Valuation Interview Questions
In this Valuation Interview Questions and Answers, you will find the top 25 frequently asked questions in valuation covered from basic, advanced to application-oriented questions with answers that will help you crack the most difficult aspect of your valuation interview with zeal and confidence.
If you want to crack a valuation interview, you better be on your toes and prepare as much as you can; because nowadays, you need to go both depth and breadth for answering interview questions.
Having said that, here we take up the top 25 valuation interview questions which are often asked in valuation interviews. They are by no way a substitute for your “preparation”; however, this guide will help you direct your attention to the right things.
Let’s get started. We have divided these top 25 valuation interview questions into three categories.
Valuation Interview Questions – Basics
Let us have a look at these basic valuation interview questions with answers.
#1 – What is Free Cash Flow to Firm?
FCFF or Free cash flow to the firmFree Cash Flow To The FirmFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders. is used in DCF financial modeling. A company generates cash flows from its operations by selling goods or services. Some of its cash goes back into the business to renew fixed assetsRenew Fixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. and for the working capital requirements. Free cash flow to the firmFree Cash Flow To The FirmThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX). is the excess cash generated over and above these expenses. Free cash flow to the firm goes to the debt holders and the equity holders.
Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure
#2- What is Free Cash Flow to Equity?
FCFE or Free Cash Flow to Equity modelFree Cash Flow To Equity ModelFCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital management is also one of the DCF approaches (along with FCFF) to calculate the Stock price. FCFE measure how much “cash” a firm can return to its shareholders and is calculated after taking care of the taxes, capital expenditure, and debt cash flows.
FCFE model has certain limitations. For example, it is useful only in cases where the company’s leverage is not volatile, and it cannot be applied to companies with changing debt leverage.
FCFE Formula = Net Income + DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. & Amortization + Changes in WC + Capex + Net Borrowings
#3 – What is Dividend Discount Model?
The Dividend Discount Model is based on the understanding that the fair value of a stock is the present value of all its future dividends.
Here the CF = Dividends.
Some examples of regular dividend-paying companies are McDonald’s, Procter & Gamble, Kimberly Clark, PepsiCo, 3M, CocaCola, Johnson & Johnson, AT&T, Walmart, etc. We can use the Dividend Discount Model to value these companies.
#4 – What is the Difference between Enterprise value and equity valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.?
This is one of the most basic interview questions on valuation. Straightforward answer –
- Enterprise Value = Market value of operating assets
- Equity Value = Market value of shareholders’ equity
For more details, have a look at Enterprise value vs. Equity ValueEnterprise Value Vs. Equity ValueThe equity value is of two types: market equity value which is the total number of shares multiplied by market share price, and the book equity, which is the value of assets minus liabilities. In contrast, enterprise value is the total value of equity plus debt minus the company's amount of cash.
#5 – What is the difference between trailing PE and forward PE?
Trailing PE Ratio uses the Historical EPS, while Forward PEForward PEForward PE ratio uses the forecasted earnings per share of the company over the next 12 months for calculating the price-earnings ratio. Forward PE ratio formula = Price per share/Projected earnings per share Ratio uses the Forecast EPS. Let us look at the below example to calculate the Trailing PE vs. forward PE Ratio.
- Trailing Price Earning Ratio formula = $234 / $10 = $23.4x
- Forward Price Earning Ratio formula = $234 / $11 = $21.3x
For more details, have a look at Trailing PE vs. Forward PE
#6 – What are the most common multiples used in valuation?
This is another basic valuation interview question. There are few common trading valuation multiples which are frequently used in valuation –
- EV to EBITEV To EBITThe EV to EBIT ratio is an important valuation metric that determines whether a company's stock is expensive or cheap in comparison to the broader market or a competitor.
- Price to Cash FlowPrice To Cash FlowPrice to Cash Flow Ratio is a value indicator that measures a company's stock price in relation to the cash flow amount it generates. This is determined as the ratio of Price Per Share to Operating Cash Flow Per Share.
- Enterprise Value to SalesEnterprise Value To SalesEV to Sales Ratio is the valuation metric which is used to understand company’s total valuation compared to its sales. It is calculated by dividing enterprise value by annual sales of the company i.e. (Current Market Cap + Debt + Minority Interest + preferred shares – cash)/Revenue
- EV to EBITDAEV To EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.
- PEG RatioPEG RatioThe PEG ratio compares the P/E ratio of a company to its expected rate of growth. A PEG ratio of 1.0 or lower, on average, indicates that a stock is undervalued. A PEG ratio greater than 1.0 indicates that a stock is overvalued.
- Price to Book ValuePrice To Book ValuePrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share
- PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share.
#7 – How would you present these valuation methodologies to investors?
The best way to approach this is to do your homework first. If possible, find out the valuation of the firm using each methodology and then show it to the investors as a “football field” chart. One thing you need to remember is you should always show a range instead of a specific number as one needs to estimate many factors before coming to the conclusions.
Learn more about Investment Banking ChartsInvestment Banking ChartsThe top 4 investment banking charts an investment banking firm must be aware of while creating excellent financial and valuation models and its analysis include PE chart, PE band chart, football field graph and scenario graph. here
#8 – What are the three most used methodologies of valuation, and how would you rank them?
This is a pretty common question, but it’s often asked. You would say – discounted cash flowDiscounted Cash FlowDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance. analysis (DCF) Valuation, comparable comp analysis, and precedent transactions are the three most used methodologies for valuation. The question about ranking is tricky. Usually, precedent transactions are higher than the comparable companies as a control premiumA Control PremiumControl Premium is the additional consideration the stock buyers are willing to pay over and above the market price to gain a majority stake. To acquire a larger interest, the buyer has to offer a different price than the market price to attract existing shareholders in selling the shares. is built into it. In the case of DCF, it can go both ways (highest or lowest) depending on the assumptions you make during the calculation.
#9 – Other than these three, what are the other methodologies? Give a brief.
Other than the above 3, you can talk about the following methodologies –
- LBO Analysis: LBOLBOLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require. Analysis helps a firm determine how much PE a firm would be able to pay to hit the “target IRR” (generally, the “target IRR” happens to be in the range of 15-25%).
- Sum of the Parts: This has two steps. Firstly, each part is valued separately. And then, they are added together.
- Liquidation Valuation: The whole idea of Liquidation ValueLiquidation ValueLiquidation value is the value of assets that remain if the company goes out of business and is no more a going concern. Liquidation value is calculated only for tangible assets such as real estate, machinery, equipment, investment etc. is to imagine that all the assets of the company are sold off. And then, once the figure comes up, the liabilities are subtracted from the figure. This is the capital (if at all) equity investors receive.
- M&A Premiums Analysis: First, M&A deals are analyzed to figure out how much premium each buyer paid and then utilizing the information to find out how much the company is worth.
- Replacement Value: The valuation of replacing the assets of the company would be the replacement value.
#10 – What is precedent transactional analysis?
In simple words, the precedent transactional analysis is a valuation methodValuation MethodDiscounted cash flow, comparable company analysis, comparable transaction comps, asset valuation, and sum of parts are the five methods for valuing a company. that takes the past transactions of similar companies to value a company.
If we break down this method in a few steps, here are they –
- Firstly, similar companies are chosen based on similar features or being in a similar industry.
- Secondly, the size of the transactions should be similar.
- Thirdly, the type of transaction and the features of buyers would be the same.
- Fourthly, transactions that happened more recently have been considered more valuable.
- Fifthly, the estimate is being made on the basis of the above factors.
#11 – Are there any factors through which you can choose comparable companies?
This valuation interview question should be easy to answer. There are exactly three factors that are used to choose comparable companies.
- Firstly, the most important factor is the industry classification. This is most important because, on the basis of this, the companies can be easily compared at a high level.
- Secondly, you need to consider the financial criteria if you want to go more specific. Under financial criteria, you would look at revenue, EBITDA, EBITDAREBITDAREBITDAR (Earnings before interest, taxes, depreciation, amortization, and restructuring/rent) is a popular measure which is used to assess the company’s performance, this is not directly present on the income statement but can be calculated by using the information on the income statement by adding rent or restructuring costs to EBITDA., EBIT, etc.
- Thirdly, the last you should consider is geography.
Usually, the first factor (industry classification) is used most, and the least used factor is geography.
Valuation Interview Questions – Application
Let us have a look at the application-oriented valuation interview questions (with answers)
#12 – How do you value a bank?
This one is an expected valuation interview question. Be sure to answer this correctly.
Banks are primarily valued using Price to Book Value multiplePrice To Book Value MultiplePrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share . This is because of the following reasons –
- Banks have assets and liabilities which are periodically marked to marketMarked To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company's actual financial condition., as it is mandatory under regulations. So, the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. value represents the market value, unlike other industries where the Balance Sheet represents the historical cost of the assets/liabilities.
- Bank assets include investments in government bonds, high-grade corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. or municipal bonds, along with commercial, mortgage, or personal loans that are generally expected to be collectible.
The below graph shows a quick comparison of the Historical Book values of JPMorgan, UBS, Citigroup, and Morgan Stanley.
#13 – What are some examples of industry-specific multiples?
This one is another important valuation interview question. Industry-specific multiples vary as per the industrial factors. Let’s look at four examples –
- Real Estate Investment Trusts (REITs): Price / Funds from operations (FFOFFOFFO (Funds from Operations) is a term used to describe the cash flows generated by Real Estate Investment Trusts (REITs). It is calculated by deducting interest income and gains on asset sales from net income for the period and adding interest expense, depreciation, and losses on asset sales.); Price / Adjusted Funds from operations (AFFO)
- Retail or Airlines: Enterprise Value (EV) / Earnings before interests, taxes, depreciation, amortization, and rent (EBITDAR)
- Technology: EV / Unique Visitors; EV / Page-views
- Energy: Price (P) / Net Asset Value (NAV); P / 1 million cubic foot equivalent (MCFE); P / 1 million cubic foot equivalent per day (MCFE / D)
#14 – When would you use the sum of the parts?
The sum of the parts is mostly useful for companies that have several divisions unrelated to each other. For example, if a company has an energy division, consumer finance division, technology division, and media division, the sum of the parts would be pretty useful.
Let us understand the Sum of the Parts valuationSum Of The Parts ValuationSum of the Parts Valuation is a valuation method wherein each of the subsidiary or segment of a Company is separately valued & then all of them are added together to estimate the business’s total value. using an example of a large conglomerate company (ticker MOJO) that operates the following business segments.
- Automobile Segment Valuation – Automobile Segment could be best valued using EV/EBITDA or PE ratios.
- Oil and Gas Segment Valuation – For Oil and Gas companies, the best approach is to use EV/EBITDA or P/CF or EV/boe (EV/barrels of oil equivalent)
- Software Segment Valuation – We use PE or EV/EBIT multiple to value Software Segment
- Bank Segment Valuation – We generally use P/BV or Residual Income Method to value Banking Sector
- E-commerce Segment – We use EV/Sales to value the E-commerce segment (if the segment is not profitable) or EV/Subscriber or PE multiple
#15 – When would you use a liquidation valuation & when liquidation valuation will produce the highest value?
LiquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order. valuation is useful when there are any bankruptcy situations. If a company has a chance to go belly up, liquidation valuation will help to understand how much capital equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc. will get after the debts have been paid off.
Liquidation valuation producing high value is highly unlikely. But if the market is severely undervaluing assets for a particular reason and the firm has substantial hard assetsHard AssetsHard assets refer to physical or tangible items that can be touched and felt. An individual or company can possess such assets for long term usage with an expectation of value appreciation in future., it could be possible. Due to this, the company’s comparable companies and precedent transactions would generate lower values, and as assets are valued pretty highly, liquidation valuation will produce a higher value.
#16 – In the case of free cash flow multiples, what would you use – equity value or enterprise value?
There are two things to remember here. First, in the case of unlevered free cash flow, you need to use enterprise valueUse Enterprise ValueEnterprise Value is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover..
Below are the enterprise value multiples –
And, in the case of levered free cash flow, you should use equity value. Here’s why. In unlevered free cash flow, interest is excluded. Thus, money is available to investors. But in the case of levered free cash flow, interest is included; thus, it is only available to equity holders.
Below is the list of Equity Value Multiples –
Valuation Interview Questions – Advanced
Let us now look at some of the advanced Valuation Interview Questions.
#17 – Which is Better PE or EV To EBITDA
This one is a tricky valuation interview question. Most people use the PE ratio as the primary valuation tool. However, there are several limitations of PE Ratio due to which EV to EBITDA is considered to be a better valuation multiple.
- PE Ratio does not take balance sheet risk into consideration. The fundamental position of the company is not reflected correctly in PE Multiple.
- Different debt to equity structure can have a significant effect on the company’s earnings. Earnings can vary widely for companies that have debt due to a component of Interest Payments affecting the Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is..
- It cannot be used when earnings are negative. For example, Box Inc. You cannot simply find PE Multiple for such unprofitable companies. One must use normalized earnings or forward multiples in such cases.
- Earnings are subject to different accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.. It can be easily manipulated by management.
#18 – How do you value Box?
Have a look at the above Box IPOBox IPOThe analysis of the Box IPO valuation can be done using various methodologies which are Relative Valuation – SaaS Comparable Comps, Comparable Acquisition Analysis, Using Stock-Based Rewards, Valuation cues from Private Equity Funding, Valuation cues from Dropbox Private Equity Funding, and Discounted Cash Flow Approach for Box IPO Valuation. Financial model with forecasts. What we note is that BOX is making losses not only at the Operating but also at the Net Income Level. How do you value such companies that grow fast but are free cash flow negative?
In such cases, we cannot apply valuation multiples like PE ratioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. (due to negative earnings), EV to EBITDAEV To EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries. (if EBITDA is negative), or DCF approach (when FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders. is negative). The valuation tool that comes to our rescue is EV to Sales!
#19 – Can Terminal Value be Negative?
Another tricky valuation interview question. The answer is theoretically YES, Practically NO!
Theoretically, this can happen when the Terminal value is calculatedTerminal Value Is CalculatedThe terminal value formula helps in estimating the value of a business beyond the explicit forecast period. It includes the value of all cash flows, regardless of duration, and is an important component of the discounted cash flow model (DCF). using the perpetuity growth method.
In the formula above, if we assume WACC < growth rate, then the Terminal Value derived from the formula will be Negative. This is very difficult to digest as a high growth company is now showing a negative terminal value just because of the formula used. However, this high growth rate assumption is incorrect. We cannot assume that a company is going to grow at a very high rate until infinite.
For more details, please have a look at this detailed Guide to Terminal valueGuide To Terminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards.
#20 – When would you not use a DCF in valuation?
In two particular situations, you should never use DCF –
- Firstly, if the firm has unpredictable or unsteady cash flows;
- Secondly, when debt and working capital serve a completely different role altogether. For example, DCF is not used to value banks as banks and financial institutions don’t reinvest their debt and working capital.
#21 – Would an LBO or DCF give higher valuation? Why?
Usually, DCF will give a higher valuation. Unlike DCF, in LBO analysis, you won’t get any cash flow between year 1 and final year. So the analysis is done on the basis of terminal value only. In the case of DCF, the valuation is done both on the basis of cash flows and the values of the terminal; thus, it tends to be higher.
Moreover, in LBO, an expected IRR (Internal Rate of ReturnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.) is set up, and then the valuation is done.
#22 – Let’s say that a company has no profit and no revenue. How would you value that company?
The simplest way to look at it is to answer that is to say that the valuation of the company would be done by using other metrics. As there is no profit and no revenue, there won’t be any cash flow. Thus, using creative multiples that will go with the inherent nature of the business will do the trick.
#23 – How would you value a mango tree?
This may seem to be a tricky question, but if you think it through, it’s actually not.
When you are asked this question, you would simply say that the mango tree would be valued as a company can be valued – first by glancing toward the comparable mango trees and what they are worth (i.e., relative valuation) and then finding out the value of the mango tree’s cash flows (i.e., intrinsic valuation).
#24 – What are the flaws with public company comparables?
There may be various flaws with public company comparables. But the following three stands out –
- The stock market doesn’t have a fixed way of reacting. It reacts impulsively to the events or happenings in the market. So, it is very difficult to predict the reaction of the stock market on a given day. Thus, the factors you use may not help you at all.
- A 100% comparison of one company with another is never possible. There will always be room for error.
- The smallest companies have tiniest stocks. And these stocks may not always reflect the actual value of the company.
#25 – How would you value a private company?
Valuing a private companyPrivate CompanyA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. is slightly different than valuing a public company. Of course, you will use the comparables, precedent transactions, DCF, but here are few differences –
- First of all, you need to think about the liquidity of the private company. Naturally, private companies wouldn’t be as liquid as public companies. Thus, while valuing the private company, the discounting rate would increase.
- It wouldn’t be possible to use future share price analysis; because there would be none.
- DCF becomes very difficult as there is no beta in the case of a private company.
In the case of a private company, the enterprise value would be taken into account.
Valuation Interview Questions and Answers Video
This article has been a guide to the Top 25 Valuation interview questions with answers. Here we’ve divided these questions into the basic, application, and advanced questions on valuation. There are many more questions that can be asked in the valuation interview. But the above are the top 25 questions on valuation that have been asked again and again.
So, prepare your fundamentals first before going into any valuation interview and keep this list of questions and answers handy so that you can refer back to them whenever you would require. We wish you all the best for your valuation interview!
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