400 Finance Interview Questions PDF

The 400 Investment Banking Interview Questions & Answers You Need to Know A Production...

The 400 Investment Banking Interview Questions & Answers You Need to Know A Production http://breakingintowallstreet.com http://www.mergersandinquisitions.com Licensed to Brian Walker of , , -. Email address: [email protected]  Copyright 2008 – 2011 Capital Capable Media LLC. All Rights Reserved. Notice of Rights No part of this book may be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 2 Licensed to Brian Walker of , , -. Email address: [email protected]  Table of Contents – Technical Questions Introduction...................................................................................................3 Technical Questions & Answers.................................................................5 Accounting Questions & Answers – Basic............................................6 Accounting Questions & Answers – Advanced................................ 19 Enterprise / Equity Value Questions & Answers – Basic................. 25 Enterprise / Equity Value Questions & Answers – Advanced........ 30 Valuation Questions & Answers – Basic............................................. 32 Valuation Questions & Answers – Advanced................................... 43 Discounted Cash Flow Questions & Answers – Basic...................... 49 Discounted Cash Flow Questions & Answers – Advanced............. 58 Merger Model Questions & Answers – Basic..................................... 61 Merger Model Questions & Answers – Advanced........................... 69 LBO Model Questions & Answers – Basic.......................................... 78 LBO Model Questions & Answers – Advanced................................ 85 Brain Teaser Questions & Answers..................................................... 92 Introduction This guide has one purpose: to help you answer the most important “fit” and technical questions in investment banking interviews. We tell you what’s important and what you need to say – nothing more and nothing less. Most other guides suffer from several problems: 1. The information is not investment banking-specific. Do you think you’re going to get a question about “Why you’re interested in this position?” I’ll tell you why you’re interested – because you want to make a lot of money! 2. The information is out-of-date, wrong or incomplete (see: The Vault Guide). These days, interviewers assume you know the basics – like how to value a company – and go beyond that with advanced questions that require thinking more than memorization. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 3 Licensed to Brian Walker of , , -. Email address: [email protected]  3. No answers are provided, or there’s minimal direction (see: The Recruiting Guide to Investment Banking). Of course, you shouldn’t memorize answers word-for- word, but it’s helpful to have an idea of how you might structure your answers. 4. The questions do not apply to interviewees from diverse backgrounds. If you worked at Goldman Sachs this past summer it’s not hard to convince them you’re serious about finance – but what if you didn’t? What if you’re making a career transition or you’re coming in as a more experienced hire? That’s what this guide is for. 5. The guides were not written by bankers. If you doubt my credentials, just refer to Mergers & Inquisitions, where I’ve written over 300 detailed articles on networking, resumes, interviews, and recruiting for investment banking and private equity. The proof is in the pudding. Your time is limited – so we get you the answers you need, when you need them (right now). What follows is a list of 400 investment banking interview questions and answers, divided into different types of “fit” questions (personal, team / leadership, “why banking,” etc.), technical questions (accounting, valuation, DCF, merger models and LBO models, and brain teasers), and other topics (restructuring, distressed M&A, and discussing transactions). This guide is quite length, but you don’t have to read everything. Pick and choose which sections are most relevant to you. I recommend reviewing the table of contents first and then skipping to the questions you are most in need of understanding. Or you can read the entire guide all at once as well – it’s up to you. In either case, though, the key is to apply what you’re learning and test yourself. Rather than reading everything passively, try to answer each question – and then check whether or not you got it right. Do that, and you’ll be several steps closer to landing investment banking offers. -Brian Mergers & Inquisitions Breaking Into Wall Street http://breakingintowallstreet.com http://www.mergersandinquisitions.com 4 Licensed to Brian Walker of , , -. Email address: [email protected]  Technical Questions & Answers Technical Questions no longer consist entirely of “How would you value a company?” and “How does Depreciation going up by $10 affect all the statements?” Sure, you may still get these questions – and we do cover them in detail below. But these days interviewers are going beyond the basics that everyone knows and asking questions that make you think instead. There are an infinite number of Technical Questions and it’s impossible to list everything you might encounter here – but these are the most common basic and advanced questions you might get. For Technical Questions there is almost always a “right answer” so we’ll go through exact answers here as well. If you find yourself not knowing the answer to a Technical Question, you shouldn’t try to fake it – just admit that you don’t know rather than stumbling through the answer. There are a few exceptions – you really do need to know the basic concepts, like simple accounting and valuation. For more advanced modeling, there’s more leeway to say that you don’t have much experience or don’t know the specific answer. If you want to learn everything behind the questions here in-depth, you should check out the Financial Modeling Fundamentals Program at a special, members-only discounted rate right here: Financial Modeling Fundamentals – Members-Only Discount You must be logged into the site to view that page. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 5 Licensed to Brian Walker of , , -. Email address: [email protected]  Accounting Questions & Answers – Basic Here are the 5 most important Accounting concepts you need to know: 1. The 3 financial statements and what each one means. 2. How the 3 statements link together and how to walk through questions where one or multiple items change. 3. Different methods of accounting – cash-based vs. accrual, and determining when revenue and expenses are recognized. 4. When to expense something and when to capitalize it. Not all expenses are created equal. 5. What individual items on the statements, like Goodwill, Other Intangibles and Shareholders’ Equity, actually mean. The questions below will cover all these concepts. 1. Walk me through the 3 financial statements. “The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company’s Assets – its resources – such as Cash, Inventory and PP&E, as well as its Liabilities – such as Debt and Accounts Payable – and Shareholders’ Equity. Assets must equal Liabilities plus Shareholders’ Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company’s net change in cash.” 2. Can you give examples of major line items on each of the financial statements? Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 6 Licensed to Brian Walker of , , -. Email address: [email protected]  Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity. Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing. 3. How do the 3 statements link together? “To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders’ Equity. The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.” 4. If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company – which statement would I use and why? You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that’s the #1 thing you care about when analyzing the overall financial health of any business – its cash flow. 5. Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why? You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking). 6. Walk me through how Depreciation going up by $10 would affect the statements. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 7 Licensed to Brian Walker of , , -. Email address: [email protected]  Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6 and both sides of the Balance Sheet balance. Note: With this type of question I always recommend going in the order: 1. Income Statement 2. Cash Flow Statement 3. Balance Sheet This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow. 7. If Depreciation is a non-cash expense, why does it affect the cash balance? Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay. 8. Where does Depreciation usually show up on the Income Statement? It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses – every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income. 9. What happens when Accrued Compensation goes up by $10? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 8 Licensed to Brian Walker of , , -. Email address: [email protected]  For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance. 10. What happens when Inventory goes up by $10, assuming you pay for it with cash? No changes to the Income Statement. On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity. 11. Why is the Income Statement not affected by changes in Inventory? This is a common interview mistake – incorrectly stating that Working Capital changes show up on the Income Statement. In the case of Inventory, the expense is only recorded when the goods associated with it are sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it. 12. Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens? At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet). http://breakingintowallstreet.com http://www.mergersandinquisitions.com 9 Licensed to Brian Walker of , , -. Email address: [email protected]  On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance. 13. Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens? After a year has passed, Apple must pay interest expense and must record the depreciation. Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income would fall by $12. On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That’s the only change on the Cash Flow Statement, so overall Cash is down by $2. On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance. Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 10 Licensed to Brian Walker of , , -. Email address: [email protected]  14. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements. After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. On the Cash Flow Statement, Net Income is down by $48 but the write-down is a non- cash expense, so we add it back – and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100. Overall, the Net Change in Cash falls by $68. On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance. 15. Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements? No changes to the Income Statement. Cash Flow Statement – Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10. On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 11 Licensed to Brian Walker of , , -. Email address: [email protected]  16. Now let’s say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario. Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPads), which is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders’ Equity is up by $6 and both sides balance. 17. Could you ever end up with negative shareholders’ equity? What does it mean? Yes. It is common to see this in 2 scenarios: 1. Leveraged Buyouts with dividend recapitalizations – it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. 2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders’ Equity. It doesn’t “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario). Note: Shareholders’ equity never turns negative immediately after an LBO – it would only happen following a dividend recap or continued net losses. 18. What is Working Capital? How is it used? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 12 Licensed to Brian Walker of , , -. Email address: [email protected]  Working Capital = Current Assets – Current Liabilities. If it’s positive, it means a company can pay off its short-term liabilities with its short- term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.” Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt). The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation. 19. What does negative Working Capital mean? Is that a bad sign? Not necessarily. It depends on the type of company and the specific situation – here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance). 20. Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a write- down of $100. First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. On the Cash Flow Statement, Net Income is down by $60 but the write-down is a non- cash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 13 Licensed to Brian Walker of , , -. Email address: [email protected]  On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it’s not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders’ Equity is also down by $60 – and both sides balance. 21. Walk me through a $100 “bailout” of a company and how it affects the 3 statements. First, confirm what type of “bailout” this is – Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here’s what happens: No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government’s investment, so the Net Change in Cash is up by $100. On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders’ Equity would go up by $100 to make it balance. 22. Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s balance sheet and how it affects the 3 statements. This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it balances. If this seems strange to you, you’re not alone – see this Forbes article for more on why writing down debt actually benefits companies accounting-wise: http://breakingintowallstreet.com http://www.mergersandinquisitions.com 14 Licensed to Brian Walker of , , -. Email address: [email protected]  http://www.forbes.com/2009/07/31/fair-value-accounting-markets-equities-fasb.html 23. When would a company collect cash from a customer and not record it as revenue? Three examples come to mind: 1. Web-based subscription software. 2. Cell phone carriers that sell annual contracts. 3. Magazine publishers that sell subscriptions. Companies that agree to services in the future often collect cash upfront to ensure stable revenue – this makes investors happy as well since they can better predict a company’s performance. Per the rules of accounting, you only record revenue when you actually perform the services – so the company would not record everything as revenue right away. 24. If cash collected is not recorded as revenue, what happens to it? Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. Over time, as the services are performed, the Deferred Revenue balance becomes real revenue on the Income Statement and the Deferred Revenue balance decreases. 25. What’s the difference between accounts receivable and deferred revenue? Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it has already collected in cash but is waiting to record as revenue. 26. How long does it usually take for a company to collect its accounts receivable balance? Generally the accounts receivable days are in the 30-60 day range, though it’s higher for companies selling high-end items and it might be lower for smaller, lower transaction- value companies. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 15 Licensed to Brian Walker of , , -. Email address: [email protected]  27. What’s the difference between cash-based and accrual accounting? Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements. 28. Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting? In cash-based accounting, the revenue would not show up until the company charges the customer’s credit card, receives authorization, and deposits the funds in its bank account – at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet. In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” Cash. 29. How do you decide when to capitalize rather than expense a purchase? If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead. 30. Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings? These days, many companies have “non-cash” charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no http://breakingintowallstreet.com http://www.mergersandinquisitions.com 16 Licensed to Brian Walker of , , -. Email address: [email protected]  longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded. 31. A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen? Several possibilities: 1. The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company’s debt all matures on one date and it is unable to refinance it due to a “credit crunch” – and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company. Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges – and all of these could end up bankrupting the company. 32. Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean? Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. It often happens in acquisitions where the buyer “overpaid” for the seller and can result in a large net loss on the Income Statement (see: eBay/Skype). It can also happen when a company discontinues part of its operations and must impair the associated goodwill. 33. Under what circumstances would Goodwill increase? Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios: 1. The company gets acquired or bought out and Goodwill changes as a result, since it’s an accounting “plug” for the purchase price in an acquisition. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 17 Licensed to Brian Walker of , , -. Email address: [email protected]  2. The company acquires another company and pays more than what its assets are worth – this is then reflected in the Goodwill number. 34. What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ? First, note that this question does not apply to you if you’re outside the US as IFRS does not permit the use of LIFO. But you may want to read this anyway because it’s good to know in case you ever work with US-based companies. LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2 different ways of recording the value of inventory and the Cost of Goods Sold (COGS). With LIFO, you use the value of the most recent inventory additions for COGS, but with FIFO you use the value of the oldest inventory additions for COGS. Here’s an example: let’s say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4. You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40 * $30 or $1,200 for the annual revenue. The difference is that in LIFO, you would use the 40 most recent inventory purchase values – $120 + $150 + $170 + $200 – for the Cost of Goods Sold, whereas in FIFO you would use the 40 oldest inventory values – $100 + $120 + $150 + $170 – for COGS. As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending inventory value would be $100 higher under FIFO and $100 lower under FIFO. In general if inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending inventory values and vice versa if inventory is getting cheaper to purchase. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 18 Licensed to Brian Walker of , , -. Email address: [email protected]  Accounting Questions & Answers – Advanced These more advanced questions cover topics like deferred tax assets and liabilities and how to actually project a company’s financial statements in an operating model. You may get some of these in investment banking interviews, but they’re more common if you’ve had significant finance experience or you’re interviewing for private equity, or with a more technical group. 1. How is GAAP accounting different from tax accounting? 1. GAAP is accrual-based but tax is cash-based. 2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation). 3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe. 2. What are deferred tax assets/liabilities and how do they arise? They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes. Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet. They’re most common with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset (see the Merger Model section for more on this). 3. Walk me through how you create a revenue model for a company. There are 2 ways you could do this: a bottoms-up build and a tops-down build. Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 19 Licensed to Brian Walker of , , -. Email address: [email protected]  Tops-Down: Start with “big-picture” metrics like overall market size, then estimate the company’s market share and how that will change in coming years, and multiply to get to their revenue. Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible. 4. Walk me through how you create an expense model for a company. To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward. Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. Cost of Goods Sold should be tied directly to Revenue and each “unit” produced should incur an expense. Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue for a more simple model. 5. Let’s say we’re trying to create these models but don’t have enough information or the company doesn’t tell us enough in its filings – what do we do? Use estimates. For the revenue if you don’t have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years. For the expenses, if you don’t have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward. 6. Walk me through the major items in Shareholders’ Equity. Common items include: http://breakingintowallstreet.com http://www.mergersandinquisitions.com 20 Licensed to Brian Walker of , , -. Email address: [email protected]  Common Stock – Simply the par value of however much stock the company has issued. Retained Earnings – How much of the company’s Net Income it has “saved up” over time. Additional Paid in Capital – This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering. Treasury Stock – The dollar amount of shares that the company has bought back. Accumulated Other Comprehensive Income – This is a “catch-all” that includes other items that don’t fit anywhere else, like the effect of foreign currency exchange rates changing. 7. Walk me through what flows into Retained Earnings. Retained Earnings = Old Retained Earnings Balance + Net Income – Dividends Issued If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends. 8. Walk me through what flows into Additional Paid-In Capital (APIC). APIC = Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises Take the balance from last year, add this year’s stock-based compensation number, and then add in the value of new stock created by employees exercising options this year. 9. What is the Statement of Shareholders’ Equity and why do we use it? This statement shows everything we went through above – the major items that comprise Shareholders’ Equity, and how we arrive at each of them using the numbers elsewhere in the statement. You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 21 Licensed to Brian Walker of , , -. Email address: [email protected]  10. What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements? Restructuring Charges Goodwill Impairment Asset Write-Downs Bad Debt Expenses Legal Expenses Disaster Expenses Change in Accounting Procedures Note that to be an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges “below the line” then you do not add it back for the EBITDA / EBIT calculation. Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not “non-recurring charges” because all companies have them every year – these are just non-cash charges. 11. How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model? Normally you make very simple assumptions and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples: Accounts Receivable: % of revenue. Deferred Revenue: % of revenue. Accounts Payable: % of COGS. Accrued Expenses: % of operating expenses or SG&A. Then you either carry the same percentages across in future years or assume slight changes depending on the company. 12. How should you project Depreciation and Capital Expenditures? The simple way: project each one as a % of revenue or previous PP&E balance. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 22 Licensed to Brian Walker of , , -. Email address: [email protected]  The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset’s useful life, and then assumes capital expenditures based on what the company has invested historically. 13. How do Net Operating Losses (NOLs) affect a company’s 3 statements? The “quick and dirty” way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same). The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet. This method reflects the fact that you’re saving on cash flow – since the DTL, a liability, is rising – but correctly separates the NOL impact into book vs. cash taxes. 14. What’s the difference between capital leases and operating leases? Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement. Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt. A lease is a capital lease if any one of the following 4 conditions is true: 1. If there’s a transfer of ownership at the end of the term. 2. If there’s an option to purchase the asset at a bargain price at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset’s fair market value. 15. Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 23 Licensed to Brian Walker of , , -. Email address: [email protected]  This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 24 Licensed to Brian Walker of , , -. Email address: [email protected]  Enterprise / Equity Value Questions & Answers – Basic For the most part, Enterprise Value and Equity Value questions are straightforward. Just make sure you know all the relevant formulas and understand concepts like the Treasury Stock Method for calculating diluted shares. 1. Why do we look at both Enterprise Value and Equity Value? Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value. 2. When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value? Enterprise Value, because that’s how much an acquirer really “pays” and includes the often mandatory debt repayment. 3. What’s the formula for Enterprise Value? EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest – Cash This formula does not tell the whole story and can get more complex – see the Advanced Questions. Most of the time you can get away with stating this formula in an interview, though. “Noncontrolling Interest” was formerly known as Minority Interest and some bankers still call it that. 4. Why do you need to add the Noncontrolling Interest to Enterprise Value? Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. So even though it doesn’t own 100%, it reports 100% of the majority-owned subsidiary’s financial performance. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 25 Licensed to Brian Walker of , , -. Email address: [email protected]  In keeping with the “apples-to-apples” theme, you must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary. 5. How do you calculate fully diluted shares? Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt or convertible preferred stock. To calculate the dilutive effect of options, you use the Treasury Stock Method (detail on this below). 6. Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each – what is its fully diluted equity value? Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all “in-the-money” – their exercise price is less than the current share price. When these options are exercised, there will be 10 new shares created – so the share count is now 110 rather than 100. However, that doesn’t tell the whole story. In order to exercise the options, we had to “pay” the company $5 for each option (the exercise price). As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created. So the fully diluted share count is 105, and the fully diluted equity value is $1,050. 7. Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each – what is its fully diluted equity value? $1,000. In this case the options’ exercise price is above the current share price, so they have no dilutive effect. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 26 Licensed to Brian Walker of , , -. Email address: [email protected]  8. Why do you subtract cash in the formula for Enterprise Value? Is that always accurate? The “official” reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to “pay” to acquire another company. It’s not always accurate because technically you should be subtracting only excess cash – the amount of cash a company has above the minimum cash it requires to operate. 9. Is it always accurate to add Debt to Equity Value when calculating Enterprise Value? In most cases, yes, because the terms of a debt agreement usually say that debt must be refinanced in an acquisition. And in most cases a buyer will pay off a seller’s debt, so it is accurate to say that any debt “adds” to the purchase price. However, there could always be exceptions where the buyer does not pay off the debt. These are rare and I’ve personally never seen it, but once again “never say never” applies. 10. Could a company have a negative Enterprise Value? What would that mean? Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You see it with: 1. Companies on the brink of bankruptcy. 2. Financial institutions, such as banks, that have large cash balances – but Enterprise Value is not even used for commercial banks in the first place so this doesn’t matter much. 11. Could a company have a negative Equity Value? What would that mean? No. This is not possible because you cannot have a negative share count and you cannot have a negative share price. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 27 Licensed to Brian Walker of , , -. Email address: [email protected]  12. Why do we add Preferred Stock to get to Enterprise Value? Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock. 13. How do you account for convertible bonds in the Enterprise Value formula? If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the convertibles as part of the company’s Debt. 14. A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding? This gets confusing because of the different units involved. First, note that these convertible bonds are in-the-money because the company’s share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt. Next, we need to divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to figure out how many individual bonds we get: $10 million / $1,000 = 10,000 convertible bonds. Next, we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: $1,000 / $50 = 20 shares per bond. So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding. We do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us. 15. What’s the difference between Equity Value and Shareholders’ Equity? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 28 Licensed to Brian Walker of , , -. Email address: [email protected]  Equity Value is the market value and Shareholders’ Equity is the book value. Equity Value can never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be any value. For healthy companies, Equity Value usually far exceeds Shareholders’ Equity. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 29 Licensed to Brian Walker of , , -. Email address: [email protected]  Enterprise / Equity Value Questions & Answers – Advanced These more advanced questions cover some of the “problems” with the traditional formula for Enterprise Value, as well as details about book value and market value. You’re not likely to get these in the standard entry-level investment banking interview, but it’s always good to be prepared. 1. Are there any problems with the Enterprise Value formula you just gave me? Yes – it’s too simple. There are lots of other things you need to add into the formula with real companies: Net Operating Losses – Should be valued and arguably added in, similar to cash. Long-Term Investments – These should be counted, similar to cash. Equity Investments – Any investments in other companies should also be added in, similar to cash (though they might be discounted). Capital Leases – Like debt, these have interest payments – so they should be added in like debt. (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well. Unfunded Pension Obligations – Sometimes these are counted as debt as well. So a more “correct” formula would be Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest – NOLs – LT and Equity Investments + Capital Leases + Unfunded Pension Obligations… In interviews, usually you can get away with saying “Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest” I mention this here because in more advanced interviews you might get questions on this topic. 2. Should you use the book value or market value of each item when calculating Enterprise Value? Technically, you should use market value for everything. In practice, however, you usually use market value only for the Equity Value portion, because it’s almost http://breakingintowallstreet.com http://www.mergersandinquisitions.com 30 Licensed to Brian Walker of , , -. Email address: [email protected]  impossible to establish market values for the rest of the items in the formula – so you just take the numbers from the company’s Balance Sheet. 3. What percentage dilution in Equity Value is “too high?” There’s no strict “rule” here but most bankers would say that anything over 10% is odd. If your basic Equity Value is $100 million and the diluted Equity Value is $115 million, you might want to check your calculations – it’s not necessarily wrong, but over 10% dilution is unusual for most companies. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 31 Licensed to Brian Walker of , , -. Email address: [email protected]  Valuation Questions & Answers – Basic These days, you need to have a better-than-average understanding of Valuation. Forget about just knowing the 3 methodologies – you need to understand how and why they’re used, which ones produce the highest or lowest values and also keep in mind exceptions to each “rule.” 1. What are the 3 major valuation methodologies? Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis. 2. Rank the 3 valuation methodologies from highest to lowest expected value. Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions. 3. When would you not use a DCF in a Valuation? You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies. 4. What other Valuation methodologies are there? Other methodologies include: Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive Replacement Value – Valuing a company based on the cost of replacing its assets LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range http://breakingintowallstreet.com http://www.mergersandinquisitions.com 32 Licensed to Brian Walker of , , -. Email address: [email protected]  Sum of the Parts – Valuing each division of a company separately and adding them together at the end M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value 5. When would you use a Liquidation Valuation? This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it’s better to sell off assets separately or to try and sell the entire company. 6. When would you use Sum of the Parts? This is most often used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value. 7. When do you use an LBO Analysis as part of your Valuation? Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a “floor” on a possible Valuation for the company you’re looking at. 8. What are the most common multiples used in Valuation? The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share). http://breakingintowallstreet.com http://www.mergersandinquisitions.com 33 Licensed to Brian Walker of , , -. Email address: [email protected]  9. What are some examples of industry-specific multiples? Technology (Internet): EV / Unique Visitors, EV / Pageviews Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations) Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize (a portion of) their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating. 10. When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value? You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to. 11. Would an LBO or DCF give a higher valuation? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 34 Licensed to Brian Walker of , , -. Email address: [email protected]  Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value. With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that. 12. How would you present these Valuation methodologies to a company or its investors? Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. As an example, see page 10 of this document (a Valuation done by Credit Suisse for the Leveraged Buyout of Sungard Data Systems in 2005): http://edgar.sec.gov/Archives/edgar/data/789388/000119312505074184/dex99c2.htm 13. How would you value an apple tree? The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation). Yes, you could do a DCF for anything – even an apple tree. 14. Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 35 Licensed to Brian Walker of , , -. Email address: [email protected]  EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only the part available to equity investors. 15. When would a Liquidation Valuation produce the highest value? This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies. 16. Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it? You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway! 17. What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value? Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered FCF already includes the effects of the http://breakingintowallstreet.com http://www.mergersandinquisitions.com 36 Licensed to Brian Walker of , , -. Email address: [email protected]  Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors. Debt investors have already “been paid” with the interest payments and principal re payments they received. 18. You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue? It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead. You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the non- financial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway. 19. How do you select Comparable Companies / Precedent Transactions? The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be. Here are a few examples: Comparable Company Screen: Oil & gas producers with market caps over $5 billion http://breakingintowallstreet.com http://www.mergersandinquisitions.com 37 Licensed to Brian Walker of , , -. Email address: [email protected]  Comparable Company Screen: Digital media companies with over $100 million in revenue Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue Precedent Transaction Screen: Retail M&A transactions over the past year 20. How do you apply the 3 valuation methodologies to actually get a value for the company you’re looking at? Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing. Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion. To get the “football field” valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology. 21. What do you actually use a valuation for? Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation. It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance. 22. Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium? http://breakingintowallstreet.com http://www.mergersandinquisitions.com 38 Licensed to Brian Walker of , , -. Email address: [email protected]  This could happen for a number of reasons: The company has just reported earnings well-above expectations and its stock price has risen recently. It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. It has just won a favorable ruling in a major lawsuit. It is the market leader in an industry and has greater market share than its competitors. 23. What are the flaws with public company comparables? No company is 100% comparable to another company. The stock market is “emotional” – your multiples might be dramatically higher or lower on certain dates depending on the market’s movements. Share prices for small companies with thinly-traded stocks may not reflect their full value. 24. How do you take into account a company’s competitive advantage in a valuation? 1. Look at the 75th percentile or higher for the multiples rather than the Medians. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. In practice you rarely do all of the above – these are just possibilities. 25. Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions? There’s no “rule” that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead – and vice versa if it’s doing well. 26. You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case? Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently http://breakingintowallstreet.com http://www.mergersandinquisitions.com 39 Licensed to Brian Walker of , , -. Email address: [email protected]  but there have been a lot of small private companies acquired at extremely low valuations. For the most part this generalization is true but there are exceptions to almost every “rule” in finance. 27. What are some flaws with precedent transactions? Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects. Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies. 28. Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen? Possible reasons: 1. One process was more competitive and had a lot more companies bidding on the target. 2. One company had recent bad news or a depressed stock price so it was acquired at a discount. 3. They were in industries with different median multiples. 29. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples? Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?” He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations. In some industries there is also a large gap between EBIT and EBITDA – anything that is very capital-intensive, for example, will show a big disparity. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 40 Licensed to Brian Walker of , , -. Email address: [email protected]  Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx. 30. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability. What’s the difference between them, and when do you use each one? P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it – you’re more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies). 31. If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant. You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher. 32. How do you value a private company? You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences: You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps. You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 41 Licensed to Brian Walker of , , -. Email address: [email protected]  Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies. A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it. 33. Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples? There’s no discount because with precedent transactions, you’re acquiring the entire company – and once it’s acquired, the shares immediately become illiquid. But shares – the ability to buy individual “pieces” of a company rather than the whole thing – can be either liquid (if it’s public) or illiquid (if it’s private). Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this. 34. Can you use private companies as part of your valuation? Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta. http://breakingintowallstreet.com http://www.mergersandinquisitions.com 42 Licensed to Brian Walker of , , -. Email address: [email protected]  Valuation Questions & Answers – Advanced These more advanced questions cover industry-specific valuation in more detail, as well as scenarios like IPO valuation, M&A premiums, and future share price analysis that are not likely to come up in entry-level interviews – but which could come up if you’re going for more advanced positions. 1. How do you value banks and financial institutions differently from other companies? For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different: You screen based on assets or deposits in addition to the normal criteria. You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on. You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA. Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation: In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple. In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations. You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps. 2. Walk me through an IPO valuation for a company that’s about to go public.