Investment Banking Interview Questions

1. How do you value a company?

This question, or variations of it, should be answered by talking about 2 primary valuation methodologies:

1. Intrinsic value (discounted cash flow valuation)
2. Relative valuation (comparables/multiples valuation)

• Intrinsic value (DCF) – This approach is the more academically respected approach. The DCF says that the value of a productive asset equals the present value of its cash flows. The answer should run along the line of “project free cash flows for 5-20 years, depending on the availability and reliability of information, and then calculate a terminal value.  Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of equity for levered DCF).  In an unlevered DCF (the more common approach) this will yield the company’s enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at equity value.  Divide equity value by diluted shares outstanding to arrive at equity value per share.
• Relative valuation (Multiples) – The second approach involves determining a comparable peer group – companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics.  Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation.  Common multiples are EV/Rev, EV/EBITDA, P/E, P/Book, although some industries place more emphasis on some multiples vs. others, while other industries use different valuation multiples altogether.  It is not a bad idea to research an industry or two (the easiest way is to read an industry report by a sell-side analyst) before the interview to anticipate a follow-up question like “tell me about a particular industry you are interested in and the valuation multiples commonly used.”

2. What is the appropriate discount rate to use in an unlevered DCF analysis?

• Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company’s cash flows as if it had no debt – so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity).
• The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate.
• Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP’s DCF module for a detailed analysis of calculating the cost of equity).

3. What 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. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.