Valuation

Practice

Answer out loud first, then check. Mark each card; the ones to review come back first next time.

1. Walk me through a DCF.

   I project the company's unlevered free cash flow for about five to ten years, driven by revenue growth, margins, capital spending and working capital. I then estimate a terminal value at the end of the projection, by Gordon growth or an exit multiple.

   I discount the yearly cash flows and the terminal value back to today at the WACC. Their sum is enterprise value. To get to equity value I subtract debt, preferred stock and noncontrolling interest and add cash, then divide by diluted shares for a value per share.

   Likely follow-up: Why do we use unlevered rather than levered free cash flow?

2. How do you calculate unlevered free cash flow?

   Start with EBIT, take tax at the company's rate to get net operating profit after tax, add back depreciation and amortisation and other non-cash charges, then subtract capital spending and the increase in net working capital. It is the cash the business generates before any payments to lenders or shareholders, which is why it is discounted at WACC.

   Likely follow-up: Would you add back stock-based compensation?

3. How do you calculate WACC?

   WACC is the cost of equity times the equity share of capital, plus the after-tax cost of debt times the debt share, using market values. The cost of equity comes from CAPM: the risk-free rate plus beta times the equity risk premium. The cost of debt is the yield on the company's debt, multiplied by one minus the tax rate because interest is usually deductible. If there is preferred stock, it gets its own weight and cost.

   Likely follow-up: Where would you get beta for a private company?

4. What are the two ways to calculate terminal value, and which do you prefer?

   Gordon growth: final-year free cash flow × (1 + g) ÷ (WACC − g). With free cash flow of $100, growth of 2% and a WACC of 8%, terminal value is 102 ÷ 0.06 = $1,700. Exit multiple: final-year EBITDA times a multiple drawn from comparables.

   I would run both and check one against the other. Gordon growth is more grounded in the company's own cash flows, but very sensitive to the growth rate; the exit multiple reflects the market but imports today's valuation levels into the future. Bankers tend to lead with the multiple, academics with Gordon growth.

   Likely follow-up: What EV/EBITDA multiple does that $1,700 imply if final-year EBITDA is $170?

5. What is the difference between equity value and enterprise value?

   Equity value is what belongs to shareholders: share price times diluted shares outstanding. Enterprise value is what the operating business is worth to all providers of capital, so it adds debt, preferred stock and noncontrolling interest and subtracts cash.

   A useful way to see it: if you bought the whole company, you would pay the equity value, take on the debt and receive the cash, so the net cost of the business is the enterprise value.

   Likely follow-up: Why is noncontrolling interest added?

6. A company raises $100 of debt and holds it as cash. What happens to equity value and enterprise value?

   Nothing, at least at first. Debt rises by $100 and cash rises by $100, so enterprise value is unchanged, and equity value is unchanged because shareholders have gained no assets net of liabilities. If the cash is then spent on a buyback or an acquisition, equity value or enterprise value changes accordingly.

   Likely follow-up: And if the company uses the $100 to pay a dividend?

7. Why do we use EV/EBITDA but P/E, and not EV/net income?

   The numerator and denominator have to belong to the same investors. EBITDA is earned before interest, so it is available to lenders and shareholders alike and pairs with enterprise value. Net income is after interest, so it belongs only to shareholders and pairs with equity value. Mixing them, for example EV/net income, makes the multiple depend on capital structure.

   Likely follow-up: Which multiple would you use for a company with heavy capital spending?

8. Rank the valuation methods from highest to lowest value.

   There is no fixed order, but precedent transactions usually come out highest, because acquirers pay a control premium and often share expected synergies. Trading comparables reflect minority stakes, so they are usually lower. The DCF can land anywhere: it depends entirely on the assumptions, which is both its strength and its weakness.

   Likely follow-up: When could comparables come out above precedents?

9. Which multiples would you use for a bank, a software start-up and an airline?

   A bank: P/E and price to tangible book value, because debt and deposits are its raw material, so enterprise value is not meaningful. A loss-making software company: EV/revenue, or EV/gross profit, since there are no earnings yet. An airline: EV/EBITDA, or EV/EBITDAR to put companies that lease and own aircraft on the same footing.

   Likely follow-up: How would you value a bank with a cash flow model?

10. How do you calculate diluted shares?

    With the treasury stock method. Assume in-the-money options are exercised and the company uses the exercise proceeds to buy back shares at the current price.

    Example: 100 million basic shares, 10 million options with a $10 strike, share price $20. Exercise brings in $100 million, which buys back 5 million shares, so the net new shares are 5 million and diluted shares are 105 million. Out-of-the-money options are ignored; convertible bonds are added if conversion is worth more than repayment.

    Likely follow-up: What happens to diluted shares if the share price rises to $40?

11. How would you get a beta for a private company?

    Take the observed betas of listed comparables, unlever each to remove the effect of its capital structure, using beta unlevered = beta levered ÷ (1 + (1 − tax rate) × debt/equity), take the median, then relever it at the target's own debt to equity ratio. That relevered beta goes into CAPM for the cost of equity.

    Likely follow-up: Why does more debt raise the cost of equity?

12. Interest rates rise by 1%. What happens to your DCF?

    The risk-free rate rises, so the cost of equity and usually the cost of debt rise, and WACC goes up. Every discounted cash flow is worth less, and the terminal value falls the most because it is furthest away and, under Gordon growth, the gap between WACC and growth narrows. Companies whose value sits mainly in distant cash flows, such as high-growth firms, are hit hardest.

    Likely follow-up: Would an exit multiple terminal value pick this up?

13. Can a company have a negative enterprise value?

    Yes. If its cash exceeds its market capitalisation plus debt, enterprise value is negative. It usually means the market expects the company to burn through its cash, or doubts the cash can reach shareholders. It tends to be rare and short-lived, and a sign to check what the balance sheet is really holding.

    Likely follow-up: Would you use EV/EBITDA for that company?

14. What is the mid-year convention?

    It assumes cash flows arrive evenly through each year rather than all at year end, so each year's cash flow is discounted by half a period less: year one at 0.5 years, year two at 1.5 and so on. It raises the valuation slightly and is closer to how businesses actually earn cash. Practice differs on whether and how to apply it to the terminal value.

    Likely follow-up: Is the effect larger at a high or a low discount rate?