Valuation - Interview Question

Despite this principle, why do valuation multiples and growth rates often NOT display as much correlation as you might expect?

1. Company valuation is ultimately based on cash flow growth, so growth rates in revenue, EBITDA, EBIT, and Net Income are, at best, rough approximations of cash flow growth. EBITDA growth and FCF growth are very different since FCF includes taxes, the Change in Working Capital, and the full CapEx amount, whereas EBITDA excludes these. 2. Not every comparable company necessarily has the same Discount Rate 3. Finally, non-financial factors could easily affect multiples. (ex. legal troubles, announced new product, or recruited a key executive)

How can you use valuation multiples in real life?

Comparable Company Analysis" or "Public Company Comparable Analysis" (and see how the company you're analyzing stacks up) But you can also use valuation multiples to determine a company's yield. For example, if a company has a P/E multiple of 10x, that means you earn 1/10, or 10%, for each dollar you invest in its Equity.

What are the three major valuation methods?

DCF, precedent transactions, and public comparable analysis

Why can't you use Equity value/EBITDA

EBITDA is attributable to all shareholders, so enterprise value must be used to reflect the value attributable to all investors

What are the most common multiples used in valuation?

EV/EBITDA, P/E, EV/Revenue, EV/EBIT, Price to Book

What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E?

First, you should note that you never look at just one multiple when valuing companies. Valuation is about the big picture, and you want to evaluate the company across a variety of multiples and methodologies. But the interviewer will probably be annoying and press you on this point, so you can say that with EV / EBITDA vs. EV / EBIT, EV / EBITDA is better in cases when you want to completely exclude the company's CapEx, Depreciation, and capital structure. EV / EBIT is better when you want to exclude capital structure, but partially factor in CapEx and Depreciation. It is common in industries, such as manufacturing, where those items are key value drivers for companies. The P / E multiple is not terribly useful in most cases because it's affected by different tax rates, capital structures, non-core business activities, and more - so you use it primarily to be "complete" and ensure that you've covered all the common multiples. Also, sometimes it is more relevant and important in certain industries, such as commercial banks and insurance firms, where you do want to factor in the interest income and expense.

What would you use in conjunction with FCF multiples: equity value or EV

For unlevered FCF you would use EV and for levered FCF you would use equity value Unlevered excludes interest expenses so it represents cash that is still available to all investors: debt and equity. Levered, which already includes interest, therefore only represents cash available to equity investors

How do you select companies for a comps model?

I use three criteria: 1) Industry classification 2) Financial measures such as revenue, EBITDA, market cap, earnings. Etc.. 3) Geographic location The most important factor among these three is industry. Geography can be less relevant in industries such as technology, but would be highly relevant if you were analyzing a E&P oil company, for example

How would you value an apple tree?

I would look at what comparable apple trees are worth for an idea of relative valuation and get an understanding of the apple trees cash flows. Bottom up approach for revenue and expenses: How much the apples can be sold for and the unit value per apple. Then I would interpret the labor cost to harvest the apples, which would give me the operating cash if the apple tree were paid for in cash with no debt. This, less taxes, would give me FCF, I would model this out for 10 years and find an appropriate terminal growth rate for FCF. I would find a reasonable discount rate (probably a risk premium based on natural disasters and market-related risk) and discount these cash flows to find an intrinsic value.

How would you value Facebook back when it wasn't making money?

I would use precedent transactions analysis and relative value to find an appropriate (and more creative) multiple that reflects implied profitability rather than analyzing actual profitability such as EV/(Unique visitor) or EV/(page views) I would never use a "far in the future" DCF analysis because you cannot reasonably predict cash flows for a company that isn't even making money yet

When you use EBITDAR in the EV / EBITDAR multiple, how must you adjust Enterprise Value?

If the denominator of a valuation multiple excludes an expense, then the numerator should include the Balance Sheet item corresponding to that expense (and vice versa). EBITDAR is EBITDA + Rental Expense, so it excludes this annual Rental Expense by adding it back. EBITDAR, you have to capitalize the company's operating leases, usually by multiplying the annual lease expense by 7x or 8x, and then add the capitalized leases to Enterprise Value. There is no existing Balance Sheet item since operating leases are off-BS, so you must create a new Balance Sheet item by capitalizing these leases.

Why do DCF valuations tend to be higher than LBO?

In an LBO, you do not add the NPV of the cash flows between year 1 and the final year, and only rely on the terminal value for valuation. The PE is seeking an acceptable price to produce a certain IRR (usually 20%), so this is less value focused. On the other hand, you do consider the cash flows between the present year and terminal period in a DCF, which tends to produce a higher valuation.

What are some industry specific multiples

Internet companies: EV/pageviews, EV / unique visitors E&P companies: P/MCFE/D (price/MCFE/Day), P/MCFE, P/(net asset value) Essentially, in tech and energy, you are looking for proven reserves and utilization (for energy) and traffic (for internet) as value drivers rather than revenue and profit Biotech companies typically aren't profitable so it's usually EV/Revenue

Why would a company be valued at a premium to competitors with similar growth and profitability?

It could be a market leader with strong competitive dynamics and greater market share than competitors It just released earnings and outperformed expectations Has a competitive advantage not reflected in its financials such as a patent

Should you use Equity Value or Enterprise Value with Free Cash Flow?

It depends on the type of Free Cash Flow. If it includes Net Interest Expense, i.e. it is just "Free Cash Flow" or Levered FCF, you use Equity Value. If it does not include the Net Interest Expense, i.e. it is Unlevered FCF, you use Enterprise Value.

A company is currently trading at 10x EV / EBITDA. It wants to sell an Asset for 2x the Asset's EBITDA. Will that sale increase or decrease the company's Enterprise Value?

It depends on what type of Asset it is. Assuming that it is a core-business Asset, then the sale will reduce the company's Enterprise Value because the company is trading away the Asset for Cash, which is a non-core-business Asset. If it's not a core-business Asset, then the company's Enterprise Value won't change. Even though the company's Enterprise Value decreases in the first case, its EV / EBITDA multiple increases because the Asset's multiple was lower than the multiple for the entire company. Pretend that the company's total EBITDA was $100, and this Asset contributed $20 of that EBITDA. The company's Enterprise Value before the sale was, therefore, $1,000. The company now sells the Asset for $40. After the sale, the company's Enterprise Value falls by $40, and its EBITDA falls by $20. So, its new EV / EBITDA is $960 / $80, or 12x. This is why companies often sell under-performing divisions: To boost their valuation multiples and increase their stock prices.

A company trades at a valuation multiple of 13x EV/EBITDA. What does that mean?

It means something only in relation to other companies and their multiples. if other, similar companies in the industry with similar growth profiles are trading at multiples of 10x EV/EBITDA, then this company might be overvalued. But if those other companies are trading at multiples of 16x EV/EBITDA, then perhaps this company is undervalued.

Would you rather buy a company trading at a 15x EV / EBITDA multiple, or one trading at a 10x multiple?

It's completely dependent on what peer companies are trading at and how this company compares. If every company in the sector is trading at multiples of 20-25x, then 15x might be cheap; if other companies are trading at multiples of 6-8x, then 10x might be expensive. When you're buying companies, you always try to find ones that are undervalued so that you can sell the stock for a higher price in the future.

What other methods are there?

Liquidation value: Assuming how much a company's assets can be sold for and then subtracting liabilities to see how much capital is attributable to common shareholders. Replacement value: determining what it would cost to replace a company's assets LBO analysis: Determining how much a PE firm would be willing to pay for a company to hit the target IRR which is generally between 20% and 25% Sum of the parts: valuing each division separately and then adding them together

If a company's cash flow matters most, why do you use metrics like EBIT and EBITDA in valuation multiples rather than CFO or FCF?

Mostly for convenience and comparability. CFO and FCF measure a company's cash flows more accurately, but they also take more time to calculate since you need a full or partial Cash Flow Statement for them. Also, the individual items within CFO and FCF vary a lot between companies, and vastly different figures for Deferred Taxes, Stock-Based Compensation, and the Change in Working Capital make it difficult to create meaningful comparisons.

When you calculate Unlevered FCF starting with EBIT * (1 - Tax Rate), or NOPAT, you're not counting the tax shield from the interest expense. Isn't that incorrect?

No, it's correct. If you're excluding the impact of a company's capital structure, you have to exclude EVERYTHING related to its capital structure. You can't say, "Well, let's exclude interest... but let's still include the tax benefits from that interest." The tax savings from the interest expense do not exist if there is no interest expense. If you counted the tax benefits from the interest expense, you'd have to include the entire interest expense as well, which would turn it into Free Cash Flow rather than Unlevered FCF.

Suppose that you graph the EV / EBITDA multiples for a set of similar companies along with the revenue growth rates, EBITDA margins, and EBITDA growth rates. Which operational metric will MOST LIKELY have the strongest correlation with the EV / EBITDA multiples?

Since a company's value depends on its CF, CF growth rate, and Discount Rate, the EV/EBITDA multiples are most likely to be correlated with the EBITDA growth rates. EBITDA growth is still closer to CF growth than revenue growth is. There might be some correlation between revenue growth rates and EV/EBITDA multiples, but the correlation will be stronger for revenue growth and EV / Revenue multiples.

Two companies have the same amount of Debt, but one company has Convertible Debt, and the other has traditional Debt. Both companies have the same Operating Income, Tax Rate, and Equity Value. Which company will have a higher P / E multiple?

Since the interest rates on Convertible Debt are lower than the rates on traditional Debt, the company with Convertible Debt will have a lower interest expense and therefore a higher Net Income. As a result, its P / E multiple will be lower. So, the company with Convertible Debt will have a lower P / E multiple, and the company with traditional Debt will have a higher P / E multiple. Advanced Note: Technically, you may have to reflect on the Income Statement the "Amortization of the Convertible Bond Discount," which is a number that reflects how the Liability component of a Convertible Bond is worth less than a normal Bond because of the lower interest rate. If you do this, then the Net Incomes of both companies will be much closer, and the P / E multiples may be almost the same.

Two companies with the exact same financial profile were bought by the same acquirer, but the EBITDA multiple for one transaction was twice the other. Why would this happen?

The company bought cheaper may have recently had recent bad news that depressed its stock price They were in industries with different median multiples

What are the advantages and disadvantages of FCF vs. Unlevered FCF vs. Levered FCF?

The main advantage of Unlevered FCF or FCFF is that it's easier to calculate and capital structure-neutral, so a company's cash flow will be the same regardless of its Cash, Debt, and Preferred Stock. Almost always use in DCF analysis to value company. Levered FCF (FCFE) is rare, partially because no one agrees on how to calculate it. if you want to take into account the company's capital structure, and it will be slightly more accurate since it includes (Mandatory) Debt Principal Repayments. FCF takes into account the company's capital structure and is more common for standalone financial statement analysis.

You're valuing a mid-sized manufacturing company, and you're comparing it to peer companies in the same industry. This company's EV / EBITDA multiple is 15x, and the median EV / EBITDA for the comparable companies is 10x. What's the MOST likely explanation?

The most likely explanation is that the market expects the company's cash flows to grow more quickly than those of other companies. For example, other companies might be expected to grow at 5%, but this company might be expected to grow at 10%. The Discount Rate is unlikely to differ by a huge amount because these companies are all about the same size and are in the same industry, which means the risk should be similar. Non-financial factors could also affect the multiple - for example, recent positive news about strategy, product, executives, intellectual property, or competitive performance might also explain why this company trades at a higher multiple than the others.

What are flaws with public companies comparables?

The stock market is dictated by human action which gives it implicit emotional bias. This can cause multiples to reflect non-fundamental adjustments Share price for smaller companies that are thinly traded may not reflect their full value

Rank the three valuation methodologies from highest to lowest in strength

There is no set rank, but I would put precedent transactions analysis over comparable companies analysis due to the control premium that is built into acquisitions reflected in this analysis. DCF is much more variable than other methodologies and tends to produce a higher value than the other two. DCF is not appropriate for companies that have highly variable cash flows that make them unpredictable, or when debt or working capital serve fundamentally different roles. For example, banks don't reinvest debt and working capital is a huge part of their balance sheets.

If EBITDA decreases, how do Unlevered and Levered FCF change?

Think of what EBITDA includes: Only Revenue, COGS, and Operating Expenses. Unlevered FCF and Levered FCF also include all those items, plus more. So, if EBITDA decreases, it means that Revenue has decreased, or that COGS or Operating Expenses have increased. If any of those happens, then both Levered FCF and Unlevered FCF should also decrease since the Operating Income that flows into both of them will also be lower. Technically, the FCF figures might stay the same if the D&A, Working Capital, or CapEx change in such a way that the change offsets the drop in Operating Income. But that's not the main point of the question; it's just an edge case.

When you are looking at industry specific multiples (such as p/scientist, for example), why are you using EV and not equity value?

This is because of the value driver, such as a scientist or a page viewer, is available to all investors, including both debt and equity. EV includes debt holder value whereas equity value only includes shareholder value. This does not apply all the time, however. You have to look at the multiple and really think about who the value driver is attributable to.

When would you use sum of the parts?

This is common in conglomerate companies where the divisions of the holdco are completely different and unrelated, which is the case with General Electric for example. Popular in healthcare valuation

When would you use a liquidation value?

This is most common in bankruptcy scenarios to see if equity shareholders are going to get a piece of the buy once the debts have been paid off.

Would you ever see something like Equity / Revenue?

This would be rare, but might be seen in large financial institutions with large enough cash balances to make their EV negative. However, P/BV and P/E would be more appropriate for financial institutions anyways. The biggest disadvantage of focusing on revenue is that it can lull you into assigning tremendous amounts of value to firms that are generating high revenue growth while actually losing significant amounts of money. Ultimately, a firm has to generate earnings and cash flows for it to have value. The revenue multiple fails in this regard quite miserably.

What do you actually use valuation for?

Usually it is used in pitch books and in client presentations when you are telling a client what they should be expecting for their own valuation. Or, if say a company is looking to acquire a company, you might use it to give them an idea of what they should expect to pay for acquiring another company. It is also used in a Fairness Opinion which occurs right before a deal closes which is supposed to prove the "value" that their client is paying or receiving is financially fair

Could a company's EV / EBITDA multiple ever equal its P / E multiple?

Yes, it's possible because Enterprise Value, EBITDA, Equity Value, and Net Income could be almost any values. For example, if Enterprise Value = $100, EBITDA = $10, Equity Value = $50, and Net Income = $5, then EV / EBITDA = 10x and P / E = 10x as well. In practice, P / E multiples tend to be higher than EV / EBITDA multiples because Net Income is usually smaller than EBITDA by a greater percentage than Equity Value is smaller than Enterprise Value.

Could a valuation multiple such as P / E or EV / EBITDA ever be negative? What would it mean?

Yes, it's possible for any valuation multiple to be negative (except for ones based on Revenue, which could be $0 but couldn't be negative). If a company has a negative Net Income or negative EBITDA, the multiples will turn negative. It means that this particular multiple is not meaningful for valuing the company, so you'll have to use other multiples or methodologies to value it.

Could Levered FCF ever be higher than Unlevered FCF?

Yes. Levered FCF includes Net Interest Expense, so if the company had a negative value for that figure, i.e. it earned more in Interest Income than it spent on Interest Expense, and it also had minimal Debt principal repayments, then Levered FCF might be higher than Unlevered FCF. This scenario is highly unusual, but it is possible.

If a company has both Debt and Preferred Stock, why is it NOT valid to use Net Income rather than Net Income to Common when calculating its P / E multiple?

You can use Equity Value or Enterprise Value in multiples, but you shouldn't create "half-pregnant" multiples that are based on metrics in between Equity Value and Enterprise Value. Also remember that if you do not include an expense in the denominator of a multiple, you have to include the Balance Sheet item corresponding to that expense in the numerator (and vice versa). So, if you use Net Income rather than Net Income to Common in this case, you'll have to use a modified version of Equity Value that adds Preferred Stock, but none of the other items that you typically add when calculating Enterprise Value. This numerator will confuse anyone looking at your analysis, so you should stick with the standard Equity Value calculation and pair it with Net Income to Common.

Two companies have the same P / E multiples but different EV / EBITDA multiples. How can you tell which one has more Debt?

You can't answer this question because the companies could be very different sizes. For example, if they both have P / E multiples of 15x, but one company has Net Income of $10 and one has Net Income of $100, the one with Net Income of $100 is likely to have more Debt - even if its EV / EBITDA multiple is lower. If you assume that both companies have the same Net Income and the same EBITDA, then you can "kind of" answer this question. In that case, the companies have the same Equity Value, so the company with the higher EV / EBITDA multiple must have a higher Enterprise Value. Most likely, that means that it has more Debt. HOWEVER, remember that other items factor into the calculation. Perhaps both companies have the same amount of Debt, but the one with the higher EV / EBITDA multiple has less Cash. Or the company with the higher multiple has a higher Unfunded Pension or Preferred Stock balance.

How do you decide whether to use Equity Value or Enterprise Value when you create valuation multiples?

You have to look at which group of investors this operational metric is available to: All the investor in the company (Equity, Debt, Preferred, and others), or just common Equity investors? If it's all the investors, use Enterprise Value; if it's just equity investors, use Equity Value. One easy rule of thumb is to look at whether the metric includes Net Interest Expense. If it does, it pairs with Equity Value; if it does not, it pairs with Enterprise Value. If you're creating a valuation multiple based on a non-financial metric, such as Unique Users or Subscribers, you almost always use Enterprise Value since those metrics are available to and benefit all the investors in the company.

What IS a valuation multiple?

shorthand for a company's value based on its cash flows, cash flow growth rate, and Discount Rate. Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate) used as a number like "10x" helps you compare houses, or companies, of different sizes and see how expensive or cheap similar houses, or companies, are.