Valuation Interview Questions

I would value a company three ways: trading comparables, precedent transactions, and a discounted cash flow (DCF) analysis. Each method gives a range of values. I would put the three ranges side by side on a 'football field' chart and settle on a triangulated value range. The relative methods show what the market and past buyers pay for similar companies. The DCF shows what the company's own future cash flows are worth. With all three, one method's weakness does not decide the answer.

Use EV / NTM Revenue. Fraud prevention companies are mostly high-growth software businesses, and many peers are unprofitable or run thin margins, so EBITDA and earnings multiples come out negative or meaningless across the peer set. Revenue is positive and comparable for every peer. Forward (next-twelve-months) revenue captures the growth that drives value in this sector.

Net income increases $40mm, cash increases $140mm, and total assets and shareholders' equity each increase $40mm. The gain is $50mm: the $150mm sale price less the $100mm book value, which is what the asset is carried at on the balance sheet after accumulated depreciation. At a 20% tax rate that gain adds $40mm to net income and sends $10mm out the door as tax. Cash picks up the full $150mm of proceeds less that $10mm. The balance sheet still balances, because cash is up $140mm while the PP&E line comes off at its $100mm book value.

A company trades at a higher P/E (price-to-earnings ratio: share price divided by earnings per share) in four cases: investors expect faster earnings growth, its cost of equity is lower (the return shareholders require, which is lower when the business is less risky), it pays out more of its earnings at the same growth rate, or its current earnings are temporarily depressed. The first three come straight out of a dividend discount model. The fourth is a denominator effect. The price reflects normal future earnings, but the ratio divides by a trough figure.

Dilutive, before synergies and other deal adjustments. In an all-stock deal, a buyer with a lower P/E (share price divided by earnings per share) issues shares valued at a low multiple to buy earnings priced at a higher one. Its earnings per share (EPS) fall. Synergies, or paying partly with cash or debt, can make the deal accretive, meaning EPS rise. A lower purchase price reduces the dilution.

We use EV/Revenue because revenue stays positive and meaningful when profit measures like EBITDA (earnings before interest, taxes, depreciation and amortization) and net income are negative or distorted. That is common at early-stage, fast-growing, or cyclically depressed companies. Revenue pairs with enterprise value (EV, the value of the whole business to both lenders and shareholders) because revenue is earned before any interest is paid. So it belongs to all capital providers.

The discount rate turns money you expect to get later into what it is worth today. It combines three things: the time value of money (a dollar today is worth more than a dollar next year), a risk premium (extra return demanded because each year's payoff is uncertain, either $100 or $0, to the extent that risk can't be diversified away), and opportunity cost (the return the client gives up by not putting the $100 into another investment of similar risk). Skip it and you treat $50 expected in year 10 as equal to $50 in hand today. That overstates the coin's value.

Valuation rises, assuming the accelerated schedule applies for tax and the company pays taxes. Total depreciation over the asset's life stays the same. Accelerated depreciation moves more of it into the early years, so the tax savings arrive sooner, and cash received sooner is worth more in present value. Reported net income is lower in the early years, but cash flow is higher, and a DCF values cash flow, not net income.

Company A pays $6.00 per Company B share. At 7x EBITDA, Company B's enterprise value (what the whole business is worth to lenders and shareholders together) is 7 × 100 = 700. Debt is 4x EBITDA, or 400. That leaves 300 of equity value for B's 50 shares, which is $6.00 per share. Paying in stock changes how A pays. The price stays the same: A issues its own shares worth that amount.

The equity is worth $0. Enterprise value (the value of the whole business to all its lenders and owners) is $50mm of EBITDA (earnings before interest, taxes, depreciation and amortization, a rough proxy for operating cash flow) × 4 = $200mm. That is $100mm short of the $300mm of debt. Shareholders are paid last and have limited liability, so their stake stops at zero and cannot go negative. Walk the $200mm down the claims in order of priority. The $100mm of senior debt (paid first) is covered twice over and should trade at or near par, meaning 100 cents per dollar of face value. The $200mm of junior debt (paid after senior) gets the remaining $100mm and should trade near 50 cents on the dollar.

Because the top and bottom of a multiple have to describe the same claim on the business. Revenue and EBITDA (earnings before interest, taxes, depreciation and amortization) are struck before any interest is paid, so they belong to everyone who funded the company, lenders and shareholders alike. That whole-company value is Enterprise Value. Equity Value is what is left for shareholders once the lenders have been paid, so putting it over a pre-interest metric like Revenue or EBITDA sets a partial claim against a full-company profit stream.

Accretive. Company A's earnings per share (EPS, net income divided by shares outstanding) rises from $1.00 to $1.25, up 25%. Assuming A pays B's $150 market value with no premium, it issues $150 ÷ $25 = 6 new shares, so the combined $20 of net income is spread over 16 shares. The shortcut: A's stock trades at 25x earnings (its P/E, or price-to-earnings ratio) and it buys B at 15x. Paying with stock for earnings priced below your own P/E is accretive.