Valuation Techniques

The Income Statement is a record of Revenues and Expenses while the Statement of Cash Flows records the actual cash that has either come in or left the company. The Statement of Cash Flows has the following categories: Operating Cash Flows, Investing Cash Flows, and Financing Cash Flows.

Interestingly, a company can be profitable as shown in the Income Statement, but still go bankrupt if it doesn't have the cash flow to meet interest payments.

2. What is the link between the Balance Sheet and the Income Statement?

The main link between the two statements is that profits generated in the Income Statement get added to shareholder's equity on the Balance Sheet as Retained Earnings. Also, the debt on the Balance Sheet is used to calculate interest expense.

3. What is the link between the Balance Sheet and the Statement of Cash Flows?

The Statement of Cash Flows starts with the cash balance, which comes from Balance Sheet. Also, to figure out Cash from Operations, you use the changes in Balance Sheet accounts (such as Accounts Payable, Accounts Receivable, etc.). The net increase in cash flow for the year goes back to the Balance Sheet of the next year.

4. What is EBITDA?

Also known as "cash flow," EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. ~ 5. Say you knew a company's net income. How would you figure out its "cash flow"?

A basic answer: You start with the company's net income. Then you add back depreciation and amortization. Then you subtract the company's Capital Expenditures (called "CapEx" for short, this is how much money the company must invest each year on plants and equipment). The number you get is the company's cash flow:

Net Income + Depreciation and Amortization - Capital Expenditures = Cash Flow

6. Walk me through the major line items on a Cash Flow statement.

Another question designed to test your accounting skills. The answer: first the Beginning Cash Balance, then Cash from Operations, then Cash from Investing Activities, then Cash from Financing Activities, and finally the Ending Cash Balance.

7. How do you value a company?

This is one of the most popular technical questions of finance interviews. Remember the several ways that we discussed, and good luck. MBAs looking for I-banking or finance in a company positions are sure to get this one.

One basic answer to this question is to discount the company's projected cash flows by a "risk-adjusted discount rate." After projecting the first five or 10 years, you add in a "Terminal Value," which represents the present value of all the future cash flows that are too far into the future to project. You can calculate the Terminal Value in one of two ways: (1) you take the earnings of the last year you projected, say year 10, and multiply it by some market multiple like 20 times earnings, and that's the terminal value; or (2) you take the last year, say year 10, and assume some constant growth rate after that like 10%. The present value of this growing stream of payments after year 10 is the Terminal Value.

For a more advanced answer, discuss the APV and WACC methods of doing a discounted cash flow analysis (DCF analysis).

Finally, you should also mention other methods of valuing a company, including looking at "comparables" - that is, how other similar companies were valued recently as a multiple of their sales, net income, or some other measure.

Note: To figure out what "discount rate" you would use to discount the company's cash flows, tell your interviewer you would use the "Capital Asset Pricing Model" (or "CAPM"). (In a nutshell, CAPM says that the proper discount rate to use is the risk-free interest rate adjusted upwards to reflect this particular company's market risk or "Beta.")

~ 8. The CEO of a $500 million company has called you, her investment banker. She wants to sell the company. She wants to know how much she can expect for the company today.

It might sound different, but this is the same question as No. 7: How do you value a company?

9. What is the formula for the Capital Asset Pricing Model?

The Capital Asset Pricing Model is used to calculate the expected return on your investment. It is a linear model with one independent variable, Beta. Beta for a company is the relative volatility of the given investment with respect to the market, i.e., if Beta is 1, the returns on the investment (stock/bond/portfolio) vary identically with the market. Here "the market" refers to a well diversified index like the Dow Jones Industrials or the S&P 500. The formula for CAPM is as follows:

Here:

r_f = Risk-free rate = the Treasury bond rate for the period for which the projections are being considered
r_m - r_f = Excess market return.
?^L = Leveraged Beta.
r_e^L = Discount rate for (leveraged) equity (calculated using the CAPM)

10. Why might there be multiple valuations for a single company?

As this chapter has discussed, there are several different methods by which one can value a company. And even if you use the rigorously academic DCF analysis, the two main methods (the WACC and APV method) make different assumptions about interest tax shields, which can lead to different valuations. ~ 11. How do you calculate the terminal value of a company?

The value of the terminal year cash flows (usually calculated for 10 years in the future) is calculated by calculating the present value of cash flows from the terminal year (in our case, Year 10) continuing forever with the following formula:

Here "g" is an assumed growth rate and rd is the discount rate. (Remember that you could also calculate the terminal value of a company by taking a multiple of terminal year cash flows, and discounting that back to the present to arrrive at an answer. This alternative method might be used in some instances because it is less dependent on the assumed growth rate (g).

12. Why are the P/E multiples for a company in London different than that of the same company in the States?

The P/E multiples can be different in the two countries even if all other factors are constant because of the difference in the way earnings are recorded two countries. Overall market valuations in American markets could be higher than those in the U.K.

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

The most commonly used multiple is earnings, thus the often-quoted price-to-earnings (P/E) ratio. Other figures that are used include revenues, EBITDA, EBIT, and book value. Which figure is used depends on the industry. For example, Internet companies are often valued with revenue multiples; this explains why companies that lose money every year can have such high market caps. Companies in the metal and mining industry are valued using EBITDA.

As discussed in the section on valuation, not only should we be aware of what financial figure is being used, we should know what time period the figure used represents: it can be for the previous or projected 12 months, for example, or for the previous or projected fiscal year.

14. How do you get the discount rate for an all-equity firm?

You use the Capital Asset Pricing Model, or CAPM.

15. Can I apply CAPM in Latin American markets?

CAPM was developed for use in the U.S. markets. However, it is presently the only tool available. Hence while it is an approximation, it is a good framework for thinking and analyzing the markets outside U.S. as fundamentally, markets are based on similar principles.

16. How much would you pay for a company with $50 million in revenue and $5 million in profit?

If this is all the information we are given we should use comparable transaction or multiples method to value this company (rather than the DCF method). To use the multiples method, you would prepare a common stock comparison, using comparable companies in the same industry, to get average industry multiples. These numbers would depend on the industry the company is in. ~ 17. How do you value a company with NOLs (net operating losses)?

The valuation would be similar as that for a company making profits. We would use the formula to get to the free cash flows. And if the present value of the free cash flows also come out to be negative, the project (or company) is a negative NPV project, and thereby a bad investment. (Typically, the management of a company will be able to show that cash flows become positive before the terminal year!)

18. 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.

19. What is Beta?

Beta is the value that represents the volatility of a stock with respect to overall market volatility.

20. How do you unlever a company's Beta?

Unlevering a company's Beta means calculating the Beta under the assumption that it is an all-equity firm. The formula is as follows:

~ 21. What is going on with the valuations of Internet companies today?

There probably is no right answer for this (although there might be some wrong answers). Here, the interviewer is trying to see how you think and how creative ideas you can come up with.

22. Do you think these valuations are justified?

Internet valuations today are based on what the investors believe is the future market potential of the Internet companies. As you know, the Internet has changed the way people do business in recent years, and revenues from Internet based advertising and e-commerce are expected to explode. Whether the current valuations are justified, however, is a point of contention.

23. Name three companies that are undervalued and tell me why you think they are.

This is a very popular question for equity research and portfolio management jobs. Here you have to do your homework. Study the stocks you like and see make valuations using various methods: DCF, multiples, comparable transactions, etc. Then choose several undervalued (and overvalued) stocks, and be prepared to back up your assessment.

For example, let's say that Coke received some bad PR recently and its stock took a hammering in the market. However, say the earnings of Coke are not expected to decrease significantly because of the negative publicity (or at least that's your analysis). Thus, Coke is trading at relatively lower P/E than Pepsi and others in the industry and is undervalued. This is an example of a line of reasoning you might offer when asked this question (the more thorough and insightful the reasoning, the better). Using some of the techniques discussed earlier and regular readings of the WSJ and other publications will help you formulate real-world examples.

Also, keep in mind that there are no absolute right answers for a question like this: If everyone in the market believed that a stock was undervalued, the price would go up and it wouldn't be undervalued anymore! What the interviewer is looking for is your chain of thought, your ability to communicate that convincingly and your preparation for the interview.

24. Walk me through the major items of an Income Statement

Revenues, expenses, and net income.

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

As discussed, different industries use different multiples. If you claim interest in a certain industry, you better know how companies in the industry are commonly valued. (Don't answer the first question without knowing the answer to the second!)