IB Valuation Questions Flashcards
Could you explain the concept of present value and how it relates to company valuations?
The present value concept is based on the premise that “a dollar in the present is worth more than a dollar in the future” due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today.
For intrinsic valuation methods (DCF, DDM), the value of a company will be equal to the sum of the present value of all the future cash flows it generates.
A company with a high valuation would imply
it receives high returns on its invested capital by investing in positive net present value (“NPV”) projects
consistently while having low risk associated with its cash flows.
What is equity value and how is it calculated?
market capitalization (“market cap”), equity value represents a company’s value to its equity shareholders.
Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding
(Represents just the residual value to equity holders)
Affected by financing decisions
How do you calculate the fully diluted number of shares outstanding?
Use the treasury stock method (“TSM”). Used to calculate the fully diluted number of shares
outstanding based on the options, warrants, and other dilutive securities that are currently
“in-the-money” (i.e., profitable to exercise).
The TSM involves summing up the number of in-the-money (“ITM”) options and warrants
and then adding that figure to the number of basic shares outstanding.
In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact.
How do you calculate equity value from enterprise value?
Equity Value = Enterprise Value – Net Debt – Preferred Stock – Minority Interest
What is enterprise value and how do you calculate it?
Enterprise value pertains to all
providers of capital.
The value of the operations of a
company to all stakeholders including common shareholders, preferred shareholders, and debt lenders. Thus, enterprise value is considered capital structure neutral
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
Which line items are included in the calculation of net debt?
Net Debt = Total Debt – Cash & Equivalents
Accounts for all interest-bearing debt, such as short-term and long- term loans and bonds, as well as non-equity financial claims (preferred stock and non-controlling interests).
When calculating enterprise value, why do we add net debt?
Because cash on a company’s balance sheet could pay down the outstanding
debt if needed.
What is the difference between enterprise value and equity value?
Enterprise value represents all stakeholders in a business, including equity shareholders,
debt lenders, and preferred stock owners. Therefore, it’s independent of the capital structure. In addition, enterprise value is closer to the actual value of the business since it accounts for all ownership stakes (as opposed to just equity owners).
Could a company have a negative net debt balance and have an enterprise value lower than its equity value?
Yes, negative net debt just means that a company has more cash than debt.
For example, both Apple and
Microsoft have massive negative net debt balances because they hoard cash.
Cash is non-operating, therefore, equity value will often be greater than enterprise value
If a company raises $250 million in additional debt, how would its enterprise value change?
Theoretically, there should be no impact as enterprise value is capital structure neutral.
The new debt raised shouldn’t impact the enterprise value, as the cash and debt balance would increase and offset the other entry.
However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact the company’s profitability and lead to a lower valuation from the higher cost of debt.
Why do we add minority interest to equity value in the calculation of enterprise value?
Minority interest (ownership above 50 but less than 100) represents the portion of a subsidiary in which the parent company doesn’t own. View the minority interest as financing provided to the subsidiary (and treated equivalent to debt)
For the EV multiples to be comparable on the numerator and denominator, the numerator will be the consolidated metric, so add the minority interest to the enterprise value
How are convertible bonds and preferred equity with a convertible treated equivalent feature accounted for when calculating enterprise value?
If the convertible bonds and the preferred equities are “in-the-money” as of the
valuation date (i.e., the current stock price is greater than their strike price), then the treatment will be the same as additional dilution from equity. However, if they’re “out-of-the-money,” they would be treated as a
financial liability (similar to debt).
What are the two main approaches to valuation?
Intrinsic Valuation: The value of a business is arrived at by looking at the business’s ability to generate cash flows. The discounted cash flow
method is the most common type of intrinsic valuation and is based on the notion that
a business’s value equals the present value of its future free cash flows.
Relative Valuation: A business’s value is arrived at by looking at comparable companies and applying the average or median multiples derived from the peer group – often EV/EBITDA, P/E, or some other relevant multiple to value the target. This valuation can be done by looking at the multiples of comparable public companies using their
current market values, which is called “trading comps,” or by looking at the multiples of comparable companies recently acquired, which is called “transaction comps.”
What are the most common valuation methods used in finance?
Comparable Company Analysis (“Trading Comps”)
Comparable Transactions Analysis (“Transaction Comps”)
Discounted Cash Flow Analysis (“DCF”)
Leveraged Buyout Analysis (“LBO”)
Liquidation Analysis
Among the DCF, comparable companies analysis, and transaction comps, which approach yields the highest valuation?
Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factor in control premiums. Control premiums can often be quite significant and as
high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.
Which of the valuation methodologies is the most variable in terms of output?
Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most
variable out of the different valuation methodologies. Relative valuation methodologies such as trading and
transaction comps are based on the actual prices paid for similar companies. While there’ll be some discretion
involved, the valuations derived from comps deviate to a lesser extent than DCF models.
How can you determine which valuation method to use?
Each valuation method has its shortcomings; therefore, a combination of different valuation techniques should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more
defensible approximation and sanity-check your assumptions. The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check
to intrinsic DCF valuation (and vice versa).
Case 1: When an investor considers
investing in a business – the analyst may identify investing opportunities where comps-derived market values for companies are significantly lower than valuations derived using a DCF
Case 2: Acquisition scenario
Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals?
All valuation methods contain some degree of
inherent bias; thus, various methods should be used in conjunction.
(Assumptions made by you or by others in the market)
General rule: When you perform relative valuation, you assume the market consensus to be accurate or at least close to
the right value of a company and that those investors in the market are rational.
What does free cash flow (FCF) represent?
Cash flow remaining after accounting for the recurring expenditures to continue operating.
Free Cash Flow (FCF) = Cash from Operations – Capex
Why are periodic acquisitions excluded from the calculation of FCF?
The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring
operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and
a normal part of operations (i.e., capex is required for a business to continue operating).
Explain the importance of excluding non-operating income/(expenses) for valuations.
For both DCF analysis or comps analysis, the intent is to “value the operations of the business”, which requires you to set apart the core operations to normalize the figures.
When performing DCF analysis, projected cash flows should include only recurring operational income (e.g., sales of goods/services) to reflect sustainable business performance, while excluding non-operating items like investment income, dividends, or asset sales. These non-core items are discretionary, non-recurring, and distort the valuation of ongoing operations.
For comparable company analysis (“comps”), non-core/non-recurring items (e.g., restructuring costs, one-time gains) must be excluded to ensure an “apples to apples” comparison of core operational performance across peers. This adjustment improves earnings quality assessment and isolates the value of primary business activities
Define free cash flow yield and compare it to dividend yield and P/E ratios.
FCF yield is based on cash generated instead of cash actually distributed. FCF yield is
more useful as a fundamental value measure because many companies don’t issue dividends (or an arbitrary fraction of their FCFs).
Free Cash Flow Yield (FCFY) = Free Cash Flow Per Share/Current Share Price
Similar to the dividend yield, FCF yield can gauge equity returns relative to a company’s share price.
If you invert the FCF yield, you’ll get…
share price/FCF per share, which produces a cash flow version of the P/E ratio
Could you define what the capital structure of a company represents?
The capital structure is how a company funds its ongoing operations and growth
plans. The optimal capital structure is the D/E
mix that minimizes the cost of capital,
while maximizing the firm value
As companies mature and build a track record of profitability, they can usually get debt financing easier and at more favorable rates since their default risk has decreased.
Why would a company issue equity vs. debt (and vice versa)?
See word doc
What are share buybacks and under which circumstances would they be most appropriate?
When a company uses its cash-on-hand to buy back some of its
shares, either through a tender offer (directly approach shareholders) or in the open market.
Right time for a share repurchase to be done should be when the company believes the market is undervaluing its shares.
Why would a company repurchase shares? What would the impact on the share price and financial statements be?
A company buys back shares primarily to move cash from the company ’s balance sheet to
shareholders, similar to issuing dividends. The primary difference is that instead of
shareholders receiving cash as with dividends, a share repurchase removes shareholders.
The impact on share price is theoretically neutral – as long as shares are priced correctly, a share buyback shouldn’t lead to a change in share price because while the share count
(denominator) is reduced, the equity value is also reduced by the now lower company cash balances. Market perceptions are the big factor, and will often cause price movements.
How would an accounting treatment of the $100 million share buyback be treated as:
Cash is credited by $100 million
Treasury stock is debited by $100 million
Why might a company prefer to repurchase shares over the issuance of a dividend?
Double taxation of dividends:
- Corporate profits taxed at corporate level
- Dividends taxed again at shareholder level
- Dividends not tax-deductible for corporations
Share repurchases:
- Increase EPS by reducing outstanding shares
- Can potentially increase share price
- Counteract dilution from stock-based compensation
- Signal management’s belief in undervalued shares
- Often one-time events, unlike dividends
Dividends vs. Share repurchases:
Dividends typically long-term, indicating company transition
Cutting dividends viewed negatively by market
Dividend cuts rare once implemented
A company with $100 million in net income and a P/E multiple of 15x is considering raising $200 million in debt to pay out a one-time cash dividend. How would you decide if this is a good idea?
If we assume that the P/E multiple stays the same after the dividend and a cost of debt of 5%, the impact to
shareholders is as follows:
Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million]
Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million)
Summary
Borrowing $200M at 5% to issue a dividend appears beneficial ($50M net gain: $200M payout vs. $150M equity drop from lower net income) if:
P/E remains 15x (ignores higher leverage risk potentially lowering P/E)
Debt cost stays low
No tax impacts
Key Risks:
Higher debt costs or multiple compression erases benefits
Debt-driven dividends are unsustainable long-term (no value-creating investments)
May signal poor growth prospects, raising equity costs
Verdict: Short-term gain under ideal assumptions, but risky long-term strategy.
When would it be most appropriate for a company to distribute dividends?
Companies that distribute dividends are usually low-growth with fewer profitable projects in their pipeline. Therefore, the management opts to pay out dividends to signal the company is confident in its long-term profitability and appeal to a different shareholder base (more specifically, long-term dividend investors).
What is CAGR and how do you calculate it?
CAGR is the annualized average growth rate ( rrr for an investment to grow from its beginning balance to its ending balance.)
What is the difference between CAGR and IRR?
Both used to measure the return on an investment.
CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making.
How would you evaluate the buy vs. rent decision in NYC?
- Make assumptions that I have enough upfront capital to make a down payment and the investment period being ten years
Option 1: Buying Scenario
Cash Flows
Outflows: Down payment, monthly mortgage, taxes, maintenance (partially offset by tax deductions).
Inflow: Property sale price based on NYC’s historical real estate growth (~4-8% annually).
IRR Calculation: Discount rate balancing initial costs, monthly expenses, and final sale proceeds
Option 2: Renting + Stock Investing
Cash Flows:
Outflows: Rent payments (escalating yearly).
Inflows: Down payment invested in stocks (assumed 5-7% annual returns).
IRR Calculation: Compares stock gains vs. rent expenses over 10 years
- Decision frameworks
Calculate both IRR
Risk-adjusted returns
Assumptions matter
Verdict
If buying’s IRR > stocks by 2-3%+, consider property if comfortable with risk.
For similar IRRs, prioritize renting + stocks for liquidity and diversification
How would you value a painting?
The pricing of the painting is a function of what someone will pay for it in the market, rather than being anchored by its fundamentals. To determine the approximate price, you would have to analyze comparable transactions
to see the amount others paid to purchase similar paintings in the past.
(A painting has no intrinsic value, generates no cash flows, and cannot be valued in the traditional sense.)
When would it be appropriate to use a sum-of-the-parts approach to valuing a company?
Each division of a company will have its unique risk/return profile and need to be broken up to value the entire company more accurately as a whole (different discount rate will value each segment, and distinct peer groups for trading and transaction comps)
E.g. Conglomerate - The company being valued
has many operating divisions in unrelated industries, each with differing risk-profiles
How does valuing a private company differ from valuing a public company?
Main difference is the availability of data. Private companies are not required to make their financial statements public. If you’re provided private company financials, the process is similar to public companies, except that private company financial disclosures are
often less complete, standardized, and reliable. In addition, private companies are less liquid and should thus be valued lower to reflect an illiquidity discount (usually ranges between ~10-30%).
What is an illiquidity discount?
When valuing private companies, is related to being unable to exit an investment
quickly. On the contrary, most investors will pay a premium for an otherwise similar asset if there’s the optionality to sell their
investment in the market (public company) at their discretion… includes a premium for being sold in the public markets with ease (called the “liquidity premium”).
Walk me through a DCF
- Forecast Unlevered Free Cash Flows (“FCFF” or “UFCF”):
- Calculate Terminal Value (“TV”):
- Discount Stage 1 & 2 CFs to Present Value (“PV”)
- Move from Enterprise Value → Equity Value
- Price Per Share Calculation
- Sensitivity Analysis
What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?
Unlevered FCF (FCFF): Capital structure neutral
FCFF = EBIT × (1 – Tax Rate) + D&A – Changes in NWC – Capex
Levered FCF (FCFE): Accounts for leverage to specifically target residual cash flows that belong to equity holders
FCFE = Cash from Operations – Capex – Debt Principal Payment
Conceptually, what does the discount rate represent?
Discount rate is a function of the riskiness of the cash flows (of a company). A higher discount rate makes a company’s cash flows less valuable, as it implies the investment carries a greater amount of risk, and
therefore should be expected to yield a higher return (and vice versa).
(put another way, the discount rate is the minimum return threshold of an investment based on comparable investments with similar risks)
What is the difference between the unlevered DCF and the levered DCF?
Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive directly at
enterprise value. Use WACC, reflect the riskiness to both debt and equity
Levered DCF: Arrives at equity value
directly. Use COE, risk of equity capital.
(If you wanted to get to enterprise value, you
would add back net debt)
What is the formula to calculate the weighted average cost of capital (WACC)?
Generally, it’s WeightExCostE + WeightExCostE (1-t)
WACC = ( Equity Debt + Equity × Requity) + [ Debt Debt + Equity × Rdebt (1 – t)]
If a company carries no debt, what is its WACC?
WACC = COE
How is the cost of equity calculated?
Most commonly estimated using the capital asset pricing model (“CAPM”),
which links the expected return on a security to its sensitivity to the overall market (most often S&P 500 is used as the proxy).
Cost of Equity (Re) = Risk Free Rate + Beta × Equity Risk Premium
How do you determine the risk-free rate?
Use a proxy, current yield on 10-year US treasury notes the preferred proxy for the risk-free rate for US-based companies. or the yield to maturity of default-free government bonds
What effect does a low-interest-rate environment have on DCF-derived valuations?
If the market’s prevailing interest rates are at low levels, valuations based on DCFs will become higher since the discount rate will be lower from the decreased risk-free rate, all else being equal.
Define the equity risk premium used in the CAPM formula.
The equity risk premium (“ERP”) measures the incremental risk (or excess return) of investing in equities over risk-free securities.
Equity Risk Premium (ERP) = Expected Market Return − Risk Free Rate
Explain the concept of beta (β).
Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to the
broader market.
Beta/Market Sensitivity Relationship
β = 0 → No Market Sensitivity
β < 1 → Low Market Sensitivity
β > 1 → High Market Sensitivity
β < 0 → Negative Market Sensitivity
What is the difference between systematic risk and unsystematic risk?
Systematic Risk: Undiversifiable risk (or market risk)
Unsystematic Risk: Company-specific (or industry) risk that can be reduced through portfolio diversification.
Does a higher beta translate into a higher or lower valuation?
Higher beta–>Higher discount rate applied to CFs–>lower valuation
What type of sectors would have higher or lower betas?
High Beta: A beta of >1 would mean the industry is highly cyclical and be more volatile than the broad market (e.g. automobiles since consumers purchase these during positive economic growth)
Low Beta: A beta of < 1 suggests the security is less volatile than the broad market (e.g. Consumer products)
What are the benefits of the industry beta approach?
The approach looks at the β of a comparable peer group to the company being
valued and then applies this peer-group derived beta to the target.
Benefits:
- Company-specific noise is eliminated
- To perform a DCF for a private company, industry beta approach would be
required as privately-held companies don’t have readily observable betas.
What are the flaws of regression betas?
Backward looking: A tech startup transitioning to maturity may see reduced volatility, rendering past beta obsolete
Large standard deviation: Assumption of the index to use, or company specific events that can cause deviations that are not indicative of a company’s true correlation with the market.
Constant capital structure: Regression beta implicitly assumes a static debt-to-equity (D/E) ratio, ignoring changes in leverage. Since beta incorporates financial risk, shifts in capital structure (e.g., taking on more debt) require adjustments:
What is the impact of leverage on the beta of a company?
In general, the more leverage used in a
capital structure, the higher the beta
given the increased volatility from debt.
What is the typical relationship between beta and the amount of leverage used?
Generally, mature companies with lower betas will have a higher percentage of debt in their capital structure because they can easily get cheap financing based on their long-lasting track record of cash flows and profitability, as well as being non-cyclical and carrying less risk than the broad market.
In comparison, a company with a high beta will be reluctant to use debt or if they do, the terms of the debt would be less favorable. From a financier’s perspective: “Would the lender be comfortable loaning money to a
company that has a higher beta and volatility throughout different economic cycles?”
What are the formulas used to unlever and relever beta?
(Since the betas of comparable companies are distorted because of different rates of leverage, we unlever the betas of these comparable companies)
1. Unleveling beta for the peer group= removing the distortion effects of leverage and isolating comparable company’s business risk
- Then, once a median or average unlevered beta is calculated, this beta is relevered at the target company’s
capital structure:
Is it possible for an asset to have a negative beta?
Yes, the most commonly cited example is gold, which has an inverse relationship with the market.
How do you estimate the cost of debt?
Market-Based Observation:
If a company has publicly traded debt, the cost of debt is directly observable as the yield on bonds with similar risk profiles.
Synthetic Rating Method:
For companies without publicly traded debt, a synthetic credit rating can be estimated based on the interest coverage ratio (EBIT/Interest Expense). This rating is then used to determine a default spread, which is added to the risk-free rate to calculate the cost of debt
- Calculate Interest Coverage Ratio:
- Assign a Synthetic Rating (from a table): “Ratio of 6.15 corresponds to an A rating (default spread = 0.95% for non-financial firms)”
+ - Add Default Spread to Risk-Free Rate:
Assume a risk-free rate (e.g., 10-year U.S. Treasury yield = 4.5%):
= Pre-tax cost of debt
Which is typically higher, the cost of debt or the cost of equity?
The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax-deductible, creating a “tax shield.”
Since the cost of equity is higher than the cost of debt, why not finance using only debt?
As more debt is incrementally added
to the capital structure, the risk to all company
stakeholders increase.
WACC decreases as debt increases until it begins to decrease again when the cost of potential financial distress offsets
the tax advantages of debt
What is the difference between WACC and IRR?
Internal Rate of Return: Rate of return on a project’s expenditures (or it’s defined as the discount rate on a stream of cash flows
leading to a net present value (NPV) of 0.)
WACC (COC): Average minimum required
internal rate of return for both debt and equity providers of capital.
IRR>WACC = Accept a project
Which would have more of an impact on a DCF, the discount rate or sales growth rate?
The discount rate’s impact would far exceed that of operational assumptions such as the sales growth rate.
How is the terminal value calculated?
Growth in Perpetuity Approach: Assuming a perpetual growth rate on cash flows after the explicit forecast period. TV = FCF/(r-g)
Exit Multiple Approach: Applying a multiple
assumption on a financial metric (usually EBITDA) in the terminal year. The multiple reflects the multiple of a comparable company in a mature state.
Why is it necessary to discount the terminal value back to the present?
Under both approaches, the terminal value represents the present value of the company’s cash flows in the final year of the 1st stage of the explicit forecast period right before entering the perpetuity stage.
TV calculated is the present value of a growing perpetuity at the very end of the stage 1 projection of cash flows.
Future value must be discounted back to its present value (PV) since the DCF is based on what a company is worth today, the current date of the valuation.
For the perpetuity approach, how do you determine the long-term growth rate?
To fact check the reasonableness of an exit multiple approach, back out into an implied growth rate.
Implied g = (TV × r – FCF Final Year )/(TV + FCF Final Year )
Implied TV Exit Multiple = TV Perpetuity Method/ EBITDA Final Year
What is the argument against using the exit multiple approach in a DCF?
DCF is an intrinsic, cash-flow based valuation method independent of the market vs exit
multiple approach, relative valuation is being brought into the valuation, it’s fairer to discuss and defend assumptions.
What is the purpose of using a mid-year convention in a DCF model?
Used for seasonal or cyclical industries. We are treating the projected cash flows as if they’re generated at the midpoint of the given period. Without this mid-year adjustment, the DCF implicitly assumes that all cash flows
are being received at the end of the year. This would be inaccurate since cash flows are generated steadily throughout the year, depending on the industry.
How would raising additional debt impact a DCF analysis?
As the percentage of debt in the capital structure increases, the cost of debt
increases from the higher default risk (which lowers the implied valuation).
(under no change): Enterprise value based on an unlevered DCF should theoretically remain relatively unchanged since the
DCF is capital structure neutral.
Imagine that two companies have the same total leverage ratio with identical free cash flows and profit margins. Do both companies have the same amount of default risk? - Question pertaining to assessing leverage risk, also what are the top two leverage ratios, and what is the lower risk (COD) =?
hen assessing leverage risk, a company’s excess cash should be considered since this cash could help paydown debt.
If one company has significantly more cash on its balance sheet, it’ll most likely be better positioned from a risk perspective.
Total debt/EBITDA, Net debt/EBITDA
Lower risk (and COD) = Higher excess cash, lower leverage ratio
When would a DCF be an inappropriate valuation method?
When you don’t have access to financial statements or the company is not expected to generate positive cash flows for the foreseeable future. So if you have a data point
such as revenue or EBIT, a comps analysis is easier to implement.
If 80% of a DCF valuation comes from the terminal value, what should be done?
The explicit forecast period may not be long enough (should range from 5 to 10 years). In the final year in the explicit stage, the company should have reached normalized, stable growth.
Alternatively, the terminal value assumptions may be too aggressive and not reflect stable growth
Why is a DCF not used to value early stage startups?
The longer the explicit forecast period, the more uncertainty surrounding the implied valuation.
A DCF valuation is most credible when looking at mature. The longer the explicit forecast
period, the more uncertainty surrounding the
implied valuation. companies with an established market position, as opposed to pre-revenue companies that have not yet determined their business model, go-to-market strategy, or target end-user.
How would you handle stock options when calculating a company’s share count?
The standard convention for stock options is to include in the dilutive share count any vested (exercisable) options whose strike price is below the current share price (“in-the-money”).
In addition, any option proceeds the company received from the exercising of those options are assumed to be used by the company to
repurchase shares at the current share price (the treasury stock method).
But certain finance professionals use all outstanding in-the-money options (as opposed to just the vested in-the-money options) to perform the analysis. The logic being that any options that are still unvested will vest
soon, and since they’re in-the-money, it’s more conservative to include them in the share count.
How would you handle restricted stock in the share count?
Some finance professionals completely ignore restricted stock from the diluted share count because they’re unvested. However, increasingly, unvested restricted stock is included in the diluted share count under the logic that eventually they’ll vest, and it’s thus more conservative to count them.
How would you handle convertible preferred stock in the share count?
Convertible preferred stock is assumed to be converted into common stock to calculate diluted shares if the liquidation value (i.e., the preferred stock’s conversion price) is lower than the current share price.
E.g. holder the right to collect either $50 per preferred share (its liquidation value) or to convert it to one share of common stock.
How would you handle convertible bonds in the share count?
Convertible bonds are assumed to be converted into common stock if the conversion price of the bond is lower than the current share price.
E.g. Since the current share price is greater
than the conversion price, we assume the bond is converted to calculate diluted shares.
How should operating leases be treated in a DCF valuation?
The present value of the lease obligation should be reflected as part of net debt when operating leases are significant for a business otherwise a liability on the BS
For forecasting purposes, do you use the effective or marginal tax rate?
DCF: the tax rate assumption used will be the tax rate paid into perpetuity.
The recommended approach is to look at the historical periods (i.e., past 3-5 years) and base your near-term tax rate assumptions on the effective tax rate. But by the time the 2nd stage of the DCF is approaching, the tax
rate should be “normalized” and be within close range of the marginal tax rate.
How does a lower tax rate impact the valuation from a DCF?
- Greater Free Cash Flows: A lower tax rate would result in more net income as fewer taxes have to be
paid to the government, meaning more earnings retention and higher cash flow. - Higher Cost of Debt: A lower tax rate results in a higher after-tax cost of debt and a higher re-levered beta, all else being equal. If the tax rate is reduced, that would mean the after-tax cost of debt would rise,
and the benefit from the tax-deductibility of interest (“tax shield”) would be reduced. - Higher Beta: A lower tax rate would result in a higher levered beta, which would cause the cost of equity and WACC to increase.
While the last two implications suggest a lower valuation, the net impact on the company’s valuation would be specific to the company’s fundamentals, and one would have to flow through all the changes in a DCF model to
see if the increased FCF offsets the increased WACC.
How does a dividend discount model (DDM) differ from a discounted cash flow model (DCF)?
What are the major drawbacks of the dividend discount model (DDM)?
Sensitive to assumptions, dividend payout ratio, dividend growth rate, and required rate of return.
The DDM cannot be used on high-growth companies as the denominator would turn negative since the growth rate would exceed the expected return rate.
The DDM is more suitable for large, mature companies with a consistent track record of paying out dividends, but even then, it can be very challenging to forecast out the growth rate of dividends paid. Most companies don’t pay out any dividends, especially as share buybacks have become common. The DDM neglects buybacks, an increasingly important source of returns for shareholders.
If the dividend payout amounts reflected true financial performance, then the output would be similar to the traditional DCF. However, poorly run companies can still “issue large dividends, distorting valuations”.
What is the purpose of using multiples in valuation?
Reflects how valuable a particular company is in relation to a specific metric. The numerator will be a measure of value such as
Equity value or enterprise value, whereas the denominator will be a financial or operating metric
Multiples are used to standardize a company’s
value on a per-unit basis. This enables comparisons in value amongst similar companies, which is the premise of relative valuation.
Contextual understanding of the target company, such as its fundamental drivers and general industry knowledge, is required.
How do you determine what the appropriate numerator is for a multiple?
The represented stakeholders in the numerator and denominator must match (equity/equity metric or debt or debt metic)
If the numerator is enterprise value, metrics such as EBIT, EBITDA, unlevered free cash flow (FCFF), and
revenue multiples can be used since these are all unlevered (i.e., pre-debt) measures of profitability.
In contrast, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and
earning per share (EPS) would be used because these are all levered (i.e., post-debt) measures.
Walk me through the process of “spreading comps.”
- Identify Comparable Companies
Select a peer group of similar public companies (trading comps) or recent M&A transactions (transaction comps) in the same industry, focusing on size, growth, and risk profiles. - Gather Financial Data
Collect historical and projected financials (revenue, EBITDA, debt) from SEC filings, equity research, and databases like Capital IQ, ensuring alignment with GAAP standards. - Standardize and Adjust Data
Scrub financials for non-recurring items, accounting discrepancies, and calendarize fiscal periods to enable consistent comparisons across peers. - Calculate Valuation Multiples
Compute multiples (e.g., EV/EBITDA, P/E) for each peer, focusing on LTM (trailing) and NTM (forward) metrics. - Benchmark and Analyze Multiples
Determine median/mean multiples, identify outliers, and validate differences using qualitative factors like growth rates or debt levels. - Apply to Target Company
Multiply the target’s financial metric (e.g., EBITDA) by the peer-derived multiple to estimate its implied value, adjusting for unique risks or growth prospects.
The process balances quantitative rigor (e.g., data standardization) with qualitative judgment (e.g., outlier removal) to derive a defensible valuation range.
When putting together a peer group for comps, what would some key considerations be?
- Operational Profile
Industry/sector, business model, and market alignment: Prioritize companies in the same or adjacent industries with similar products/services, customer bases, and geographic exposure to ensure comparable market dynamics. - Financial Profile
Size, growth, and profitability: Focus on revenue, EBITDA, and market cap (typically ½ to 2x the target’s size) to match financial scale, while evaluating margins, growth rates, and return metrics (e.g., ROIC) for performance comparability
Should the target company being valued be included in its peer group?
Many professionals exclude the target company being valued from the peer group because the target’s
inclusion would skew the multiple towards the target’s current valuation. However, if the intuition behind a comps analysis is that the market may misprice individual stocks but is correct on the whole, then logic dictates
that the target should be included in its market-based valuation.
What are the primary advantages of the trading comps approach?
Public Filings (data is readily available): Trading comps involves public companies, making data collection far more convenient since all their reports and filings are easily accessible online.
Less Data Required (less data because you have public info): Implementation is a key advantage of trading comps, as proper DCFs cannot be built without detailed financials and supplementary data. But to get a decent trading comps-based valuation, only a few data points (e.g., EBITDA, revenue, net income) are required, making it easier to value companies when access to data sets is limited.
Current Valuations (up to date valuations): Trading comps reflect up-to-date, current valuations based on investor sentiment as of the present day, since it’s based on the latest prices paid in the public markets.
What are the main disadvantages of performing trading comps?
Putting together a peer group of “pure-play” companies by itself can be a challenging task,
especially if the target is differentiated and has few (or no) direct competitors.
Even with a well-thought-out, similar peer group, explaining the differences in valuation
can be difficult as the comparison is always “apples to oranges.”
Understanding valuation gaps between a company and its comparables involves judgment, which can be very challenging – plus, the market is often emotional and fluctuates irrationally, bringing in more external factors to consider.
Low trade volume and less followed equities may not reflect their true fundamental value, making them less useful for trading comps.
To perform transaction comps, how would you compile the data?
Deal announcement press releases,
proxy filings, merger agreement, target company’s filings (annual and quarterly reports), research reports, financial data vendors such as Bloomberg, Capital IQ, or FactSet (for estimated earnings forecasts)
What do transaction comps tell you that trading comps cannot?
Transaction comps can provide insights into control premiums that buyers and sellers should expect when negotiating a transaction.
Transaction comps can validate potential buyers’ existence in the private markets
and if a particular investment strategy has been successfully implemented before.
In M&A, why is a control premium paid?
A control premium refers to the amount an acquirer paid over the market trading value of the shares being acquired (usually shown as a percentage//necessary to incentivize existing shareholders to sell their shares.)
From the perspective of the shareholders of the acquisition target: “What would compel existing shareholders to give up their ownership if doing so is not profitable?”
Besides incentivizing existing shareholders to sell, what other factors lead to higher control
premiums being paid?
- Competitive Deals
Heightened buyer competition drives higher premiums due to bidding wars, particularly in auction-style sale processes. - Synergies
Expected cost savings, revenue synergies, or operational efficiencies justify higher premiums if achievable post-acquisition. - Asset Scarcity
Unique or irreplaceable assets critical to the acquirer’s strategic goals command premiums, especially with no comparable alternatives. - Undervalued Target
Buyers pay premiums perceived as reasonable relative to their internal valuation, even if market views the price as excessive. - Mismanagement
Underperforming targets with poor leadership justify premiums, assuming restructuring and management changes unlock latent value.
Each factor reflects strategic, financial, or market dynamics shaping premium decisions.
Why is transaction comps analysis often more challenging than trading comps?
Challenging when there has been limited
(or no) M&A activity within the relevant space, or the comparable transactions were
completed a long time ago in a completely different economic environment. Data from those prices paid might not reflect current market trends and investor sentiment.
Only relatively recent transactions (within the last five years) offer insight into & Weaknesses industry valuations.
Transaction contact must also be looked at which can influence the final purchase price (form of consideration, type of buyer (financial or strategic) and deal’s circumstances)
When putting together a peer group for transaction comps, what questions would you ask?
What was the transaction rationale from both the buyer and seller’s perspective?
Was the acquirer a strategic or a financial buyer?
How competitive was the sale process?
Was the transaction an auction process or negotiated sale?
What were the economic conditions at the time of the deal?
Was the transaction hostile or friendly?
What was the purchase consideration?
If the industry is cyclical (or seasonal), did the transaction close at a high or low point in the cycle?
When valuing a company using multiples, what are the trade-offs of using LTM vs. forward
multiples?
- LTM Multiples
Objective but backward-looking: Use actual financial results (reliable for smaller firms with unreliable forecasts) but require adjustments for non-recurring items to reflect sustainable earnings. - Forward Multiples
Forward-looking but speculative: Reflect future growth and synergies (critical for M&A) but depend on subjective forecasts, which risk inaccuracy due to market volatility or flawed assumptions. - Best Practice
Combine both: Present LTM and forward multiples side-by-side to balance historical accuracy with future potential, mitigating the weaknesses of each approach.
This dual approach ensures a more holistic valuation, accounting for both proven performance and growth expectations.
Why might two companies with identical growth and cost of capital trade at different P/E multiples?
If one company has a higher return on
invested capital (ROIC), a higher P/E ratio should be expected.
Other reasons may include relative mispricing or inconsistent EPS calculations, often caused by non-recurring items or different accounting policies.
Should two identical companies with different leverage ratios trade at different EV/EBITDA
multiples?
Short answer, no. You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a
company’s value and profits independent of its capital structure. Technically, they won’t be exactly equal because enterprise value depends on the cost of capital, so there’ll be some variation.
Should two identical companies with different leverage ratios trade at different P/E multiples?
P/E multiples can vary significantly due to leverage differences for otherwise identical companies. All else being equal, as a company borrows debt, the EPS (denominator) will decline due to higher interest expense.
The impact on the share price, on the other hand, is hard to predict and depends on how the debt is used:
If the debt proceeds go unused and generate no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment. In this scenario, the share price and
P/E ratio can be expected to decline.
But if that debt were used to invest and grow the business, the P/E ratio should increase.
Simply put, debt adds more risk to equity investors (given their junior position in the capital structure) with little potential return, and investors will value the company at a lower P/E.
What are some common enterprise and equity value multiples?
Enterprise Value Multiples: EV/Revenue, EV/EBIT, EV/EBITDA
Equity Value Multiples: Price/Earnings (P/E), Price/Book (P/B), Price/Levered Cash Flows
Which multiples are the most popular in valuation?
Most common:
Enterprise Value/EBITDA multiples
EV/EBIT and P/E.
Industry and company-specific:
P/B ratios are used to value financial
institutions
EV/Revenue multiples are used to value unprofitable companies
(EV – Capex)/EBITDA multiples can be used for capital-intensive industries such as manufacturing or cable companies.
Why would it be incorrect to use enterprise value and net income in a multiple?
There would be a mismatch between the represented investor groups in the numerator and denominator.
Enterprise value represents the value of the operations to all stakeholders in a company, meaning the cash flows belonging to both lenders and equity providers of capital.
Net income, however, represents the residual
value that flows just to equity shareholders.
Why might one company trade at a higher multiple than another?
Superior fundamentals:
Better growth prospects
Higher return on invested capital (ROIC)
Lower cost of capital (WACC)
More robust cash flow generation
Investors are forward-looking. Therefore, companies with better growth trajectories and signs of being well managed with efficient capital allocation are rewarded with higher valuations.
Intuitively, what does the P/E ratio mean?
Determine a company’s relative value against the industry average and its peers ( “How much is the market willing to pay for a
dollar of this company’s earnings?”). Goal: Is the company undervalued, fairly valued, or overvalued?
PE ratio = Current share price/EPS
PE ratio = Market capitalization/NI
A company is currently trading at 12.5x EBITDA, is it overvalued?
The answer depends on the company’s industry being valued and how its valuation fares compared to the rest of its peer group. For instance, a software company trading at 12.5x would be near the sector median, whereas a double-digit multiple in an industry such as Oil & Gas is rare.
What does a high P/E ratio relative to a peer group imply?
Might mean the market is overvaluing the
company. Alternatively, it could mean the company has less earnings than its peer group (or is a younger company).
The use of P/E multiples is most useful when the company is mature and its peer
group has a similar capital structure.
A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back P/E ratio, and how would you interpret this situation?
- P/E Ratio Comparison
Past P/E: $10 share price ÷ $2.00 EPS = 5.0x
Current P/E: $10 share price ÷ $1.00 EPS = 10.0x
Conclusion: The P/E ratio doubled despite unchanged share price. - Key Interpretation
Apparent Overvaluation: A higher P/E suggests the market values each dollar of earnings less efficiently today, raising concerns about overvaluation unless justified by future growth or strategic shifts. - Drivers of EPS Decline
Dilution: The EPS drop likely stems from share issuance (e.g., capital raises or stock-funded acquisitions), not declining profits.
Market Sentiment: A stable share price post-dilution implies investor confidence in the use of proceeds (e.g., growth investments or accretive M&A). - Critical Considerations
EPS vs. Net Income: Distinguish between dilution (share count ↑) and profit erosion (net income ↓).
Forward Outlook: A sustained high P/E requires proof that capital deployment will enhance future earnings.
This scenario highlights how capital structure changes (e.g., dilution) can distort valuation metrics independently of operational performance.
When would the use of the PEG ratio be appropriate?
Used to standardize the P/E ratio and enable comparisons among companies with different
expected long-term growth rates (g).
Generally, a PEG ratio:
1 = Fairly valued
<1 = Undervalued
>1 = Overvalued
PEG ratio = (P/E)/g
There are two approaches for the growth rate used:
Trailing PEG: The growth rate can be based on a company’s historical growth. For example, the LTM growth rate could be used, or the annualized growth rate over the past 3-5 years.
- Forward PEG: The more commonly used option calculates the growth rate from a 1-3 year projection based on consensus estimates or an annualized version of those growth rates.
When would you value a business using the P/B ratio?
Can be used when the company’s book value captures a substantial part of its real value. An
example would be commercial banks, as most of their assets and liabilities are frequently re-valued and similar to their actual market values.
When should you value a company using a revenue multiple vs. EBITDA?
Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, multiples based on revenue are the only available option to gain some level of insight.
How would you value a pre-revenue early stage internet company?
Using multiples such as EV/DAU or EV/MAU.
An internet company with no revenue or negative profitability could be valued using user engagement metrics such as the subscriber count, monthly active users, daily active users, and website hits.
Why is calendarization a required step when performing comps analysis?
Calendarization involves aligning the fiscal year ending dates of a group of comparable companies to allow for a more accurate comparison. The general convention is to adjust the financials so that all the fiscal years end in December. The reason calendarization is necessary is that cyclicality and seasonality can skew results and create discrepancies when making comparisons.
If the market matters most when valuing public companies, do we even need a comps analysis? Why not just use the market cap directly to value the company?
The market may be efficient on average, but it can be off when pricing individual companies.
If the market were perfectly efficient, it would price individual equities correctly, rendering a comps analysis pointless.But, investors can be overly emotional and overreact, creating
investment opportunities.
When applying a peer group derived EV/EBITDA multiple onto your target company, what is an argument for using the group’s median multiple instead of the mean?
Medians remove the distortive impact of outliers on the peer group multiple.
When using larger peer groups (5+), the median is preferable over the mean because it limits distortions from outliers, which
increases as more companies are included. The mean might be preferable for smaller peer groups with fewer than five comparable companies and no outliers.
