1_PE Technical Interview

Can you walk me through the specifics of a DCF?

-A DCF values a company based on the present value of its cash flows and the present value of its terminal value. -To build a DCF, you start by projecting out future cash flows for a period of time. The time period you use to project out cash flows is generally about 5-10 years depending on the maturity of the company, type of company, and current health of the company. Cash flows are equal to EBIT times one minus the tax rate, plus depreciation and amortization expense, minus capital expenditures, minus changes in net working capital. This measure of free cash flow is unlevered or debt-free. This is because it does not include interest and so is independent of debt and capital structure. -Next we need a way to predict the company's terminal value, it's value of the company for the years beyond the projection period. There are two methods for doing this, the gordon growth (also called the perpetuity method) method and the terminal multiple method. -To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow perpetually. This growth rate should be modest, for example, average long-term expected GDP growth. To calculate terminal value we multiply the last year's free cash flow by 1 plus the chosen growth rate, and then divide by the discount rate minus the growth rate. -The second method, the Terminal Multiple method, is the one that is more often used in banking. In order to use this method, you multiply the last year's cash flows by an appropriate valuation multiple. This most common metric to use is EBITDA. We typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months basis. -Once we have projected free cash flow and terminal value, we need to discount them back to the present day to take into account the time value of money using the appropriate discount rate, which is generally your weighted average cost of capital. In order to calculate WACC you'll need to calculate cost of debt. You'll also need to calculate cost of equity which you will do by using the Capital Asset pricing Model.

What are aspects that you would look out for in an investment?

-Business model: how they generate money, how the company works -Market share/Size of the market: how defensible is it, opportunities for growth -Margins & cost structure: fixed vs. variable costs, operating leverage and future opportunity -Capital requirements: sustaining vs. growth CapEx, additional funding required -Operating efficiency: analyzing ratios such as inventory turnover, working capital management, etc. -Risk: assessing the riskiness of the business across as many variables as possible -Customer satisfaction: understanding how customers regard the business -Management team: how good is the team at leading people, managing the business, etc. -Culture: how healthy is the culture and how conducive to success All of the above criteria need be assessed in three ways: how they are in (1) the past, (2) the near term, future and (3) the long-term future.

When should you value a company using revenue multiple vs EBITDA?

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

What is the right numerator for a revenue multiple?

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.

What are the most important factors in a merger model?

From a valuation perspective, the most important factors in an M&A model are synergies, the form of consideration (cash vs shares), and purchase price. Synergies will enable the acquiring company to realize value by enhancing revenue or reducing operating costs, and this is typically the biggest driver of value in an M&A deal (note: synergy values are very hard to estimate and can often be overoptimistic). The mix of cash vs share consideration can have a major impact on accretion/dilution of per share metrics (such as EPS). To make a deal more accretive the acquirer can add more cash to the mix and issue fewer shares. Finally, the purchase price and takeover premium are a major factor in the value that's created.

How would you value a company with negative historical cash flow?

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

How do you value a company?

It would depend on the circumstances- for example how mature the company is, whether they have revenues, whether or not they have positive cash flows. One way to value would be by using a DCF, which entails projecting out a company's cash flows and arriving at valuation by taking the present value of the company's future cash flows and the present value of the firm's terminal value. This approach attempts at determining a firm's intrinsic value. These values would be discounted back by using an appropriate weighted average cost of capital. In an unlevered DCF, the approach would yield the company's enterprise value, from which net debt needs to be subtracted in order to arrive at equity value. Equity value can then be divided by diluted shares to arrive as equity value per share, or stock price.

What assumptions is an LBO model most sensitive to?

LBO models are most sensitive to the total leverage the business can service (based on a debt/EBITDA ratio, typically), the cost of debt, and the acquisition or exit multiple assumptions. In addition, operating assumptions for the business play a major role as well.

Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk. Company A is trading at a 15 P/E multiple, while the other trades at 10 P/E. which would you prefer as an investment?

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

What determines how much debt you can put on a company?

The amount of debt that a company can obtain depends on a variety of different factors. Some of these factors include: -Current capital structure and types of debt -EBITDA and ability to handle interest expense -Size of the company -Industry (stable or cyclical) -Current credit rating -State of the credit markets Using a Net Debt / EBITDA multiple, a bank can get a quick sense for how much debt a company could take on and still be in line with the average leverage levels of the peer set or industry. You can also use this method to check for covenant compliance if a firm has a covenant that specifies a Debt / EBITDA multiple or if a credit rating agency has promised a downgrade if the company falls below a certain debt / EBTIDA level.

What is usually higher, cost debt or 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

How would you value a company using a multiples approach?

When valuing based upon relative multiples, the most important aspect is determining a strong comparable peer group- companies in the same industry, with similar risks, growth profiles, and return on capital characteristics. While it is impossible to find two identical companies, there are ways to mold peer sets around these characteristics which make them realistic and valuable in determining a companies value.

What are the limitations of a DCF model?

While discounted cash flow analysis is the best method available for assessing the intrinsic value of a business, there are several limitations. One issue is that the terminal value represents a disproportionately large amount of the value of the total business, and the assumptions used to calculate the terminal value (perpetual growth or exit multiple) are very sensitive. Another issue is that the discount rate used to calculate net present value is very sensitive to changes in assumptions about the beta, risk premium, etc. Finally, the entire forecast for the business is based on operating assumptions that are nearly impossible to predict.

An investment banker gives you a deal book - how do you verify the information in it?

I would conduct extensive due diligence- including financial, customer, commercial, vendor, legal, etc.

What is the significant of the three financial statements?

The income statement shows a company's revenues and expenses and works its way down to net earnings. The balance sheet show the company's assets (such as cash, merchandise inventory, and PP&E), it's liabilities (such as debt and accounts payable), and shareholder's equity. Lastly, the cash flow statement begins with cash flows from operating activities, then shows cash flows from investing activities, and then cash flow from financing activities, resulting in the company's net change in cash.

What is the advantage to a vendor loan?

Vendor finance is the provision of a loan from one company to another so that goods can be purchased from the company providing the loan. Vendor finance has a number of advantages which include: The vendor increases their sales, the vendor earns interest on the loan which is usually higher than that available from other financial institutes and the vendor has a firm business relationship with the borrowing company.

If depreciation were to go up by $10, how does that impact the financial statements?

First, let's start with the income statement. If depreciation increases, revenue stays the same, but expenses will increase causing a $10 reduction in operating income (EBIT). However, the $10 reduction in EBIT also means less taxes. Assuming a 40% tax rate, your net income would decrease by $6. The reduction of $6 in net income flows onto the top line of the cash flow statement, but the $10 depreciation is a non-cash expense that gets added back so overall cash flows from operations goes up by $4. On the balance sheet, PP&E gets reduced by $10 as it was depreciated, and cash increases by $4 due to the changes on the cash flow statement. Overall, assets are down $6. Since net income fell by $6 as well, the shareholder's equity account on the balance sheet is down by $6 and thus the two sides of the balance sheet balance.

Explain the mechanics of an LBO model?

Step 1: Lay out the Sources and Uses assumptions assumptions and some example company. "Lets assume we have an consumer retail company. My first step would be to lay out some assumptions with regards to source an uses. - I need to know how much I will pay for the company. This can be expressed as a multiple of EBITDA. Let's assume 8 times of current EBITDA, which I think is a reasonable multiple. If current sales are 500 and EBITDA margin is 20%, then EBITDA is 100, that means 8*100 = 800 is what I need to pay. - I need to know how much of that purchase price will be paid in equity and how much through debt. Lets assume that I will use 50% of debt and 50 % of equity. So that means I used 400 of equity and 400 of debt. - Also, lets now assume that we will sell this company in 5 years, at a same 8 times EBITDA multiple. Step 2. Make some basic cash flow assumptions "Now I need to know about the financial forecast to see what the cashflow looks like and see how much of debt I can repay over the period. My cashflow before debt repayment is calculated as: EBITDA - Capex - Changes in Working capital - Interest paid on the debt - Taxes. I assume EBITDA can grow from 100 to 150 over five years. Then lets say that based on those forecasts, I am able to repay 20 of debt per year that is 100 over the next five years." Step 3. Calculate your IRR -I have spent 400 of equity and taken 400 of debt -After 5 years, EBITDA is 150, and assuming I can sell at a 8 times multiple, I will get 150 * 8 = 1,200. From that 1,200, I need to repay the 400 of debt but I already repaid 100 over the last 5 years, therefore I only have 300 left to repay. That leaves me with 1200 - 300 = 900 of equity. -My overall return is therefore 900 / 400 = 2.25x return over 5 years, which is roughly an 18% IRR

How do you solve for WACC?

The WACC (Weighted Average Cost of Capital) is the discount rate used in a Discounted Cash Flow (DCF) analysis to present value projected free cash flows and terminal value. The WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile. ---> Specifically the formula for WACC is: Cost of Equity (Ke) times % of Equity (E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) To estimate the cost of equity, we will typically use the Capital Asset Pricing Model ("CAPM")/ To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies.

Why are EBITDA and FCF important to private equity investors?

The ability to generate EBITDA and sufficient cash flow is paramount importance to the success of any LBO as it allows the PE firm to make required interest payments and pay down the principal on the debt they owe

What indicators would quickly tell you if an M&A deal is accretive or dilutive?

The quickest way to tell if a deal between two public companies would be accretive is to compare their P/E multiples. The company with a higher P/E multiple can acquire lesser valued companies on an accretive basis (assuming the takeover premium is not too big). Another important factor is the form of consideration and mix of cash vs share (see above question).

How do you calculate cost of equity?

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 )

How do you solve for Cost of Equity?

To calculate a company's cost of equity, we typically use the Capital Asset Pricing Model (CAPM). The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium. The risk free rate (for a U.S. company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond. Beta (See the following question on Beta) should be levered and represents the riskiness (equivalently, expected return) of the company's equity relative to the overall equity markets. The equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term. Prior to the credit crises, most banks tend to use an equity risk premium of between 4% and 5%. However, today is assumed that the equity risk premium is higher.