1. How do you value a company?

This question, or variations of it, should be answered by talking about 2 primary valuation methodologies:

1. Intrinsic value (discounted cash flow valuation)

2. Relative valuation (comparables/multiples valuation)
 Intrinsic value (DCF) - This approach is the more academically respected approach. The DCF
says that the value of a productive asset equals the present value of its cash flows. The answer should run
along the line of “project free cash flows for 5-20 years, depending on the availability and reliability of
information, and then calculate a terminal value.  Discount both the free cash flow projections and terminal
value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of
equity for levered DCF).  In an unlevered DCF (the more common approach) this will yield the company’s
enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at
equity value.  Divide equity value by diluted shares outstanding to arrive at equity value per share.
 Relative valuation (Multiples) - The second approach involves determining a comparable peer
group – companies that are in the same industry with similar operational, growth, risk, and return on capital
characteristics.  Truly identical companies of course do not exist, but you should attempt to find as close to
comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these
multiples on the relevant operating metric of the target company to arrive at a valuation.  Common multiples
are EV/Rev, EV/EBITDA, P/E, P/Book, although some industries place more emphasis on some multiples
vs. others, while other industries use different valuation multiples altogether.  It is not a bad idea to
research an industry or two (the easiest way is to read an industry report by a sell-side analyst) before the
interview to anticipate a follow-up question like “tell me about a particular industry you are interested in and
the valuation multiples commonly used.”  
2. What is the appropriate discount rate to use in an unlevered DCF analysis?

 Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think
about this is to think of unlevered cash flows as the company’s cash flows as if it had no debt – so no
interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both
the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of
capital to all providers of capital (both debt and equity).
 The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while
the cost of equity is more difficult to estimate. 
 Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the
expected return of equity to its sensitivity to the overall market (see WSP’s DCF module for a detailed
analysis of calculating the cost of equity). 

3. What is typically higher – the cost of debt or the cost of equity?

 The cost of equity is higher than the cost of debt because the cost associated with borrowing debt
(interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher
because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at
liquidation.   

4. How do you calculate the cost of equity?

There are several competing models for estimating the cost of equity, however, the capital asset pricing
model (CAPM) is predominantly used on the street.  The CAPM links the expected return of a security to its
sensitivity the overall market basket (often proxied using the S&P 500).  The formula is:

Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf )
 Risk free rate: The risk free rate should theoretically reflect yield to maturity of a default-free
government bonds of equivalent maturity to the duration of each cash flows being discounted. In practice,
lack of liquidity in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the
preferred proxy for the risk-free rate for US companies.
 Market risk premium: The market risk premium (rm-rf) represents the excess returns of investing
in stocks over the risk free rate. Practitioners often use the historical excess returns method, and compare
historical spreads between S&P 500 returns and the yield on 10 year treasury bonds.
 Beta (β): Beta provides a method to estimate the degree of an asset’s systematic (non-
diversifiable) risk. Beta equals the covariance between expected returns on the asset and on the stock
market, divided by the variance of expected returns on the stock market. A company whose equity has a
beta of 1.0 is “as risky” as the overall stock market and should therefore be expected to provide returns to
investors that rise and fall as fast as the stock market. A company with an equity beta of 2.0 should see
returns on its equity rise twice as fast or drop twice as fast as the overall market. 
5. How would you calculate beta for a company?

Calculating raw betas from historical returns and even projected betas is an imprecise measurement of
future beta because of estimation errors (i.e. standard errors create a large potential range for beta).  As a
result, it is recommended that we use an industry beta. Of course, since the betas of comparable
companies are distorted because of different rates of leverage, we should unlever the betas of these
comparable companies as such: 

 β Unlevered = β(Levered) / [1+ (Debt/Equity) (1-T)]

Then, once an average unlevered beta is calculated, relever this beta at the target company’s capital
structure:

 β Levered = β(Unlevered) x [1+(Debt/Equity) (1-T)]

6. How do you calculate unlevered free cash flows for DCF analysis?

Free cash flows = Operating profit (EBIT) * (1 –tax rate) + depreciation & amortization – changes in net
working capital – capital expenditures                                        

7. What is the appropriate numerator for a revenue multiple?

The answer is enterprise value. The question tests whether you understand the difference between equity
value and enterprise value and their relevance to multiples.  Equity value = Enterprise value – Net Debt
(where net debt = gross debt and debt equivalents – excess cash).  For more on this equation see WSP’s
article atwww.wallstreetprep.com/blog/.   

EBIT, EBITDA, unlevered cash flow, and revenue multiples all have enterprise value as the numerator
because the denominator is an unlevered (pre-debt) measure of profitability.  Conversely, EPS, after-tax
cash flows, and book value of equity all have equity value as the numerator because the denominator is
levered – or post-debt.

8. How would you value a company with negative historical cash flows?

Given that negative profitability will make most multiples analyses meaningless, a DCF valuation approach
is appropriate here. 

9. When should you value a company using a revenue multiple vs. EBITDA?
Companies with negative profits and EBITDA will have meaningless EBITDA multiples.  As a result,
Revenue multiples are more insightful.  

10. Two companies are identical in earnings, growth prospects, leverage, returns on capital,
and risk.  Company A is trading at a 15 P/E multiple, while the other trades at 10 P/E. Which
would you prefer as an investment?

10 P/E: A rational investor would rather pay less per unit of ownership. 

A debenture is an unsecured loan you offer to a company. The company does not give
any collateral for the debenture, but pays a higher rate of interest to its creditors. In
case of bankruptcy or financial difficulties, the debenture holders are paid later than
bondholders. Debentures are different from stocks and bonds, although all three are
types of investment. Let us discuss about different types of investment options for small
investors and entrepreneurs.

Debentures vs. Stocks: 

When you buy stocks, you become one of the owners of the company. Your fortunes rise
and fall with that of the company. If the stocks of the company soar in value, your
investment pays off high dividends, but if the stocks decrease in value, the investments
are low paying. Higher the risk you take, higher the rewards you get.

Debentures are more secure than stocks, in the sense that you are guaranteed
payments with high interest rates. You are paid an interest on the money you lend the
company until the maturity period, after which whatever you invested in the company is
paid back to you. The interest is the profit you make from debentures. While stocks are
for those who like playing the field, and are willing to take risks for the sake of high
returns, debentures are for people who want a safe and secure income.

Debentures vs. Bonds: 

Debentures and bonds are similar except for one difference - bonds are more secure
than debentures. In case of both, you are paid a guaranteed interest that does not
change in value irrespective of the fortunes of the company. However, bonds are more
secure than debentures, but carry a lower interest rate. The company provides collateral
for the loan. Moreover, in case of liquidation, bondholders will be paid off before
debenture holders.

A debenture is more secure than a stock, but not as secure as a bond. In case of
bankruptcy, you have no collateral you can claim from the company. To compensate for
this, companies pay higher interest rates to debenture holders.

All investment, including stocks bonds or debentures carry an element of risk. If you are
unsure of the investment options that are best for your business, then you can consult a
small business consultant who will guide you to the best investment options available to
you. Investing wisely today can pay heavy dividends tomorrow.