Valuation Interview Questions for Finance II

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The main valuation methods (DCF, Comparable Company Analysis, and Precedent Transactions) differ in how they approach valuing a company:

• Discounted Cash Flow (DCF): Values a company based on its future cash flows, discounted to the present using a discount rate (usually WACC). It’s focused on the company's own financials and future performance.
• Comparable Company Analysis (Comps): Values a company by comparing it to similar companies in the same industry, using valuation multiples (e.g., EV/EBITDA). It’s market-based and reflects how similar companies are valued by the market.
• Precedent Transactions: Values a company by looking at historical M&A transactions in the same industry, using multiples derived from those deals. It reflects what acquirers have paid for similar companies in past transactions.

Each method has its strengths and is used in different contexts to cross-check the results.

There is no definitive ranking that always applies, as it depends on the context. However, generally:

• Precedent Transactions tend to produce higher values than Comparable Companies due to the Control Premium paid in acquisitions.
• A DCF can vary significantly; it often results in the highest value, but it can also produce the lowest, depending on the assumptions made (e.g., discount rate, growth rate).

After all, the DCF is the most variable method, while Precedent Transactions typically produce higher values than Comparable Companies.

Other valuation methodologies include:

• LBO Analysis: Determining how much a firm could pay for a company to hit a target Internal Rate of Return (often used in Private Equity).
• Liquidation Valuation: Valuing a company’s assets as if they were sold off and subtracting liabilities to determine the equity remaining.
• M&A Premiums Analysis: Analyzing past M&A deals to determine the premium paid by acquirers, then applying it to your company’s valuation.
• Sum of the Parts: Valuing each division of a company separately and adding them together.
• Future Share Price Analysis: Projecting the future share price using P/E multiples of comparable companies and discounting it to present value.
• Replacement Value: Valuing a company based on the cost to replace its assets.

An LBO Analysis is used primarily when evaluating a Leveraged Buyout to determine how much a private equity firm could pay for a company while achieving a target IRR. 

It is often used to establish a “floor” valuation, as the amount a PE firm can afford to pay is typically lower than what strategic buyers might offer. This helps set the lower bound for a company's valuation.

IRR stands for Internal Rate of Return. It is the discount rate that makes the net present value (NPV) of all future cash flows from an investment equal to zero. 

In an LBO analysis, IRR is used to determine the return a private equity firm expects to earn on its equity investment. The goal is typically to achieve an IRR in the range of 20-25% to ensure a successful investment, guiding how much debt and equity can be used in the transaction.

A Liquidation Valuation is primarily used in bankruptcy scenarios to assess whether equity shareholders will receive any capital after the company's debts are settled. 

It is often used to help struggling businesses decide whether to sell off assets individually or attempt to sell the company as a whole.

The most common multiples used in valuation include:

• EV/Revenue: Compares Enterprise Value to revenue, used for high-growth companies.
• EV/EBITDA: Compares Enterprise Value to EBITDA, focusing on cash flow from operations.
• EV/EBIT: Similar to EV/EBITDA, but includes depreciation and amortization.
• P/E (Price-to-Earnings): Compares share price to earnings per share (EPS), often for public companies.
• P/BV (Price-to-Book Value): Compares share price to book value per share, useful for asset-heavy companies.

For a high-growth tech startup, the most commonly used multiple is EV/Revenue. Since these companies often have little or no profits in the early stages, EV/EBITDA or P/E may not be relevant.

However, industry-specific multiples may also be relevant, such as:

• EV/Unique Monthly Visitors: Used for internet-based businesses to value a company based on user traffic.
• EV/MAUs (Monthly Active Users): Common for SaaS and app-based companies, focusing on user engagement.
• EV/Bookings: Used for companies with subscription-based revenue models, particularly in SaaS, to assess future revenue potential

In the energy sector, common industry-specific multiples include:

• EV/EBITDAX: Measures Enterprise Value relative to Earnings Before Interest, Taxes, Depreciation, Amortization, and Exploration Expense. This multiple is used because energy companies handle exploration expenses differently (some capitalize, others expense them), and adding back exploration expense normalizes the numbers.
• EV/Daily Production: This multiple compares Enterprise Value to a company’s daily oil or gas production, typically used for upstream companies to reflect their production capacity.
• EV/Proved Reserve Quantities: Valuing a company based on its proved reserves of oil & gas, this multiple helps estimate the company’s value based on the amount of extractable resources it owns.

You would typically use Equity Value instead of Enterprise Value when the focus is on the value attributable to equity shareholders. This applies in the following situations:

• P/E (Price-to-Earnings) and P/BV (Price-to-Book Value) are equity-based multiples, where you're measuring the company’s value relative to earnings or book value, which is directly relevant to equity investors.
• Equity Value/Revenue: This is very rare but can be used for financial institutions with large cash balances and negative Enterprise Value. It may also be used when comparing financial and non-financial institutions, where you use Revenue multiples for non-financials but show a similar figure for financial institutions.

In most cases, though, P/E and P/BV are more commonly used for financial institutions, while for most industries, EV/EBITDA or EV/Revenue would be more typical.

For Unlevered Free Cash Flow (FCF), you would use Enterprise Value, as it represents the value available to all investors, excluding interest payments. 

For Levered Free Cash Flow, you would use Equity Value, since it accounts for interest expense and debt repayments, representing the cash flow available only to equity investors after debt obligations are met.