Preparing for an equity valuation interview? Look no further. We’ve compiled the top 50 equity valuation interview questions and answers to help you ace your interview and land your dream job in finance. From basic concepts like enterprise value and equity value to advanced topics like valuation methodologies and financial modeling, we cover the most common equity valuation interview questions asked by top firms.
Equity valuation interview questions test your technical knowledge, problem-solving skills, and ability to explain valuation concepts clearly. By mastering these equity valuation interview questions and answers, you’ll be well-prepared to impress your interviewer and stand out from the competition.
1. What are the main valuation methodologies?
The three main valuation methodologies are Comparable Companies Analysis (Comps), Precedent Transactions Analysis (Precedents), and Discounted Cash Flow Analysis (DCF). Comps values a company based on the valuation multiples of similar public companies. Precedents values a company based on the multiples paid for similar companies in past M&A transactions. A DCF values a company based on the present value of its expected future cash flows. Equity valuation interview questions often test your knowledge of the key differences, uses, and limitations of each methodology.
2. What are the differences between enterprise value and equity value?
Enterprise value represents the total value of a company’s core business operations. It includes both equity and debt financing. Equity value represents only the value available to common shareholders. Enterprise Value = Equity Value + Debt + Preferred Shares + Minority Interest – Cash. Equity Value = Enterprise Value – Debt – Preferred Shares – Minority Interest + Cash. Enterprise value is the starting point to determine what a company is worth to all investors. Equity valuation interview questions may ask you to calculate equity value from enterprise value or vice versa.
3. How do you calculate diluted shares outstanding?
To calculate diluted shares outstanding, start with the basic shares outstanding and add any additional shares that could be issued through stock options, restricted stock units, warrants, or convertible securities. Use the treasury stock method for options and warrants. Assume in-the-money options/warrants are exercised and the proceeds are used to repurchase shares at the current price. For convertible securities, assume they are converted into common shares if the conversion is dilutive. Equity valuation interview questions test your understanding of how dilutive securities impact a company’s equity value per share.
4. Walk me through how you would value a mature, stable company. What methodology would you use?
For a mature, stable company, a good methodology to use is Comparable Companies Analysis. Key steps are:
1) Select comparable public companies based on business and financial similarity
2) Spread comps’ key operating and financial metrics
3) Calculate comps’ valuation multiples like EV/EBITDA, P/E, EV/Sales
4) Benchmark your company’s metrics vs. the comps
5) Select appropriate multiple(s) for your company based on its relative performance
6) Apply selected multiple(s) to your company’s metrics to determine valuation range
Equity valuation interview questions often focus on which methodology is best suited for a company based on its characteristics.
5. What are the key factors to consider when selecting comparable companies?
When selecting comparable companies for valuation purposes, consider:
1) Industry – Companies in the same industry facing similar market dynamics
2) Size – Companies of similar size as measured by revenue, assets, market cap
3) Profitability – Companies with similar margins and return on capital
4) Growth – Companies with similar historical and expected growth rates
5) Geography – Companies with similar geographic exposure
No company will be a perfect comp. The goal is to select companies that provide a reasonable basis for comparison.
Equity valuation interview questions often probe your comp selection thought process.
6. When would you not use a DCF to value a company?
A DCF is less suitable for valuing companies with:
1) Negative or highly uncertain cash flows – e.g. startups, turnarounds, or companies in highly cyclical industries
2) Significant non-operating assets – e.g. large cash balances, investments in other companies, unutilized real estate
3) A changing business mix – e.g. companies undergoing divestitures or major strategic shifts
4) Limited financial information – e.g. private companies with no reliable cash flow data
A DCF relies heavily on long-term cash flow projections, so it’s best used for mature, stable companies.
Equity valuation interview questions test your judgment on the best valuation approach for different situations.
7. What are some common multiples used in valuation?
Commonly used valuation multiples include:
1) Enterprise Value multiples: EV/Revenue, EV/EBITDA, EV/EBIT
2) Equity Value multiples: P/E (Price-to-Earnings), P/BV (Price-to-Book Value), P/S (Price-to-Sales)
3) Industry-specific multiples: EV/Production for oil & gas companies, Price/FFO per share for REITs
The choice of multiple depends on the industry, the company’s financial characteristics, and the purpose of the valuation. Equity valuation interview questions test your ability to select and interpret the most relevant multiples for a given company or situation. Demonstrating a nuanced understanding of different multiples can help you stand out.
8. Walk me through a DCF. What are the key components?
The key steps in a DCF are:
1) Project unlevered free cash flows:
– Project financials (revenue, expenses, capex, NWC)
– Calculate EBIT, taxes, D&A, capex, NWC changes
– Derive unlevered FCF for explicit forecast period
2) Determine terminal value
– Estimate perpetuity growth rate or exit multiple
– Calculate terminal value using Gordon Growth Model or exit multiple method
3) Discount cash flows to present value using WACC
4) Calculate enterprise value as sum of PV of cash flows and PV of terminal value
5) Adjust EV for non-operating assets/liabilities
6) Divide by diluted shares to get equity value per share
Equity valuation interview questions often focus on the key assumptions and drivers in a DCF.
9. What are the main factors that drive a company’s terminal value in a DCF?
A company’s terminal value is driven by:
1) Long-term growth rate – Higher growth means higher terminal value. The growth rate should reflect a company’s expected long-term growth profile and industry outlook.
2) WACC (Weighted Average Cost of Capital) – A higher WACC leads to a lower terminal value as future cash flows are discounted more heavily.
3) EBITDA or NOPAT margins – Higher margins mean more cash flow, driving a higher terminal value.
4) Capital intensity (Capex and NWC) – More capital-intensive companies will have lower free cash flow and thus lower terminal values.
5) Terminal multiple – If using an exit multiple method, the selected EV/EBITDA or other multiple has a significant impact.
10. How would valuation differ for a high-growth vs a mature company?
For a high-growth company:
– Emphasize near-to-medium term growth in revenue and profits
– Put more weight on future cash flows in DCF
– Focus on P/S and EV/Sales multiples until company reaches profitability
– Pay less attention to book value and asset multiples
For a mature company:
– Focus more on profitability, returns on capital, and cash flows
– Equal or greater emphasis on terminal value than near-term cash flows in DCF
– Focus on earnings and cash flow multiples like P/E, EV/EBITDA
– Asset-based valuation like P/BV can be a useful cross-check
The best valuation approach varies based on a company’s financial profile and stage in the business life cycle.
11. How would you value a privately-held company differently from a public company?
Key considerations when valuing a private company:
1) Information availability – Private companies disclose less financial information, so assumptions and estimates play a bigger role
2) Illiquidity – Private company shares are less liquid, so often apply a 10-20%+ illiquidity discount to public company multiples
3) Size – Private companies are often smaller, so may deserve a lower multiple than larger public peers
4) Adjustments – May need to adjust a private company’s financials (e.g. owner compensation) to make them comparable to public companies
5) Valuation cross-checks – With no market price, a combination of valuation approaches (DCF, comps, precedents) is important for triangulation
While the mechanics are the same, valuing private companies requires more judgment, inferences, and adjustments.
12. What is a control premium and when would it apply in a valuation?
A control premium is the additional value an acquirer is willing to pay above the current trading price to gain a controlling stake in a company. Key drivers are:
– Synergies – Revenue and cost benefits not available to minority investors
– Strategic value – Value of controlling the company’s strategic direction
– Operational control – Ability to influence management, operations, and capital allocation
– Scarcity – Premium for buying a hard-to-replicate asset or market position
Control premiums often range from 20-40%+ and are seen in precedent transaction multiples. They would apply when valuing a target company in an M&A context or a majority stake, not for minority stakes or passive investments.
13. What is the treasury stock method and when would you use it?
The treasury stock method is used to calculate the potential dilutive impact of stock options, warrants, or other convertible securities on a company’s shares outstanding.
Key steps are:
1) Determine the proceeds the company would receive if all dilutive securities were exercised (strike price x number of options/warrants)
2) Assume the company uses the proceeds to repurchase shares at the current market price
3) Net increase in shares = Potential shares issued – Shares repurchased
4) Add net increase in shares to basic shares outstanding to get diluted shares outstanding
The treasury stock method assumes no change in the company’s aggregate value, only changes in the number of shares outstanding. It is used in equity valuation to arrive at a fully diluted share count and value per share.
14. Walk me through an example of how the treasury stock method works.
Sure, let’s walk through an example:
– Company A has 100 million basic shares outstanding and a current share price of $50
– It has 10 million outstanding employee stock options with an average strike price of $20
– Proceeds if all options exercised = 10 million x $20 = $200 million
– Shares repurchased with proceeds = $200 million / $50 current price = 4 million shares
– Net increase in shares = 10 million options exercised – 4 million shares repurchased = 6 million
– Diluted shares outstanding = 100 million basic + 6 million net increase = 106 million
This example shows how the treasury stock method assumes option exercise proceeds are used to buy back shares, offsetting some of the dilution. Equity valuation interview questions may ask you to walk through this type of calculation.
15. How would an increase in a company’s share price affect its diluted share count under the treasury stock method?
An increase in a company’s share price would decrease its diluted share count under the treasury stock method. Here’s why:
– A higher share price means the company could repurchase more shares with the proceeds from option exercises
– More shares repurchased leads to a smaller net increase in shares outstanding
– Thus, the dilutive impact of outstanding options/warrants is reduced when the share price rises
Conversely, a decrease in the share price would increase the diluted share count as fewer shares could be repurchased, leaving a larger net increase in shares.
Understanding this dynamic is important for equity valuation as it impacts the denominator (shares outstanding) in your per share valuation calculations.
16. What is the basic formula for enterprise value?
The basic formula for enterprise value is:
Enterprise Value = Equity Value (Market Cap) + Total Debt + Preferred Stock + Minority Interest – Cash & Equivalents
This formula sums up the market value of all investor claims on a company (equity, debt, preferred stock, minority interest) and subtracts out the value of cash & equivalents which are considered non-operating assets.
Equity valuation interview questions will often test your understanding of enterprise value and how it differs from equity value. Being able to quickly lay out the EV formula is important.
17. Why do we subtract cash in the enterprise value formula?
We subtract cash in the enterprise value formula because:
1) Enterprise value is meant to capture the value of a company’s core business operations. Cash and equivalents are considered non-operating assets.
2) Interest income from cash is typically excluded from EBIT and EBITDA, the denominator in EV multiples. So for consistency, cash is excluded from the numerator.
3) In an acquisition, cash on the target’s balance sheet is “free” to the acquirer – it reduces the effective purchase price. Subtracting cash gives a better picture of the net cost to acquire the target’s operating assets.
While not a perfect measure, subtracting all cash and equivalents is standard practice when calculating enterprise value. Equity valuation interview questions often touch on the logic behind this adjustment.
18. What are some issues with the basic enterprise value formula?
Some potential issues with the basic EV formula:
1) Includes all cash – Really should only subtract “excess” cash not needed for operations
2) Ignores other non-operating assets like investments in public securities, unconsolidated subsidiaries, or unutilized real estate which may have significant value
3) Doesn’t distinguish between on- and off-balance sheet financing like operating leases
4) Doesn’t factor in under-/over-funded pensions which represent a real economic asset/liability
5) Debatable whether treating preferred as debt or equity is appropriate in all cases
More nuanced EV calculations adjust for these items, but the basic formula is still the most common. Equity valuation interview questions may touch on when the basic formula could be misleading.
19. How do equity value multiples like P/E and enterprise value multiples like EV/EBITDA differ?
Key differences are:
1) Numerator – P/E uses equity value (market cap) while EV/EBITDA uses enterprise value (market cap + net debt)
2) Denominator – P/E uses net income, which is post-tax and post-interest. EV/EBITDA uses EBITDA, which is pre-tax and pre-interest.
3) Capital structure – P/E is affected by a company’s leverage and interest expense. EV/EBITDA is capital structure-neutral.
4) Normalized earnings – EBITDA excludes non-cash and non-recurring items, making EV/EBITDA less susceptible to one-time events vs P/E
5) Industry conventions – P/E is more commonly used for financial, real estate, and mature, stable industries. EV/EBITDA is favored for capital-intensive or highly levered industries.
In general, EV/EBITDA is seen as a more comprehensive valuation measure, but both have a place in an analyst’s toolkit.
20. If a company’s EV/EBITDA multiple is 8x and its EBITDA margin is 20%, what is its implied P/S multiple?
We can solve this in two steps:
1) Rearrange the EV/EBITDA equation to solve for EV:
EV = 8 x EBITDA
2) Recognize that EBITDA / Sales = 20% (the EBITDA margin). Substitute this into the equation:
EV = 8 x 20% x Sales
EV = 1.6 x Sales
So if a company trades at 8x EBITDA and has a 20% EBITDA margin, it trades at 1.6x Sales (EV/Sales).
This type of shortcut is helpful in quickly estimating valuation based on margin assumptions. Being able to quickly do this math and move between multiples is important for equity valuation interview questions.
21. Define the cash conversion cycle. How does it impact valuation?
The cash conversion cycle (CCC) measures how long it takes a company to convert investments in working capital (inventory and receivables) into cash flows from sales. The formula is:
CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
A shorter CCC means a company can generate cash more quickly. This is a positive for valuation as it reduces the cash tied up in working capital and the financing needed to support operations.
Companies with shorter CCCs typically command higher valuation multiples as they are more efficient at managing working capital. Conversely, a longer CCC can be a drag on valuation.
Cash conversion cycle is a key metric in evaluating the quality of a company’s cash flows and working capital management.
22. What is goodwill? How does it impact valuation?
Goodwill is an intangible asset that arises when a company acquires another business for a price higher than the fair value of its identifiable net assets (assets – liabilities).
Goodwill = Purchase Price – Fair Value of Net Assets
Goodwill represents the value of intangible assets that are hard to quantify, like a strong brand, customer relationships, intellectual property, or an assembled workforce.
From a valuation perspective:
– High goodwill can indicate a company has made expensive acquisitions at premium prices. It may signal overpayment or difficulties realizing synergies.
– Goodwill is subject to impairment testing. Large write-offs can significantly impact a company’s reported earnings and book value.
– Goodwill is excluded from tangible book value, a common valuation metric for financial firms.
While goodwill is not inherently good or bad, it’s important to understand what it represents and potential impacts on valuation. Equity valuation interview questions may ask you to interpret a company’s goodwill balances.
23. When might a company trade below its book value?
A company might trade below its book value (P/BV < 1) for a few reasons:
1) Distressed or unprofitable operations – If a company is losing money or at risk of bankruptcy, the market may assign little value to its net assets.
2) Asset-light business models – For service or technology companies, book value may understate true economic value as key assets are intangible (e.g. human capital, IP).
3) Low returns on capital – If a company earns returns on equity below its cost of capital, the market may discount the value of its net assets.
4) Overstated asset values – Book values based on historical cost may overstate the current market value of assets, especially for firms with older, less productive assets.
Trading below book value often signals the market is skeptical about a company’s ability to generate value from its assets. Equity valuation interview questions may ask you to interpret a low P/BV ratio.
24. How do you calculate WACC?
WACC (Weighted Average Cost of Capital) is a company’s blended cost of equity and debt financing. It’s calculated as:
WACC = (E/V * Cost of Equity) + (D/V * Cost of Debt * (1-Tax Rate))
Where:
– E/V = Equity Value / Total Enterprise Value
– D/V = Debt Value / Total Enterprise Value
– Cost of Equity = Risk-free Rate + (Beta * Equity Risk Premium)
– Cost of Debt = Company’s average pre-tax debt yield
The equity and debt weights are based on a company’s target capital structure at market values.
WACC represents the minimum return a company must earn on its assets to satisfy all its investors. It’s commonly used as the discount rate in DCF valuation. Equity valuation interview questions often test your ability to explain and calculate WACC.
25. What are the main drivers of a company’s beta?
A company’s beta measures the sensitivity of its stock returns to changes in the overall market. Key drivers include:
1) Business risk – The inherent volatility of a company’s operations and cash flows. Higher business risk leads to higher beta.
2) Operating leverage – Companies with high fixed costs tend to have higher betas as their earnings are more sensitive to changes in sales.
3) Financial leverage – Higher debt-to-equity ratios lead to higher betas as leverage amplifies the volatility of earnings.
4) Cyclicality – Companies in cyclical industries tend to have higher betas as their performance is tied to economic cycles.
In general, companies with more stable, predictable cash flows and lower leverage tend to have lower betas.
Beta is a key input in estimating a company’s cost of equity. Equity valuation interview questions often test your understanding of beta drivers and implications.
26. What is the formula for unlevering beta?
To unlever beta (remove the impact of financial leverage), we use the following formula:
Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) * (Debt/Equity)))
Where:
– Levered Beta is the company’s actual, observed beta
– Tax Rate is the company’s marginal tax rate
– Debt/Equity is the company’s debt-to-equity ratio (at market values)
Unlevering beta allows us to compare betas across companies with different capital structures. It isolates the business risk component of beta.
To relever beta (i.e. to estimate a company’s beta at a different capital structure), we just rearrange the formula:
Levered Beta = Unlevered Beta * (1 + ((1 – Tax Rate) * (Debt/Equity)))
Unlevering and relevering betas is a key step in estimating the cost of equity for DCF valuation. Equity valuation interview questions often test your mechanics and intuition around levered and unlevered betas.
27. If two companies are identical except one has debt and the other does not, which will have a higher beta?
The company with debt will have a higher beta.
Here’s why:
– Beta measures the risk of a company’s equity
– Debt increases the volatility of a company’s equity returns as it amplifies gains and losses
– This increased volatility translates into a higher beta
– We can see this mathematically in the beta levering formula:
Levered Beta = Unlevered Beta * (1 + ((1 – Tax Rate) * (Debt/Equity)))
As Debt/Equity rises, so does Levered Beta. This concept is important for understanding how capital structure impacts risk and required returns. It’s also key for comparing betas across companies. Equity valuation interview questions may test your intuition on the relationship between leverage and beta.
28. How does beta impact a company’s cost of equity?
Beta is a key input in calculating a company’s cost of equity using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-free Rate + (Beta * Equity Risk Premium)
Where:
– Risk-free Rate is the expected return on a risk-free asset (usually a 10-year government bond yield)
– Equity Risk Premium is the excess return investors demand to hold risky equities over risk-free assets
As beta increases, so does a company’s cost of equity. A higher beta implies higher systematic risk, so investors demand a higher return to compensate.
For example, if the risk-free rate is 3%, the equity risk premium is 5%, and a company’s beta is 1.2, its cost of equity would be:
3% + (1.2 * 5%) = 9%
If beta increased to 1.5, cost of equity would rise to 10.5%.
Understanding beta’s role in the cost of equity is crucial for DCF valuation and assessing investor return requirements. Equity valuation interview questions often test this relationship.
29. What are the steps to calculate terminal value in a DCF?
There are two common approaches to calculate terminal value in a DCF:
1) Perpetuity Growth Method
– Assumes cash flows will grow at a constant rate forever
– Formula: Terminal Value = (Final Year Cash Flow * (1 + Long-term Growth Rate)) / (Discount Rate – Long-term Growth Rate)
– Key inputs are the final year cash flow, long-term growth rate, and discount rate (WACC)
2) Exit Multiple Method
– Assumes the company is sold at the end of the projection period at a multiple of EBITDA or another metric
– Formula: Terminal Value = Final Year EBITDA (or other metric) * Exit Multiple
– Key inputs are the final year EBITDA (or other metric) and assumed exit multiple based on comparable companies
In both cases, the terminal value is then discounted back to present value using the WACC or discount rate. Terminal value often makes up a large portion of a company’s total DCF value, so it’s important to use reasonable assumptions. Equity valuation interview questions often focus on how terminal value is calculated and key sensitivities.
30. How do you estimate the long-term growth rate for a DCF terminal value?
The long-term growth rate is meant to capture a company’s expected growth in perpetuity after the explicit projection period. Some common approaches:
1) Assume a rate in line with long-term GDP growth (3-4%), as few companies can outgrow the economy indefinitely
2) Use analyst estimates of long-term EPS growth, which tend to be in the 4-7% range for mature companies
3) For a cyclical company, use a rate that reflects mid-cycle conditions rather than a peak or trough year
4) Consider the company’s reinvestment rate and expected ROICs, as growth is driven by reinvesting at a positive spread to the cost of capital
As a general rule, be conservative with long-term growth rates in a DCF. Overly optimistic assumptions can inflate terminal value and lead to unrealistic valuations. The long-term growth rate is a key sensitivity in any DCF model that equity valuation interview questions are likely to probe.
31. What long-term growth rate assumption would cause a DCF model to break?
In a DCF, the long-term growth rate must be less than the discount rate (WACC). If growth equals or exceeds the discount rate, the DCF model will break.
Here’s why:
– Mathematically, the terminal value formula has the discount rate minus growth in the denominator. If growth equals or exceeds the discount rate, this denominator goes to zero or negative, causing the terminal value to approach infinity or turn negative.
– Intuitively, it doesn’t make sense for a company to grow faster than its cost of capital indefinitely. This would imply the company is expected to earn excess returns and expand value forever, which is not economically feasible as competition should eventually drive down returns.
As a rule of thumb, the spread between the discount rate and long-term growth should be at least 2-3 percentage points in a DCF. A common error is to overestimate long-term growth, causing the model to break down.
Understanding this relationship is crucial for building a sound DCF. Equity valuation interview questions may ask what happens when the long-term growth rate equals or exceeds the WACC.
32. Walk me through how you would approach a sum-of-the-parts (SOTP) valuation.
A sum-of-the-parts valuation values each of a company’s businesses or divisions separately and then adds them together to get the total company value.
Key steps:
1) Segment the company into distinct business units or divisions
2) Forecast financials for each segment separately
3) Determine the most appropriate valuation methodology for each segment based on its characteristics
– For mature, stable segments use public comps or DCF
– For high-growth, loss-making segments use revenue multiples or DCF with longer projections
– For non-core assets like real estate or investments, use market values or asset-based valuation
4) Determine the value of each segment using the chosen methodology
5) Add up the segment values to get the total company value
6) Consider applying a conglomerate discount (typically 5-10%) to reflect the challenges of managing disparate businesses
SOTP valuation is most relevant for diverse companies with multiple unrelated lines of business. It allows you to apply different valuation techniques to the segments and compare to pure-play peers.
Equity valuation interview questions may ask when an SOTP approach is appropriate and have you walk through the key steps.
33. When would you use an LBO model to value a company?
An LBO (leveraged buyout) model values a company based on the returns a financial sponsor could achieve by buying the company with a mix of debt and equity, improving its performance, and selling it later.
LBO valuation is most relevant in a few scenarios:
1) When a company is an actual LBO target
– The model shows the price a PE firm could pay and still earn its target return
2) To estimate a “floor valuation” for the company
– The LBO model provides a conservative estimate of what a company is worth to a financial buyer, which is usually less than a strategic buyer would pay
3) To assess the potential for a company to be taken private
– If the LBO model suggests a PE firm could pay a premium to the current trading price, it signals the company could be an attractive take-private candidate
4) To evaluate the company’s current leverage and capital allocation policies
– The model can show if a company is underleveraged compared to what a PE firm would do
Even if a company is not an imminent LBO target, the LBO analysis still provides useful insights into its valuation, capital structure, and potential for value creation.
In any case, it’s important to be aware of the assumptions and limitations of an LBO model, as the outputs are highly sensitive to inputs like leverage, exit multiple, and target returns. Equity valuation interview questions may ask in what situations an LBO model would be an appropriate valuation approach.
34. What are the steps to build an LBO model?
The key steps to build an LBO model are:
1) Input transaction assumptions
– Purchase price (usually based on an entry multiple)
– Debt/equity ratio and types of debt used
– Financial sponsor’s target return (IRR)
2) Build operating model
– Project income statement, focusing on revenue, margins, and cash flow
– Model impact of business plan initiatives and operational improvements
3) Create debt schedule
– Project required debt paydown based on a combination of contractual repayments and excess cash flow sweep
– Calculate annual interest expense based on debt balances and interest rates
4) Build sources and uses of funds
– “Sources” include debt and equity funding
– “Uses” include purchase price, transaction fees, and financing fees
5) Calculate exit proceeds and returns
– Assume an exit year and exit multiple to calculate exit enterprise value
– Deduct remaining debt balance to get equity value
– Calculate IRR based on initial equity investment and exit proceeds
LBO models focus on cash flow generation to pay down debt and the financial sponsor’s potential return. They’re less detailed than merger models or operating models in projecting the balance sheet and working capital.
Knowing the key components and mechanics of an LBO model is important for equity valuation interview questions.
35. How does leverage impact returns in an LBO model?
Leverage is a key driver of returns in an LBO model. In general, higher leverage leads to higher potential equity returns (and vice versa). Here’s how:
1) Leverage amplifies returns on the upside
– A given increase in enterprise value translates into a larger increase in equity value and IRR with higher leverage
2) Leverage reduces the amount of equity required
– By using more debt financing, the financial sponsor can acquire the company with less of its own equity, increasing the potential multiple of money (MoM) return
3) Leverage provides a tax shield
– Interest expense on LBO debt is tax-deductible, reducing the company’s tax bill and increasing cash flow available for debt paydown
However, leverage is a double-edged sword. It also increases risk:
– Leverage amplifies losses on the downside if the company underperforms
– High debt levels reduce financial flexibility and increase the risk of default
The key in an LBO is to find the right balance – enough leverage to boost returns, but not so much that it puts the company at risk.
Equity valuation interview questions may ask you to explain how leverage impacts LBO returns and to discuss the tradeoffs involved.
36. What are the main drivers of returns in an LBO model?
The main drivers of returns (measured by IRR and MoM) in an LBO model are:
1) Exit multiple
– A higher exit multiple means the PE firm can sell the company for a higher price, increasing returns
2) Revenue growth
– Faster revenue growth leads to a higher exit valuation and more cash flow to pay down debt
3) Margin expansion
– Improving EBITDA margins through operational efficiencies or cost cutting increases cash flow for debt paydown and leads to a higher exit valuation
4) Leverage
– Higher leverage boosts returns by increasing upside on exit and reducing the amount of equity required (as previously discussed)
5) Debt paydown
– Paying down more debt over the holding period leads to more equity value at exit
Of these drivers, exit multiple tends to have the largest impact as it directly determines the company’s value at sale. Modest changes in the multiple can swing IRR and MoM significantly.
Revenue growth and margin expansion are also high-impact as they flow through to higher exit value and cash flow. Leverage and debt paydown have a more moderate impact.
Equity valuation interview questions may ask you to identify and rank the drivers of LBO returns, and to explain how each factor impacts the financial sponsor’s ultimate payoff.
37. What’s the difference between the equity method and proportional consolidation method of accounting for an investment?
The equity method and proportional consolidation are two ways a company can account for investments in other companies. The key differences are:
Equity method:
– Used when the investor has significant influence but not majority control (typically a 20-50% ownership stake)
– The investor records its proportional share of the investee’s net income on its own income statement (not revenue or expenses)
– The carrying value of the investment on the balance sheet is adjusted up/down based on the investee’s profit/loss
Proportional consolidation:
– Used when two companies share control of a joint venture (rare)
– The investor records its proportional share of the JV’s revenue, expenses, assets, and liabilities on its own financial statements
– Essentially, the JV’s financials are combined with the investor’s in proportion to its ownership stake
The key distinction is that the equity method only impacts the investor’s net income, while proportional consolidation affects all aspects of its financial statements.
In general, the equity method is much more common. Proportional consolidation is not allowed under US GAAP and has limited use under IFRS.
Understanding these accounting concepts is important for interpreting financial statements and valuation metrics. Equity valuation interview questions may test your knowledge of different consolidation methods.
38. What are the main steps in valuing a company using public comps?
The key steps to value a company using public comps are:
1) Select comparable companies
– Identify public companies in the same industry with similar business models, financial characteristics, and growth prospects
– Focus on 5-10 closest comps
2) Gather financial data on comps
– Collect key financial metrics like revenue, EBITDA, net income, book value of equity, etc.
– Pull data from the latest 10-K/10-Q filings and supplemental SEC filings
3) Calculate valuation multiples
– Compute Enterprise Value (EV) and Equity Value multiples for each comp
– Common multiples: EV/Revenue, EV/EBITDA, P/E, P/BV
– Use forward-looking estimates (e.g. NTM EBITDA) if available
4) Benchmark the company’s metrics to comps
– Compare the company’s growth, margins, returns, etc. to the comps
– Determine if the company is over/underperforming vs. peers
5) Select appropriate multiple ranges
– Choose a reasonable range for each relevant multiple based on the company’s relative performance and qualitative factors
– Typically around the 25th to 75th percentile of the comps
6) Apply multiples to the company’s metrics
– Multiply the company’s revenue, EBITDA, earnings by the selected ranges
– Use forward-looking estimates for the company if available
7) Triangulate to determine valuation range
– Consider the valuation ranges implied by different multiples
– Narrow to a reasonable range based on the company’s key value drivers
Public comps are a cornerstone of relative valuation. The key is to select truly comparable firms and make thoughtful judgments on where the company should fall within the peer group range. Equity valuation interview questions will likely have you walk through these steps and justify your comp selection and multiple choices.
39. What are the key differences between public comps and precedent transactions?
Public comps and precedent transactions are both market-based valuation approaches, but they differ in a few key ways:
Public Comps:
– Based on current trading multiples of comparable public companies
– Reflects minority, non-controlling interest (no control premium)
– Valuation reflects current market sentiment and forward-looking estimates
– Multiples can be calculated easily with public financials and pricing data
Precedent Transactions:
– Based on M&A deal multiples for comparable target companies
– Reflects value paid for control (includes control premium)
– Valuation reflects market sentiment at time of deal, not necessarily current
– Deal terms can be hard to find, especially for private transactions
In general, precedent transaction multiples tend to be higher than public comps due to the control premium and potential for synergies priced into M&A deals.
Precedent transactions can also be harder to find good comps for, as M&A deals are less frequent than public trading data.
Another key difference is the implied value: public comps reflect the current market value of a minority stake, while precedent transactions reflect the value paid for full control in the past.
Equity valuation interview questions often test your knowledge of the key differences, advantages, and limitations of these valuation approaches.
40. Walk me through how you would value a high-growth tech startup.
Valuing a high-growth tech startup is challenging as these companies often have limited financial history, negative earnings, and uncertain future prospects. A few approaches:
1) Forward Revenue Multiple
– Calculate the company’s projected NTM or Year 2 revenue
– Find public comps that are a few years ahead in terms of scale and growth rate
– Apply a revenue multiple in line with these faster-growing, larger-scale comps
2) Revenue Growth-Adjusted Multiples
– Calculate the company’s projected revenue growth rate over the next 1-3 years
– Divide public comps’ revenue multiples by their respective growth rates to get a growth-adjusted multiple
– Apply the median or mean growth-adjusted multiple to the startup’s forward revenue and growth rate
3) DCF with Probability-Weighted Scenarios
– Project revenue under different adoption curves and market share capture assumptions
– Assume long-term margin and reinvestment levels in line with mature comps
– Probability-weight different scenarios (base, upside, downside) to get a weighted average valuation range
4) Recent Financing Round Valuation
– Use the post-money valuation and terms of the latest financing round as a benchmark
– Consider whether the company has de-risked or hit milestones since then to warrant a higher valuation
With limited financial data, qualitative considerations are key. Evaluate the quality of the founding team, key risks to the business model, competitive dynamics, customer concentration, and revenue visibility.
The key is to focus more on forward-looking KPIs (e.g. bookings, recurring revenue, net retention) and qualitative angles, rather than historical financials. Equity valuation interview questions may test your creativity and judgment in valuing high-growth startups.
41. How would you value a mature, slow-growing company?
For a mature, slow-growing company, I would focus on:
1) Discounted Cash Flow (DCF) Analysis
– Project 5-10 years of cash flows based on modest revenue growth and margin assumptions
– Assume a terminal growth rate in line with long-term GDP (2-3%)
– Use a higher discount rate (WACC) to reflect the risk of future disruption or competitve threats
– Consider a sum-of-parts DCF if the company operates distinct business segments with different growth profiles
2) Public Comps with EV/EBITDA and P/E multiples
– Identify public companies with similar growth rates, margins, returns on capital, and business risks
– Apply a discount or premium to the peer median based on the company’s relative competitive position and growth prospects
– Focus on EV/EBITDA and P/E multiples as they are most relevant for mature, profitable businesses
3) Dividend Discount Model (if the company pays a meaningful and consistent dividend)
– Project the company’s dividends per share based on payout ratio and earnings growth expectations
– Use the Gordon Growth model for the terminal value, assuming a long-term dividend growth rate in line with earnings
– Discount dividends and terminal value at the cost of equity to get the present value per share
For mature companies, cash flow-based valuation approaches like DCF and DDM tend to be more relevant than revenue or growth multiples.
It’s also important to consider potential risks like technological disruption, shifting consumer preferences, or competitive threats that could derail the company’s stable growth trajectory. Equity valuation interview questions may ask you to justify which valuation approach is most appropriate for a mature company and explain your key assumptions.
42. How would you value a declining or distressed company?
Valuing a declining or distressed company is challenging as the going concern assumption may not hold. A few approaches:
1) Liquidation Value
– Estimate the value of the company’s assets if they were sold off piecemeal
– Consider the time, costs, and discounts associated with a forced liquidation
– Deduct liabilities and liquidation costs to arrive at the net liquidation value
– Compare to the company’s current market value to assess if it’s a viable going concern
2) Sum-of-Parts Valuation
– Value each of the company’s businesses separately using relevant methods (DCF, comps)
– Apply a private company/illiquidity discount to each segment
– Add up the segment values and deduct liabilities to get the equity value
– Consider which businesses are saleable and could be divested to raise cash
3) M&A Comps with Synergies
– Look for precedent M&A deals involving distressed or declining companies in the same industry
– Consider the synergies that strategic buyers priced in (e.g. cost savings from combination)
– Apply similar synergy estimates to the company’s financials to arrive at a potential takeout price
4) Book Value or Net Asset Value
– As a last resort, look at the company’s book value or net asset value (NAV)
– Adjust for any over/understated assets or unrecorded liabilities
– Consider if book value reflects the true economic value of the assets
In a distressed situation, equity value may be minimal or wiped out entirely if liabilities exceed the value of the assets. Equity valuation interview questions may ask you to walk through the liquidation or sum-of-parts math for a distressed company. The key is to be realistic about asset values and potential buyer interest.
43. How do you decide which valuation approach to use for a given company?
Choosing the appropriate valuation approach depends on the company’s characteristics and the purpose of the valuation. Key considerations:
1) Stage in Life Cycle
– Early-stage, pre-profit: Focus on forward revenue multiples, growth-adjusted multiples, and probability-weighted DCFs
– High-growth: Emphasize forward multiples (EV/Revenue, EV/EBITDA), DCF with long-term projections
– Mature: Use historical multiples (EV/EBITDA, P/E), DCF with stable growth assumptions
– Declining/distressed: Focus on asset-based valuation, liquidation value, M&A comps
2) Industry and Business Model
– Consistent business models (consumer staples, utilities): Use P/E multiples, dividend yield, DCFs
– Cyclical businesses (energy, industrials): Use cycle-average multiples, DCF with sensitivity analysis
– Asset-light businesses (software, services): Use forward revenue multiples, DCF with reinvestment analysis
– Highly regulated industries (banks, insurance): Use P/BV multiples, dividend yield, excess returns models
3) Financial Characteristics
– Profitable, stable margins: Use EV/EBITDA and P/E multiples
– Inconsistent or negative earnings: Use forward revenue and EBITDA multiples
– Capital-intensive vs. asset-light: Adjust for depreciation, CapEx levels in DCF
– Strategic vs. financial buyer: Consider potential synergies, control premium paid in precedent deals
4) Purpose and Audience
– M&A advisor: Emphasize DCF and strategic comps that reflect synergies and control premium
– Corporate management: Emphasize comps to peers and value of internal business plan in DCF
– Investor/portfolio manager: Focus on forward multiples, DCF with sensitivity analysis
The best valuation approach aligns with the company’s key value drivers, is feasible given the financial data available, and fits the strategic situation at hand. In practice, it’s best to use multiple approaches to triangulate a reasonable range, rather than relying on a single method.
Equity valuation interview questions will test your judgment in selecting valuation approaches based on a company’s profile and the valuation context.
44. What is your favorite valuation methodology and why?
My personal favorite is a Discounted Cash Flow (DCF) analysis, for a few reasons:
1) Fundamental Focus
– A DCF values a company based on the present value of its expected future cash flows
– It focuses on the key drivers of intrinsic value – cash flow growth, profitability, and risk
– Multiples and other methods are more relative and don’t capture the company’s unique fundamentals as well
2) Explicit Assumptions
– Building a DCF forces you to make explicit assumptions about revenue growth, margins, reinvestment needs, and cost of capital
– It provides a structured framework to evaluate the impact of different scenarios and assumptions
– Multiples and other methods have more implicit, “black box” assumptions baked in
3) Flexibility
– A DCF can be adapted to value any type of company or cash flow stream
– You can break out value across different business segments, geographies, or products
– This flexibility is harder with multiples as the reporting segments may not match comparable companies
4) Insight into Value Creation
– By projecting and discounting cash flows, a DCF shows the magnitude and timing of expected value creation
– It can help identify key value drivers and risks, and evaluate potential upside/downside
– Multiples are more of a snapshot and don’t provide as much insight into the levers of value creation over time
That said, a DCF is only as good as its assumptions. It’s important to cross-check with other methods like comps and precedents to ensure the outputs are reasonable. I believe DCF is a powerful tool, but it’s best used in conjunction with other approaches as part of a well-rounded valuation.
45. How would you explain enterprise value (EV) vs. equity value to a client unfamiliar with valuation concepts?
I would explain it like this:
“Imagine a company is a house. Buying a share of stock is like renting a room in that house. Buying 100% of the company’s stock – the equity value – is like owning the whole house.
But that company probably also has some debt, like a mortgage on the house. If you bought the whole company, you’d be responsible for the mortgage payments too. You’d own all the rooms (assets), but you’d also have to pay off the mortgage (liabilities).
Enterprise value represents the total cost of buying the whole house (company), including any mortgage (debt). It’s the value of all the rooms (assets), to ALL investors, not just the ones renting rooms (equity investors).
So in summary:
– Equity value is the value of the company to just the shareholders. It’s the number of shares times the share price.
– Enterprise value is the value of the company to ALL investors – both shareholders and debtholders. It’s the total cost of acquiring the company outright.
To get from equity value to enterprise value, you add the company’s debt and subtract its cash on the balance sheet. Adding debt means the buyer has to take on more costs, increasing the total price. Subtracting cash means the buyer gets to keep that cash, reducing the effective price.
Does that analogy help explain the difference?”
46. Walk me through how you would assess a company’s liquidity position.
To assess a company’s liquidity position, I would look at a few key metrics:
1) Current Ratio
– Current Assets / Current Liabilities
– Measures the company’s ability to cover short-term obligations with short-term assets
– A ratio above 1.0 suggests the company has enough liquid assets to cover near-term liabilities
2) Quick Ratio
– (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
– A more conservative measure of liquidity, as it excludes inventory and other less liquid current assets
– A ratio above 1.0 suggests the company could cover its current liabilities even if it couldn’t sell inventory
3) Operating Cash Flow
– Cash flow generated by the company’s core business operations
– Positive and growing operating cash flow is a good sign of liquidity and financial health
– I would look at operating cash flow trends and compare to capital expenditure needs
4) Free Cash Flow
– Operating Cash Flow – Capital Expenditures
– Represents the cash flow available for discretionary uses like debt repayment, dividends, or acquisitions
– Positive free cash flow gives the company more flexibility and liquidity cushion
5) Debt Service Coverage Ratio
– (Operating Income + Depreciation & Amortization) / (Interest + Principal Payments)
– Measures the company’s ability to cover its debt obligations with operating cash flow
– A ratio well above 1.0 suggests the company generates plenty of cash flow to service its debt
6) Net Debt Position
– (Short-term Debt + Long-term Debt – Cash & Equivalents)
– Shows the company’s debt burden net of its most liquid assets
– A large net debt position relative to operating cash flow or EBITDA could signal liquidity risk
I would look at these metrics in the context of the company’s industry, business model, and access to capital markets. It’s also important to consider any upcoming maturities, seasonal working capital needs, or other cash flow timing issues. Liquidity is about both the quantity and timing of cash inflows and outflows. A holistic view across multiple metrics is needed to get a true picture.
47. How do you account for stock-based compensation (SBC) in a DCF valuation?
Accounting for SBC in a DCF is a bit tricky, as it is a non-cash expense that still has economic cost to shareholders. Here’s how I would approach it:
1) Forecast SBC expense as usual on the income statement
– SBC is often a function of hiring plans and employee retention strategy
– It should be modeled based on the company’s projected headcount growth and equity compensation practices
– Treat it as an operating expense, similar to cash compensation
2) In the free cash flow calculation:
– If using CFO – CapEx method:
• No adjustments needed as SBC is already a non-cash add-back in CFO
– If using Net Income + D&A – CapEx – Change in NWC method:
• Start with Net Income including the SBC expense
• Add back Depreciation & Amortization, but not SBC as it is already in Net Income
• Subtract CapEx and Change in NWC as usual
3) Do not include SBC in the shares outstanding used to calculate terminal value
– SBC expense is already captured in the free cash flows
– Including SBC in the share count would be double-counting its cost
4) In the discount rate calculation:
– If using WACC, no adjustments needed as the cost of SBC is captured in the cash flows
– If using APV, add the tax shield from SBC (like other operating expenses) to the unlevered cash flows
The key principle is to capture the economic cost of SBC in the free cash flows, but avoid double-counting by not including it in the share count or discount rate. It’s also important to be consistent in the treatment of SBC across all companies if using public comps. Some companies guide to non-GAAP earnings excluding SBC, so adjustments may be needed for apples-to-apples comparisons. Equity valuation interview questions may test your understanding of the economic impact of SBC and how it flows through a DCF.
48. What are some common pitfalls or mistakes in valuation?
Some common valuation pitfalls and mistakes include:
1) Overreliance on a single methodology
– Each valuation approach has its limitations and biases
– Triangulating across multiple methods (DCF, comps, precedents) is important for a balanced view
2) Neglecting the big picture and strategic context
– Valuation should tell a cohesive story about the business and its prospects
– Getting lost in the details of spreadsheets without tying the numbers to the qualitative narrative is a common trap
3) Aggressive or unrealistic assumptions
– Overly optimistic growth rates, margins, or exit multiples can inflate valuations
– Downside scenarios and sensitivity analysis are important to stress test key assumptions
4) Improper selection of comparable companies
– Choosing comps that are not truly similar in terms of business model, end markets, financial profile
– Need to adjust for differences in growth, profitability, and risk when deriving valuation ranges
5) Double-counting of risks or growth
– Applying a high discount rate to reflect risk, but then also using conservative cash flow assumptions
– Embedding high growth in both the explicit forecast period and the terminal value
6) Mismatch between cash flows and discount rate
– Using nominal cash flows with a real discount rate, or vice versa
– Inconsistency between the risk profile of the cash flows and the discount rate used
7) Mechanical application of premiums/discounts
– Arbitrarily slapping on a control premium or minority discount to public comps
– Need to consider the specific strategic and governance dynamics of the situation
Valuation is as much art as science. Avoiding these common pitfalls requires a balance of technical rigor and business judgment. Equity valuation interview questions may ask you to identify potential errors in a valuation and suggest ways to refine the analysis.
49. How do you think about valuation differently for a strategic buyer vs. a financial buyer?
The key differences in valuation between strategic and financial buyers are:
Strategic Buyers:
– Synergies: Strategic buyers often factor in revenue and cost synergies when valuing a target. These could include cross-selling opportunities, economies of scale, or elimination of redundant costs. The value of these synergies is unique to each strategic buyer.
– Longer-term view: Strategic buyers usually have a longer investment horizon and may value a target’s long-term strategic fit more than near-term financial returns. They may be willing to pay a premium for a “strategic asset” that complements their existing business.
– Unique assets: Strategic buyers may ascribe higher value to unique assets like intellectual property, brand equity, or customer relationships that are hard to replicate or build organically.
Financial Buyers:
– IRR focus: Financial buyers like PE firms are more focused on the internal rate of return (IRR) they can achieve by buying, improving, and reselling a business. They typically have a 3-5 year investment horizon and a target IRR threshold.
– Leverage: Financial buyers often use more debt in their capital structure to boost equity returns. The value they can pay is constrained by the amount of debt the target’s cash flows can support at an acceptable IRR.
– Standalone value: Financial buyers generally value a business based on its standalone potential, without factoring in buyer-specific synergies. They may underwrite some “generic” operational improvements, but not strategic synergies.
– Governance: Financial buyers usually require control positions to drive changes and exit on their own timeline. They may discount minority stakes or situations with governance restrictions.
In general, strategic buyers can often pay higher premiums than financial buyers due to synergies and a longer-term investment horizon. However, financial buyers can move faster and provide more deal certainty in some situations.
The valuation approach (DCF vs. comps vs. precedents) may not differ greatly between the two, but the key assumptions and focus areas likely will. Strategic buyers will focus more on long-term cash flows and unique assets, while financial buyers will focus more on near-term IRR and debt capacity.
Understanding these different perspectives is important in any M&A situation. Equity valuation interview questions may ask you to contrast the valuation approaches and key drivers for different types of buyers.
50. How would you approach valuing a company for an IPO (initial public offering)?
Valuing a company for an IPO is a bit different than a typical M&A or investment valuation. Key considerations:
1) Focus on public comps
– The most relevant valuation approach is public company comparables (trading comps)
– Need to select public companies that will be seen as peers post-IPO
– Consider the company’s size, growth profile, profitability, and business model relative to comps
2) Equity value, not enterprise value
– The valuation should be based on equity value multiples (P/E, P/Sales) rather than enterprise value multiples (EV/EBITDA, EV/Sales)
– This is because IPO proceeds are typically used to pay down debt or fund growth, so the pre-IPO capital structure is less relevant
3) Discount for IPO uncertainty
– The IPO valuation may be discounted relative to public peers to reflect the uncertainty and risk of the IPO process
– The “IPO discount” is typically around 10-20%, but can vary based on market conditions and investor demand
4) Growth and profitability trade-off
– Investors will look at the company’s growth and profitability relative to public peers
– High growth companies (e.g. tech startups) may command premium multiples even with lower profitability
– More mature, profitable companies will be compared more on P/E and EV/EBITDA
5) Qualitative factors
– The company’s management team, corporate governance, and use of IPO proceeds will also impact its valuation
– A strong management team with a clear growth strategy and aligned incentives can support a higher valuation
– Conversely, concerns about corporate governance or insider selling can drive a lower valuation
6) Market timing
– The overall market sentiment and recent IPO performance can significantly impact valuation
– In a “hot” IPO market, valuations may be inflated across the board
– In a “cold” market, even strong companies may need to temper valuation expectations
The IPO valuation process is a balancing act between the company’s growth potential, market demand, and peer benchmarking. Setting the right valuation is critical to ensure a successful offering and aftermarket trading. Equity valuation interview questions may ask you to walk through the key factors and multiples you would consider in setting IPO price range. Understanding the nuances of IPO valuation is important for anyone involved in taking a company public.
Mastering equity valuation is a critical skill for any finance professional. By understanding the key concepts, methodologies, and nuances covered in these top 50 equity valuation interview questions, you’ll be well-prepared to impress in interviews and on the job.
Remember, valuation is not just about crunching numbers. It’s about telling a story about a company’s growth prospects, competitive position, and risk profile. The best valuations weave together quantitative analysis with qualitative insights.
As you practice these equity valuation interview questions, focus on the “why” behind each answer. Interviewers will be looking for your thought process and ability to apply valuation concepts to real business situations. With the right preparation and mindset, you’ll be able to confidently tackle any valuation question that comes your way. Good luck!
