Investment banking valuation interview questions are typically not hard you need to have a better-than-average understanding of Valuation. Here we've divided these questions into basic, application and advanced questions on valuation.
Q1- What's the main difference between an income statement and a cash flow statement?
Suggested Answer: The sales and expenses incurred by a company are recorded on their income statement. When a company's cash flows are recorded, it shows how much cash is actually being used and where it is being spent by the company over a given period of time. Some additional items that could be included on the cash flow statement include the issuance or repurchase of debt or equity, capital expenditures, and other investments, among others.
Amortization and depreciation will be reflected on the balance sheet, but they will be added back to net income on the cash flow statement because they are expenses rather than a use of cash in the first place.
Q2- What are the link between the balance sheet and the cash flow statement?
Suggested Answer: The beginning cash on the statement of cash flows is derived from the balance sheet of the previous accounting period. The change in net working capital, which is equal to current assets minus current liabilities, has an impact on the cash from operations amount. Depreciation comes from property, plant, and equipment, which effects cash from operations. Property, plant, and equipment changes resulting from the purchase or sale of specific assets will have an impact on cash flow from investing. To sum it up, the ending cash balance on the cash flow statement equals the beginning cash balance on the new balance sheet.
Q3- How do you choose between the different valuation methodologies?
Suggested Answer: Because each method has a distinct ability to provide useful information, you should not limit yourself to just one method. The most effective method of determining the value of a company is to employ a variety of valuation techniques in tandem. In the case of a precedent transaction valuation that you believe to be extremely accurate, you may decide to give that result greater weight. Alternatively, if you are extremely confident in the outcome of your DCF analysis, you will place greater emphasis on it. The process of determining the worth of a company is both an art and a science.
Q4- What is the Capital Assets Pricing Model, and how does it work?
Suggested Answer: The capital asset pricing model (CAPM) is a simplified representation of how financial markets price securities and, as a result, determine expected returns on capital investments. The model provides a method for quantifying risk and converting it into estimates of expected return on equity.
Q5- Which two of the three primary financial statements would you choose if you had to choose just two, and why?
Suggested Answer: In order to recreate the cash flow statement, I would require a copy of the income statement as well as the beginning and ending balance sheets. - The cash flow statement begins with net income and adjusts for non-cash operating expenses, primarily D&A, which are derived from the income statement.
After that, it subtracts the change in working capital, which is taken from each balance sheet. If you take the year over year change in PP&E from the Balance Sheet and add Depreciation Expense to that, you get CAPEX. If you take away any cash inflows from the sale of capital assets, you get CAPEX-free cash. Repayments of debt on the Cash Flow from Financing section of the Cash Flow Statement can be inferred from changes in short-term and long-term debt balances over time, while also adjusting for any debt capital raised. - Repurchases of equity on the Balance Sheet, dividends paid to equity investors, and equity capital raised on the Balance Sheet would all be reflected on the Balance Sheet as well.
Q6- What would you offer for a company with $50 million in revenue and a profit of $5 million?
Suggested Answer: Because you have no information about the company's historical or projected performance, as well as no information about the company's capital structure, it would be impossible to perform a DCF analysis on the company. You could identify a group of comparable companies and conduct a multiples analysis using the ratios from those that are most relevant to the company being valued, assuming you are familiar with the industry in which the firm operates.
Q7- What is the aim of Free Cash Flow in the first place? What are you trying to achieve?
Suggested Answer: You can calculate free cash flow by looking at how much money a company has left over after it pays its operating expenses and keeps its capital expenditures up to date; in other words, how much money a company has left over after it pays the costs of running its business.
Q8- Why do you choose 5 or 10 years for DCF projections in the "near future"?
Suggested Answer: That's about as far ahead as you can reasonably predict for the vast majority of businesses. For most businesses, less than 5 years would be too short to be useful, and more than 10 years would be too difficult to project.
Q9 - Is there a valid reason why DCF we might project ten years or more at times?
Suggested Answer: If your industry is one that cycles, such as chemicals, you might consider doing this occasionally because it may be necessary to show the entire cycle from low to high.
Q10 - For the Discount Rate, what do you generally use?
Suggested Answer: The WACC (Weighted Average Cost of Capital) is used in an unlevered DCF analysis, and it represents the "Cost" of all three types of capital: equity, debt, and preferred stock. In a Levered DCF analysis, the cost of equity is used instead of the cost of debt.
Q11 - If FCF is negative, what happens to the DCF? Is it possible that EBIT will be negative?
Suggested Answer: Nothing "happens" because you can continue to run the analysis in the background. If one or both of these become negative, the Company's value will almost certainly decrease as a result of the reduction in the present value of Free Cash Flow that will result.
Even if free Cash Flow is negative, the analysis is not necessarily invalid - if it becomes positive after a certain point, the analysis may still be valid.
If your company never achieves positive cash flow, you may want to forego the DCF calculation.
Q12 - What happens if your DCF uses Levered FCF instead of Unlevered FCF?
Suggested Answer: Because the cash flow is only available to equity investors, leveraged free cash flow provides you with Equity Value rather than Enterprise Value.
Q13 - What should you use as a Discount Rate if you're using Levered FCF?
Suggested Answer: Due to the fact that we are ignoring debt and preferred stock, and are only concerned with the equity value for Levered FCF, you would use Cost of Equity rather than WACC.
Q14 - What is the formula for calculating WACC?
Suggested Answer: WACC = Cost of Equity (% Equity) + Cost of Debt (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred)
In all cases, the percentages refer to the percentage of the company's capital structure that each component contributes to the total.
It is possible to use the Capital Asset Pricing Model (CAPM - see the next question) to estimate the cost of equity, whereas for the other variables, you typically look at comparable companies and comparable debt issuances, along with the interest rates and yields issued by similar companies, to obtain estimations.
Q15 - What is the formula for calculating the cost of equity?
Suggested Answer: Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
Equivalent "safe" government bonds in your home country should yield a yield similar to that of a 10-year or 20-year US Treasury bond. Beta is calculated based on the "riskiness" of Comparable Companies, and the Equity Risk Premium is the percentage by which stocks are expected to outperform "risk-free" assets such as US Treasury bonds.
Normally, you would obtain the Equity Risk Premium from a publication known as Ibbotson's Journal.
Take note that, depending on your bank and group, you may also want to include a "size premium" and a "industry premium" to account for the additional risk and expected returns associated with either of those.
As a result of expectations that small-cap stocks will outperform large-cap stocks in the future, as well as expectations that certain industries will outperform others, these premiums reflect those expectations.
Q16 - What about dividends? The cost of equity informs us how much an equity investor may anticipate to make on a given investment, but what about dividends? Isn't it true that dividend yield should be factored into the equation?
Suggested Answer: As a result, dividend yields are already factored into Beta, which describes returns that are greater than those of the market as a whole - and those returns include dividends.
Q17 - Do you still multiply the Cost of Debt in the WACC Formula by (1-Tax Rate) if a company is losing money? If they're not paying taxes, how will they have a tax ?
Suggested Answer: Although this is a valid point, in practice you will still multiply by (1 - Tax Rate) in order to achieve the desired result. Instead of focusing on whether or not the Debt is currently lowering the company's tax burden, it is more important to consider whether or not there is a possibility that this will happen in the future.
Q18 - How can you figure out what a company's optimal capital structure is? What does it mean?
Suggested Answer: The "optimal capital structure" is the combination of debt, equity, and preferred stock that reduces the company's weighted average cost of capital (WACC). There is no real formula for determining this because you'll always find that Debt should account for 100 percent of a company's capital structure because it's always cheaper than Equity and Preferred Stock... but that can't happen because all companies require a certain amount of Equity as well as Debt. More than that, adding more Debt has a knock-on effect on both equity and preferred, resulting in an equation with no solution that is multivariable in nature. By experimenting with a few different scenarios and observing how WACC changes, you might be able to approximate the optimal structure - but there is no mathematical solution to this problem.
Q19 - Take a look at how businesses performed during the financial crisis. Is there an increase or decrease in WACC?
Suggested Answer: Consider the individual components of WACC: the cost of equity, the cost of debt, the cost of preferred, and the percentages associated with each of these components. After that, consider the individual components of the Cost of Equity: the Risk-Free Rate, the Equity Risk Premium, and the Beta factor. In order to stimulate spending, governments around the world will lower interest rates. However, the equity risk premium will rise significantly as investors demand higher returns before investing in stocks. Because of all of the volatility, the beta would also rise.
As a result, we can anticipate that the Cost of Equity will rise, as the latter two increases will more than offset the decline in the Risk-Free Rate, as previously stated. What this means for the WACC is that:
The cost of debt and the cost of preferred stock would both rise as it becomes more difficult for businesses to borrow money.
The debt-to-equity ratio would almost certainly rise as a result of falling stock prices, resulting in a decrease in equity value for the majority of companies while debt remained unchanged...
As a result, debt and preferred stock would likely account for a greater proportion of a company's capital structure on a proportional basis. But keep in mind that the Cost of Debt and the Cost of Preferred both rise, so the shift isn't that significant.
As a result, the WACC is almost certain to increase because almost all of these variables are pushing it upward - the only variable that is pushing it downward is the reduced Risk-Free Rate. In addition, there is a more straightforward way to think about it: given all other factors being equal, did companies become more or less valuable during the financial crisis? Because the market discounted their future cash flows at higher rates, they were deemed less valuable. As a result, the WACC must have increased.
Q20 - What is the formula for calculating the Terminal Value?
Suggested Answer: Optionally, you can apply an exit multiple to the company's Year 5 earnings (EBITDA, EBIT, or free cash flow) (Multiples Method), or you can use the Gordon Growth method to estimate the value of the company based on its growth rate into perpetuity (Gordon Growth Method). The following is the formula for Terminal Value calculated using the Gordon Growth method: Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate). It's important to note that, regardless of which method you use, you're estimating the same thing: the present value of the company's Free Cash Flows from the final year into infinity, as of the final year.
Q21- Why would you calculate the terminal value using the GGM rather than the Multiples Method?
Suggested Answer: In banking, the Multiples Method is almost always used to calculate the Terminal Value in a DCF. This is because it is more accurate. Because they are based on comparable companies, it is easier to obtain appropriate data for exit multiples; however, determining a long-term growth rate requires more guesswork. However, if you do not have any good Comparable Companies or if you believe that multiples will change significantly in the industry several years down the road, you may want to consider Gordon Growth as an option. Example: If an industry is cyclical (such as chemicals or semiconductors), you might be better off using long-term growth rates rather than exit multiples when analyzing the industry.
Q22 - When computing Beta and the Discount Rate, shouldn't you use a company's desired capital structure rather than its present capital structure?
Suggested Answer: In principle, yes. If you know that a company's capital structure will undoubtedly change in a specific, predictable way in the future, by all means, use that information. In practise, you almost never know this information ahead of time, so making this kind of assumption isn't very practical.
Q23 - Do you think free cash flow a measure of profitability?
Suggested Answer: While earnings or net income are measures of profitability, free cash flow is a measure of profitability that excludes non-cash expenses from the income statement while including spending on equipment and assets from the balance sheet, along with changes in working capital.
Q24 - What does the Gordon Growth Model indicate?
Suggested Answer: The Gordon growth model is based on the assumption that a stock's dividend will grow at a constant rate in perpetuity. In the absence of any other factors, the market value of a stock will rise in proportion to the investor's required rate of return.
Q25 - What's the difference between a levered and an unlevered fcf?
Suggested Answer: Expenses account for the difference between leveraged and unlevered free cash flow. Levered cash flow refers to the amount of money a company has left over after it has met its financial commitments. Unlevered free cash flow refers to the amount of money a company has left over after paying all of its financial obligations.
Q26 - What are the most commonly used multiples?
Suggested Answer: Price to Earnings Enterprise Value / EBITDA Return on Equity Return on Assets Price to Book Value
Q27 - Tell me the difference between PE ,EV/EBIT and EV/EBITDA?
Suggested Answer: P/E is affected by the company's capital structure, whereas EV/EBIT and EV/EBITDA are not affected by the company's capital structure. In industries where interest payments and expenses are critical, this is a useful tool (ex: banks)
You're more likely to use EV/EBIT in industries where D&A is significant and capital expenditures are significant, as opposed to just about any other ratio (ex: manufacturing)
EV/EBITDA excludes depreciation and amortisation and is used in industries where fixed assets are less important and depreciation and amortisation is comparatively smaller (ex: internet companies)
Q28 - For a revenue multiple, what is the appropriate numerator?
Suggested Answer: Because revenue is an unlevered (or pre-debt) measure of profitability, Enterprise Value can be calculated.
Q29 - When should you use a revenue multiple instead of EBITDA to value a company? What happens when a company's EBITDA is negative?
Suggested Answer: In order to avoid companies with negative profits and EBITDA from having meaningless EBITDA multiples, we should use Revenue multiples instead.
Q30 - Explain what WACC stands for and how you'd go about calculating each component.
Suggested Answer: WACC is an abbreviation for "Weighted Average Cost of Capital," and it is the most commonly used Discount Rate when determining the value of a company.
The formula for calculating it is as follows: multiply the percent Equity in a company's capital structure by the "Cost" of that Equity, multiply the percent Debt in a company's capital structure by the "Cost" of that Debt, and add the results together (and factor in any other sources of capital).