Investment Banking Interview Questions

Walk me through a DCF.

"A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate - usually the Weighted Average Cost of Capital. Once you have the present value of the Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC. Finally, you add the two together to determine the company's Enterprise Value."

Walk me through a basic merger model.

"A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer's EPS increases or decreases. Step 1 is making assumptions about the acquisition - the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one. Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer's Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS."

Can you name two companies that you think should merge?

...

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive. On an intuitive level if you're paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you're paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contrast, is always a shot in the dark. However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price. However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I've personally never seen it, but once again "never say never" applies.

Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Possible reasons: 1. One process was more competitive and had a lot more companies bidding on the target. 2. One company had recent bad news or a depressed stock price so it was acquired at a discount. 3. They were in industries with different median multiples.

Rank the 3 valuation methodologies from highest to lowest expected value.

Precedent transactions methodology is likely to give a higher valuation than Comparable Companies methodology. This is because when companies are purchased, the target's shareholders are typically paid a price that is higher than the target's current stock price (a control premium). Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium, resulting in a higher valuation than a public market valuation (minority interest based valuation). DCF will also likely result in a higher valuation than Company comparables analysis because DCF is a control based methodology and because most projections tend to be pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but it is fair to say that DCF valuations tend to be more variable bc DCF is sensitive to a multitude of inputs or assumptions.

Walk me through what flows into Retained Earnings.

Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued If you're calculating Retained Earnings for the current year, take last year's Retained Earnings number, add this year's Net Income, and subtract however much the company paid out in dividends.

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Several possibilities: 1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company. Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges - and all of these could end up bankrupting the company.

Why would a company want to acquire another company?

Several possible reasons: 1. The buyer wants to gain market share by buying a competitor. 2. The buyer needs to grow more quickly and sees an acquisition as a way to do that. 3. The buyer believes the seller is undervalued. 4. The buyer wants to acquire the seller's customers so it can up-sell and cross-sell to them. 5. The buyer thinks the seller has a critical technology, intellectual property or some other "secret sauce" it can use to significantly enhance its business. 6. The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case?

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital. Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You should confirm that this is what the interviewer is asking for.

Which industries are you interested in? What are the multiples that you use for those industries?

Tech Investment banking - Most common multiples for early growth/startups would be EV/Revenue Some unique measurements such as: EV/Unique Visitors EV/Subscribers - Software EV/Registered Users

Would an LBO or DCF give a higher valuation?

Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you're only valuing it based on its terminal value. With a DCF, by contrast, you're taking into account both the company's cash flows in between and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Why do you use 5 or 10 years for DCF projections?

That's usually about as far as you can reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10 years is too difficult to predict for most companies.

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

The "official" reason: Cash is subtracted because it's considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer would "get" the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you'd really have to "pay" to acquire another company. It's not always accurate because technically you should be subtracting only excess cash - the amount of cash a company has above the minimum cash it requires to operate.

How do you know if your DCF is too dependent on future assumptions?

The "standard" answer: if significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. In reality, almost all DCFs are "too dependent on future assumptions" - it's actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value. But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions...

How do you select Comparable Companies / Precedent Transactions?

The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry - that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

What is an accretive merger?

The type of merger in which the acquiring company's earnings per share increase. With regard to P/E ratio, this happens when a company with a higher P/E ratio acquires a company with a lower P/E ratio. The acquiring company's earnings per share should rise following the merger.

When would you use Sum of the Parts?

This is most often used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?" He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a big disparity. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx - that's the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

How do you value a private company?

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences: 1. You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you're valuing is not as "liquid" as the public comps. 2. You can't use a premiums analysis or future share price analysis because a private company doesn't have a share price. 3. Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies. 4. A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would probably just estimate WACC based on the public comps' WACC rather than trying to calculate it.

Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a "far in the future DCF" because you can't reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can't predict cash flow, use other metrics - don't try to predict cash flow anyway!

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use the Cost of Equity rather than WACC since we're not concerned with Debt or Preferred Stock in this case - we're calculating Equity Value, not Enterprise Value.

Walk me through the major items in Shareholders' Equity.

1. Common Stock - Simply the par value of however much stock the company has issued. 2. Retained Earnings - How much of the company's Net Income it has "saved up" over time. 3. Additional Paid in Capital - This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering. 4. Treasury Stock - The dollar amount of shares that the company has bought back. 5. Accumulated Other Comprehensive Income - This is a "catch-all" that includes other items that don't fit anywhere else, like the effect of foreign currency exchange rates changing.

What are the four most commonly used valuation techniques?

1. Discounted cash flow (DCF) analysis 2. Multiples method 3. precedent 4. LBO

What are the complete effects of an acquisition?

1. Foregone Interest on Cash - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition. 2. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt. 3. Additional Shares Outstanding - If the buyer pays with stock, it must issue additional shares. 4. Combined Financial Statements - After the acquisition, the seller's financials are added to the buyer's. 5. Creation of Goodwill & Other Intangibles - These Balance Sheet items that represent a "premium" paid to a company's "fair value" also get created.

What are the three major financial statements?

1. Income Statement 2. Balance Sheet 3. Cash Flow Statement

How do you take into account a company's competitive advantage in a valuation?

1. Look at the 75th percentile or higher for the multiples rather than the Medians. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. In practice you rarely do all of the above - these are just possibilities.

What are the flaws with public company comparables?

1. No company is 100% comparable to another company. 2. The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates depending on the market's movements. 3. Share prices for small companies with thinly-traded stocks may not reflect their full value.

What are some flaws with precedent transactions?

1. Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all have huge effects. 2. Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.

Walk me through your resume.

•I grew up in Los Angeles and had a Economics teacher that helped quite a bit and paved my way into the world of business. • Decided to attend San Jose State University because of the proximity to silicon valley - mainly interested in tech and business. I felt there was no better option given my financial situation and interests. •I learned more about investment banking the summer of 2016 when Microsoft acquired LinkedIn. My interest in tech led me to do some more research and then I basically discovered investment banking as a result of this acquisition. •After that I began to take some small steps to start a career in investment banking started at a lower mm/business brokerage shop in San Jose then a Search Fund internship that focused on Tech Enabled Servies, Software Services and B2B. • After my time at both of those internships and speaking with analysts at both BB and MM I have arrived here at [Company Name].

Give me an example of a time you worked as part of a team.

•SBDC Logistics Chair •In charge of securing funding from our student involvement and associated Students •Original Budget of $2k secured ~3k worth of funding. •Projected our estimated revenue and expenses, revenue generators included shirt sales, ticket sales. Expenses included media boosts, fliers, venue fee. •Successfully raised about $10k to give directly to Culture Shock Oakland

All else being equal, which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why? 1. Cash is "cheaper" than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt. 2. Cash is also less "risky" than debt because there's no chance the buyer might fail to raise sufficient funds from investors. 3. It's hard to compare the "cost" directly to stock, but in general stock is the most "expensive" way to finance a transaction - remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here. 4. Cash is also less risky than stock because the buyer's share price could change dramatically once the acquisition is announced.

What are synergies, and can you provide a few examples?

Basically, the buyer gets more value than out of an acquisition than what the financials would predict. There are 2 types: revenue synergies and cost (or expense) synergies. 1. Revenue Synergies: The combined company can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies as a result of the deal. 2. Cost Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

Company A is considering acquiring Company B. Company A's P/E ratio is 55 times earnings, whereas Company B's P/E ratio is 30 times earnings. After Company A acquires Company B, will Company A's earnings per share rise, fall, or stay the same?

Company A's earnings per share will rise, because of the following rule: When a higher P/E company buys a lower P/E company, the acquirer's earnings-per-share will rise. The deal is said to be accretive, as opposed to dilutive, to the acquirer's earnings.

Why do we look at both Enterprise Value and Equity Value?

Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value, because that's how much an acquirer really "pays" and includes the often mandatory debt repayment.

What's the difference between Equity Value and Shareholders' Equity?

Equity Value is the market value and Shareholders' Equity is the book value. Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders' Equity could be any value. For healthy companies, Equity Value usually far exceeds Shareholders' Equity.

What types of sensitivity analyses would we look at in a DCF?

Example sensitivities: 1. Revenue Growth vs. Terminal Multiple 2. EBITDA Margin vs. Terminal Multiple 3. Terminal Multiple vs. Discount Rate 4. Long-Term Growth Rate vs. Discount Rate And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).

How would you value a company with no revenue?

First you would make reasonable assumptions about the company's projected revenues (and projected cash flows) for future years. Then you would calculate the Net Present Value of these cash flows.

When should a company issue debt instead of issuing equity?

First, a company needs a steady cash flow before it can consider issuing debt (otherwise, it can quickly fall behind interest payments and eventually see its assets seized). Once a company can issue debt, it should almost always prefer issuing debt to issuing equity. Also, interest payments on bonds are tax deductible. A company may also wish to issue debt if it has taxable income and can benefit from tax shields. Finally, issuing debt sends a quieter message to the market regarding a company's cash situation.

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

Walk me through a Sum-of-the-Parts analysis.

In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division's value to get the total for the company. Example: We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA and a consumer goods division with $75 million EBITDA. We've selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods. Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company's total value.

Walk me through an IPO valuation for a company that's about to go public.

1. Unlike normal valuations, in an IPO valuation we only care about public company comparables. 2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company's Enterprise Value based on that. 3. Once we have the Enterprise Value, we work backward to get to Equity Value and also subtract the IPO proceeds because this is "new" cash. 4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say "An IPO priced at..." this is what they're referring to. If you were using P / E or any other "Equity Value-based multiple" for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.

What other Valuation methodologies are there?

3. LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range 4. Sum of the Parts - Valuing each division of a company separately and adding them together at the end

What is a leveraged buyout? How is it different than a merger?

A leveraged buyout occurs when a group, by refinancing a company with debt, is able to increase the valuation of the company. LBOs are typically accomplished by either financial groups such as KKR or company management, whereas M&A deals are led by companies in the industry.

What is a dilutive merger?

A merger in which the acquiring company's earnings per share decreases as a result of the merger. Also remember the P/E rule: A dilutive merger happens when a company with a lower P/E ratio acquires a company with a higher P/E ratio.

Whats is EBITDA?

A proxy for cash flow

What kind of stocks would you issue for a startup?

A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock).

Why do you want to work for [bank]?

After speaking with [banker 1], [banker 2] and [banker 3], I was drawn to the people on the teams at [bank], and the culture. Something that also stood out to me is how much [bank] invests in their people. Especially after finding out that a many of senior bankers have started at the analyst level, it really makes me believe I'm joining a culture of people who are vested in their junior bankers. It's really my goal to learn and contribute as much as I can, and I think [bank] is the perfect place for me to do that.

If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Why would an acquisition be dilutive?

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer's foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares. Acquisition effects - such as amortization of intangibles - can also make an acquisition dilutive.

Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part available to equity investors.

What's the formula for Enterprise Value?

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest - Cash This formula does not tell the whole story and can get more complex - see the Advanced Questions. Most of the time you can get away with stating this formula in an interview, though. "Noncontrolling Interest" was formerly known as Minority Interest and some bankers still call it that.

What is the difference between Goodwill and Other Intangible Assets?

Goodwill typically stays the same over many years and is not amortized. It changes only if there's goodwill impairment (or another acquisition). Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line. There's also a difference in terms of what they each represent, but bankers rarely go into that level of detail - accountants and valuation specialists worry about assigning each one to specific items.

Why should we hire you?

I believe you should hire me because of my determination to break into IB. Sitting in front of you here today alone shows my drive to work in banking. My university and GPA aren't the best so I had to work much harder than the average interviewee to secure this interview and likely have had more technical interviews to prove my competency.

Why do you want to do investment banking?

I want the opportunity to challenge myself, have a more holistic understanding of business, and still help a client. In no other field out of an MBA can you get a more meaningful corporate experience, and I feel like I would be selling myself short because with banking I will be able to surround myself with the sharpest people.

Walk me through how Depreciation going up by $10 would affect the statements.

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.

What do investment bankers do?

Investment bankers help companies raise capital or advise them on a transactions like mergers or acquisitions.

Where does Depreciation usually show up on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?

It might be saving its cash for something else or it might be concerned about running low if business takes a turn for the worst; its stock may also be trading at an all-time high and it might be eager to use that instead (in finance terms this would be "more expensive" but a lot of executives value having a safety cushion in the form of a large cash balance).

Which method of calculating Terminal Value will give you a higher valuation?

It's hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

Why do most mergers and acquisitions fail?

Like so many things, M&A is "easier said than done." In practice it's very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division. Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties' best interests in mind is likely to fail.

How Do the three financial statements link?

Net income from the IS flows into Equity on the BS and into the top line of the CFS Changes to BS items appear as working capital changes on the CFS Investing and financing activities affect BS items such as PP&E, DEbt, and shareholders equity. Cash and shareholders equity items on the balance sheet act as plugs, with cash flowing in from the final line on the CFS

What happens when Inventory goes up by $10, assuming you pay for it with cash?

No changes to the Income Statement. On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Comparable Companies and pick the median of the set, or something close to it. As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

What do you usually use for the discount rate?

Normally you use WACC (Weighted Average Cost of Capital), though you might also use Cost of Equity depending on how you've set up the DCF.

What's an appropriate growth rate to use when calculating the Terminal Value?

Normally you use the country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. For companies in mature economies, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

When do you use an LBO Analysis as part of your Valuation?

Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a "floor" on a possible Valuation for the company you're looking at.

Can you use private companies as part of your valuation?

Only in the context of precedent transactions - it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Walk me through a Cash Flow Statement

Operating Activities - Includes the cash effects of transactions involved in calculating net income. Investing activities - Cash from non-operating activities or activities outside the normal scope of business. This involves items classified as assets in the Balance Sheet and includes the purchase and sale of equipment and investments. Financing Activities - Involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as issuing payment of debt or equity. Net income, Cash from Operations, then Cash from Investing Activities, then Cash from Financing Activities, and finally the Ending Cash Balance.

Your client is a privately held human resources software company. You are advising the company in the potential sale of the company. Who would you expect to pay more for the company: Oracle Software (a competitor), or Kohlberg Kravis Roberts (an LBO fund)?

Oracle. A strategic buyer like Oracle would typically pay more than a financial buyer like KKR. Oracle would be able to derive additional benefits and therefore higher cash flows from the purchase than would KKR. For example, Oracle would be able to cut support and administrative staff, combine the company's R&D budget with Oracle's, get lower costs on supplies and manufacturing in larger volumes, etc.

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability. What's the difference between them, and when do you use each one?

P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it - you're more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).

How do you calculate WACC?

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred). In all cases, the percentages refer to how much of the company's capital structure is taken up by each component. For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM - see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

What's the flaw with basing terminal multiples on what public company comparables are trading at?

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range. This method is particularly problematic with cyclical industries (e.g. semiconductors).

What role does a merger model play in deal negotiations?

The model is used as a sanity check and is used to test various assumptions. A company would never decide to do a deal based on the output of a model. It might say, "Ok, the model tells us this deal could work and be moderately accretive - it's worth exploring more." It would never say, "Aha! This model predicts 21% accretion - we should definitely acquire them now!"

What are the most common multiples used in Valuation?

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

What are the different multiples that can be used to value a company?

The most commonly used multiple is EV/Ebitda and price-to-earnings multiple, or "P/E ratio." The relevant multiple depends on the industry. For example, Internet companies are often valued with revenue multiples; this explains why companies with low profits can have such high market caps. Companies in the metals and mining industry are valued using EBITDA.

Let's say a company overpays for another company - what typically happens afterwards and can you give any recent examples?

There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the company decides it overpaid. A recent example is the eBay / Skype deal, in which eBay paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and eBay later ended up writing down much of the value and taking a large quarterly loss as a result.

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

There's no "rule" that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it's doing well.

Let's say we're valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

There's no discount because with precedent transactions, you're acquiring the entire company - and once it's acquired, the shares immediately become illiquid. But shares - the ability to buy individual "pieces" of a company rather than the whole thing - can be either liquid (if it's public) or illiquid (if it's private). Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Why do Goodwill & Other Intangibles get created in an acquisition?

These represent the value over the "fair market value" of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price. More specifically, Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property - valuable, but not true financial Assets that show up on the Balance Sheet.

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

This could happen for a number of reasons: 1. The company has just reported earnings well-above expectations and its stock price has risen recently. 2. It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. 3. It has just won a favorable ruling in a major lawsuit. 4. It is the market leader in an industry and has greater market share than its competitors.

How do you calculate WACC for a private company?

This is problematic because private companies don't have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

How far back and forward do we usually go for public company comparable and precedent transaction multiples?

Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years. You're more likely to look backward more than 1 year and go forward more than 2 years for public company comparables; for precedent transactions it's odd to go forward more than 1 year because your information is more limited.

How would you present these Valuation methodologies to a company or its investors?

Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.

What do you actually use a valuation for?

Usually you use it in pitch books and in client presentations when you're providing updates and telling them what they should expect for their own valuation. It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that "proves" the value their client is paying or receiving is "fair" from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Why do you need to add the Noncontrolling Interest to Enterprise Value?

Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial performance. In keeping with the "apples-to-apples" theme, you must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Are there any problems with the Enterprise Value formula you just gave me?

Yes - it's too simple. There are lots of other things you need to add into the formula with real companies: 1. Net Operating Losses - Should be valued and arguably added in, similar to cash. 2. Long-Term Investments - These should be counted, similar to cash. 3. Equity Investments - Any investments in other companies should also be added in, similar to cash (though they might be discounted). 4. Capital Leases - Like debt, these have interest payments - so they should be added in like debt. 5. (Some) Operating Leases - Sometimes you need to convert operating leases to capital leases and add them as well. 6. Unfunded Pension Obligations - Sometimes these are counted as debt as well. So a more "correct" formula would be Enterprise Value = Equity Value - Cash + Debt + Preferred Stock + Noncontrolling Interest - NOLs - LT and Equity Investments + Capital Leases + Unfunded Pension Obligations... In interviews, usually you can get away with saying "Enterprise Value = Equity Value - Cash + Debt + Preferred Stock + Noncontrolling Interest" I mention this here because in more advanced interviews you might get questions on this topic.

How do you calculate the Terminal Value?

You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity. The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).

When would you not use a DCF in a Valuation?

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or biotech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not reinvest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies.

When you're looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?

You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both debt and equity) in a company. The same logic doesn't apply to everything, though - you need to think through the multiple and see which investors the particular metric is "available" to.

How do you determine the Purchase Price for the target company in an acquisition?

You use the same Valuation methodologies we already discussed. If the seller is a public company, you would pay more attention to the premium paid over the current share price to make sure it's "sufficient" (generally in the 15-30% range) to win shareholder approval. For private sellers, more weight is placed on the traditional methodologies.