrinsic value (discounted cash flow valuation), and Relative valuation (comparables/multiples valuation).

Intrinsic value (DCF)

This approach is the more academically respected approach. The DCF says that the value of a productive asset equals the present value of its cash flows. The answer should run along the line of “project free cash flows for 5-20 years, depending on the availability and reliability of information, and then calculate a terminal value.

Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of equity for levered DCF). In an unlevered DCF (the more common approach) this will yield the company’s enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at equity value. Divide equity value by diluted shares outstanding to arrive at equity value per share.

Relative valuation (Multiples)

The second approach involves determining a comparable peer group – companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics. Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples.

Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation.Common multiples are EV/Rev, EV/EBITDA, P/E, P/Book, although some industries place more emphasis on some multiples vs. others, while other industries use different valuation multiples altogether. It is not a bad idea to research an industry or two (the easiest way is to read an industry report by a sell-side analyst) before the interview to anticipate a follow-up question like “tell me about a particular industry you are interested in and the valuation multiples commonly used.”

Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company’s cash flows as if it had no debt – so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity).

The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate.

Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP’s DCF module for a detailed analysis of calculating the cost of equity).

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.

There are several competing models for estimating the cost of equity, however, the capital asset pricing model (CAPM) is predominantly used on the street. The CAPM links the expected return of a security to its sensitivity the overall market basket (often proxied using the S&P 500). The formula is: Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf )

Risk free rate

The risk free rate should theoretically reflect yield to maturity of a default-free government bonds of equivalent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the preferred proxy for the risk-free rate for US companies.

Market risk premium

The market risk premium (rm-rf) represents the excess returns of investing in stocks over the risk free rate. Practitioners often use the historical excess returns method, and compare historical spreads between S&P 500 returns and the yield on 10 year treasury bonds.

Beta (β)

Beta provides a method to estimate the degree of an asset’s systematic (non-diversifiable) risk. Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market. A company whose equity has a beta of 1.0 is “as risky” as the overall stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the stock market. A company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop twice as fast as the overall market.

Calculating raw betas from historical returns and even projected betas is an imprecise measurement of future beta because of estimation errors (i.e. standard errors create a large potential range for beta). As a result, it is recommended that we use an industry beta. Of course, since the betas of comparable companies are distorted because of different rates of leverage, we should unlever the betas of these comparable companies as such:

- β Unlevered = β(Levered) / [1+ (Debt/Equity) (1-T)]

Then, once an average unlevered beta is calculated, relever this beta at the target company’s capital structure:

- β Levered = β(Unlevered) x [1+(Debt/Equity) (1-T)]

Free cash flows = Operating profit (EBIT) * (1 –tax rate) + depreciation & amortization – changes in net working capital – capital expenditures

The answer is enterprise value. The question tests whether you understand the difference between equity value and enterprise value and their relevance to multiples. Equity value = Enterprise value – Net Debt (where net debt = gross debt and debt equivalents – excess cash).

EBIT, EBITDA, unlevered cash flow, and revenue multiples all have enterprise value as the numerator because the denominator is an unlevered (pre-debt) measure of profitability. Conversely, EPS, after-tax cash flows, and book value of equity all have equity value as the numerator because the denominator is levered – or post-debt.

Given that negative profitability will make most multiples analyses meaningless, a DCF valuation approach is appropriate here.

Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, Revenue multiples are more insightful.

10 P/E: A rational investor would rather pay less per unit of ownership

Source:https://www.wallstreetprep.com/knowledge/top-10-investment-banking-inte…