Updated 24 May 2020
In this article, we focus on technical skills. You should be prepared to showcase your knowledge of the broad issues around how companies are valued.
Valuing companies is one of the core functions of a financial analyst. The valuation of a company aims to find the correct and fair value (or current worth) of the company's shares by applying appropriate tools and evaluating all aspects of the business.
A company valuation can, broadly speaking, be divided into two main types of valuation:
DCF analysis is used to calculate the company’s current value based on its future cash flows. It is a more academic approach.
In theory, an opportunity for investment should be considered where the cost of investment is less than the DCF value. It estimates an investor’s return on investment, based on the concept that the value of money increases day by day.
Relative valuation, on the other hand, is about the comparison of two companies. In other words, the company is compared to other industry players to find its value. Certain metrics are used for this comparison, one of the most common being the P/E (price-to-earnings) ratio.
The valuation methodologies you should be familiar with include:
You will need to understand how and why each valuation methodology is used, which ones produce the highest or lowest values and bear in mind that there are some exceptions to each ‘rule’.
In asking questions about company valuations, recruiters will be looking to find out whether you are familiar with the key concepts used when valuing companies and whether you can talk about them confidently.
When preparing for your interview, ensure that you:
The comparables analysis method (also known as the multiples method) is one that values similar companies using the same financial metrics. Some commonly used multiple metrics are:
Enterprise value (EV) is the total value of all company assets. Equity value (or market capitalization) is the market value of shareholders’ equity within that company.
Equity value is calculated by taking the enterprise value (the total value of the company) and deducting net debt (total debt minus any cash).
Equity value = enterprise value – net debt
Enterprise value is the sum of a company's equity value (or market capitalization) plus any debt, less any cash there is sitting in the bank.
Enterprise value = market capitalization + debt – cash
Cash is subtracted from the company value because when a company is purchased, the cash can be used by the purchaser to reduce the debt.
Enterprise value is used more commonly in the valuation of companies because it considers factors that aren’t included when calculating equity value and therefore provides a more accurate overview of the company’s value.
The Price to Book Value multiple (or P/B ratio) is used as the primary valuation tool for banks.
The Price to Book Value multiple compares a company's net assets (those owned by shareholders) relative to the price per share.
A bank’s balance sheet will typically represent the market value (as opposed to the historical value), as it is mandatory under regulations for a bank’s assets and liabilities to be periodically marked to market.
(See below for why you wouldn’t use DCF to value a bank.)
Liquidation value is calculated by assessing the total worth of a company’s physical assets. It does not include intangible assets. Therefore, it is essentially the value of a company’s land, buildings, fixtures and fittings, machinery and equipment, or inventory and cash.
A liquidation valuation would be carried out if a company is being assessed for bankruptcy, calculating how much capital equity remains after the debts have been paid off.
It is unlikely that a liquidation valuation will produce a high value unless the company has substantial hard assets which, for whatever reason, the market is undervaluing.
The price-to-earnings (P/E) ratio is used widely as the primary financial metric for valuations but it has several flaws and limitations. The Enterprise Value to EBITDA (EV/EBITDA) may be a better solution when taking into consideration the limitations of price-to-earnings.
The P/E ratio is often used to indicate potential for future growth but, as it doesn’t consider balance sheet risk, the fundamental position of the company is, arguably, not correctly reflected.
One issue is that the earnings part of the metric is easily manipulated or is based on historical or forecasted data which can not be guaranteed. Also, it cannot be used when earnings are negative.
The EBITDA method removes debt costs, taxes and depreciation from the calculation which may provide a clearer picture.
The enterprise value (see above) can be used to calculate the EV/EBITDA ratio by dividing the enterprise value by EBITDA to find a more comprehensive earnings multiple.
A DCF is a discounted cash flow and is a valuation method used to estimate the value of an investment based on its future cash flows.
A financial analyst would never use a DCF when:
For example, consider DCF, comparable company analysis and precedent transactions.
Things to consider include:
Precedent transactions are likely to give the highest valuation since a transaction value would include a premium for shareholders over the actual value.
The DCF would likely rank next, but that would largely depend on the quality of the assumptions applied.
Financial analysts often look at comparable companies when making valuations. This is based on the theory that, if investors are willing to pay a certain amount for a company then they should also be willing the pay that same amount for a similar company.
Some factors that are taken into account when choosing comparable companies for valuation are:
Often, publicly traded companies are used for comparable analysis. To be successfully compared, the public comparable company should be similar to the company being valued in areas that include:
Public company comparables are useful for valuation as they usually operate within the stock market and, therefore, their financial statements are regulated in similar ways. They are also subject to the same economic conditions and market pressures.
The downside of public company comparables is that analysing public companies does not give the full picture. Valuations do not give anything away about the economic climate and the current state of the stock market. Stocks may not reflect the actual value of the company and analysis alone will not give much information about premiums paid in transactions.
It does not automatically follow that all accretive transactions are good and all dilutive deals are bad.
During your investment banking interview, you will likely be asked questions about company valuations. You will need to demonstrate a basic understanding of key concepts and recall a fair amount of information.
Therefore, take some time before your interview to review basic concepts and definitions around company valuations and build your knowledge.
If your undergraduate degree was not business or finance-related, you will need to ensure you have built up your knowledge by reading around the subject and having mastered technical terms and definitions.
Practise your answers, write notes and practise speaking out loud. Try recording your answers to time yourself. It is recommended that you keep answers to between one and two minutes so try to condense complicated topics down into their basic parts to keep your answers concise.
Practising these top 10 valuation interview questions along with our comprehensive guide on investment banking interview questions will ensure you are on the road to success.
You may be interested in these other articles on WikiJob: