Questions Valuation - Interview PDF

Ferdinand Petra HEC ‐ IB Elective 2019
(Draft as of 11/3/19)
Questions – Valuation part (Accounting & Value creation)
WITH SUGGESTED ANSWERS ‐ Main contributor: Mike Mori / Reviewed by F. Petra
1. What do you include in WC? What you do not include in it?
 WC = (all ST assets – cash & cash eq.) – (all ST liabilities – ST financial debt)
 WC = Operating WC + non‐operating WC
 Operating WC (linked to the operating cycle of the firm → depends on level of ac vity):
o Asset: A/R + Inventory + Prepaid Expense (e.g. insurance)
o Liability: A/P + unearned (or deferred) revenues (e.g. multi‐year contract –
newspaper editor) + Accrued expense
 Non‐operating WC:
o Tax payable, dividend payable, deferred taxes (asset & liabilities)
 Do not include fixed assets

2. Why do companies have tax payable on their B/S
 Income taxes for a specific year are usually payed in the following year. Between the
moment the income tax is booked and the time it is actually paid, it represents a liability
for the company.
 Accordingly, tax payable is the account in the current liabilities section of a company's
balance sheet, which reflects this liability to the tax authorities. It is compiled of taxes
due to the government within one year.

3. When you pay interest to debtholders, do the amount of debt on B/S change? Same
question in case of a zero coupon bond you issue?
 For regular debt, the amount of debt on the B/S does not change, because the interest
paid represents an expense which only flows through the P&L and does not impact the
debt position on the balance sheet.
 For zero coupon bonds, it is different, because the “interest” is paid in a single payment
at maturity (it is included in the payment of the bond’s face value to the bond holder).
Thus, during the lifetime of the bond, the interest is recognized on an accrual basis and
added to the debt position on the B/S every year. A zero coupon bond with a face value
of 1,000 will be recorded at 800 (for example) when the bond is issued and the 800 will
increase every year by the amount of accrued interest up to maturity of the bond

4. How does a PP&E account evolve from beginning to end of fiscal year?
 PP&E EoY = PP&E BoY + Capex – Depreciation – Net BV of PP&E sold

5. A controls B but do not own 100% of it. What do you see on A’s balance sheet?
 Company A’s consolidated balance sheet will show non‐controlling interest (equal to the
book equity value of B attributable to the non‐controlling shareholders) as a component
of the company’s group shareholders’ equity
 Company consolidated Assets and Liabilities will be equal to the sum of 100% of A ones
and 100% of B ones

6. Case 1: A owns 100% of B; Case 2: A owns 80% of B; is there any cash difference during the
fiscal between these two cases?
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 Assumption: This question refers to the cash balance on the consolidated balance sheet
 Answer: If B pays dividends, then there will be a difference in the consolidated cash
balance, because a part of the paid dividend goes to the minority shareholder (i.e. that
part does not stay on the consolidated balance sheet). If the subsidiary does not pay any
dividends, the consolidated cash balance will be the same in both cases.

7. Case 1: A owns 30% of B (B pays 10 of dividend); case 2: A owns 5% of C (C pays 60 of
dividend). What cash flow difference between the 2 cases?
 Since both are minority stakes, there is no full consolidation and a difference in cash flow
would have to stem from a difference in received dividends
 In case 1, A receives a dividend of 3; in case 2, A receives a dividend of 3 as well. Thus,
there is no cash flow difference between these two cases

8. 2 companies operating in the same mature business have had (over the past 5 years)
respectively ROCE of 10% and 15%, ROE of 20% and 15%. Which company would you
acquire (assuming same price tag)?
 Acquire the company with the higher ROCE because the ROCE measures how effectively
a company uses its capital to generate returns.
 The higher ROE of the 1st company is simply due to differences in the capital structure,
i.e. by changing the capital structure of the 2nd company to that of the 1st company, the
ROE of the 2nd company would be higher than the ROE of the 1st company (i.e. >20%).

9. 2 companies operating in the same industry have had similar ROCE around 15%. The
second company did a large goodwill impairment 2 years ago following worsening
conditions in the geographical market in which it made an acquisition. How would you deal
with that information?
 It depends on whether or not this goodwill impairment has already been adjusted for
during the calculation of the ROCE of the second company
 If not, adjust the ROCE by adding the goodwill impairment (after tax – even though most
of the case not tax deductible) back to the CE to get an adjusted ROCE. Also remove the
write‐down expense (after tax) from the net operating profit after tax (NOPAT) to
compute the ROCE from 2 years ago.
 Therefore, if not adjustment have been made on the ROCE of 15%, it means company 2
adjusted ROCE should be lower than 15%, implying company 1 has a better return

10. Everything else being equal, which one of the 2 following companies will have a higher EV:
a. Company selling discretionary or non‐discretionary product?
The company selling discretionary products has a higher operating risk because of the
stronger impact of cyclicality on its business (i.e. sensitivity to GDP growth). Thus, the
company selling discretionary items has a lower EV.

b. Company in a regulated business or in an unregulated business?
It depends, there could be two possible scenarios:
1. Regulatory uncertainties → higher opera ng risk → lower EV
2. Regulatory protection → lower opera ng risk → higher EV

c. Smaller or larger company?
Smaller companies are less diversified in term of product mix, clients, suppliers, etc.
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→ higher opera ng risk → lower EV

d. A fabless firm or a capital‐intensive one?
Capital‐intensive businesses have higher reinvestment needs (i.e. capex) which increase
the operating risk (as they have higher fixed costs = Capex vs. only variable cost if they
outsource) → lower EV

11. What is the accounting link between ROCE and ROE? What interest rate should we use in
this formula?
ROE = ROCE + (ROCE – kd(1‐T))xND/E
ROCE is after tax
ND: net financial debt
E: Book value of shareholders equity
kd : ‘accounting’ net Interest Expenses/ ND

12. In the WACC calculation, why do we weight Ke and Kd with Market Value of Debt and
Equity and not Book values?
 Because the WACC can be viewed as the cost for the company to “renew” today the
entire funding of its operations (hence weights in market value and after‐tax cost of
debt)

13. Does the WACC formula evolve if the company has preferred shares? What other impact
this would have?
 For the WACC calculation, other capital providers maybe added if material (this includes
preferred shares)
 In this case, we would have to add “Cost of preferred shares (=return on preferred
shares) x weight of preferred shares” to the WACC formula
 Furthermore, we would have to include the preferred shares when calculating the weight
of the different kinds of capital in the WACC formula [e.g. EqV/(EqV + Vd + preferred
shares)]

14. What is the name of “expected ROCE – Wacc”?
 Spread (as well called ‘excess return’) is the difference between the expected return on
capital employed and the weighted average cost of capital
 There is value creation if the spread is positive

15. If a company has an EV>CE, what can we infer about expected value creation?
 EV > CE implies that expected ROCE > WACC “over time”; i.e. we can expect future value
creation if the positive spread can be sustained

16. Is an increased future growth always a good news for shareholders?
 Growth is a double‐edged sword:
o It can accelerate value creation (ROCE > WACC) or value destruction (ROCE <
WACC)
o It will require investment (therefore putting pressure on ROCE)
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 Therefore an increased future growth is a good news only if it is accompanied with value
creation

Page 4

Questions – Valuation part (EV‐EqV bridge)
1. In which cases the value of net debt maybe significantly different from its book value?
 Significant worsening of the company credit rating since the issuance of the debt, which
can go up to distressed stage
 Fixed rate debt with large difference in rates between issuance date and current date

2. Except using BV, what other valuation methods can we use to value NCI and Associates? Be
specific on the computation you would make
 For NCI:
o Market value if available (i.e. listed);
 Computation: NCI = Minority stake (in %) x Market capitalization of the
subsidiary
o Use multiples (e.g. P/B, P/E) of comparable companies
 Computation (with P/B multiple): NCI = BV of NCI x P/B multiple of
comparable companies
 Computation (with P/E multiple): NCI = Earnings attributable to NCI x P/E
multiple of comparable companies
 We usually will assume that the P/E and P/B used above will be the same
as the parent’s consolidated ones (with a discount to reflect the lack of
liquidity)
 For Associates:
o Market value if available (i.e. listed)
 Computation: Associate = Stake owned (in %) x Market capitalization of
Associate
o If no market value but enough information, you can use P/E, P/B multiple or DCF
valuation, taking into account lack of liquidity (specific computations are
analogous to those for NCI in the previous paragraph)

3. How would you define (with a sentence) the EV of a company (from the asset side
standpoint)?
Enterprise Value is the value of 100% of controlled subsidiaries’ net operating assets

4. What type of provisions do you usually consider as debt‐like liability?
 Provision for underfunded pensions (incl. OPEBs)
 Provisions for Environmental exposure
 Provisions for large litigations (e.g. Asbestos)
 Abnormal/unusual provisions

5. What asset‐like elements can you encounter in firms?
 Associate
 Minority equity investment (or debt investment) in a company
 A non‐utilized asset (asset that does not generate earnings or cash flows)
 Tax loss carry forward
 Pension surplus (debatable; aggressive approach)
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 Fair value of hedging instruments

6. Do you consider financial leases as a financial debt?
 Capital/Financial leases are to be included in financial debt (or to be considered as ‘debt‐
like’ items)

7. What are OPEBs? Do you consider them as debt‐like?
 Other post‐employment benefits (OPEB) are the benefits that an employee will begin to
receive at the start of retirement. This does not include pension benefits paid to the
retired employee. Other post‐employment benefits that a retiree can be compensated
for are life insurance premiums, healthcare premiums and deferred‐compensation
arrangements.
 OPEBs (Other postemployment benefits) in the US are usually unfunded pension plans
(i.e. companies do not put money aside) and thus they have to be treated as “debt‐like”
items (usually included during calculation of provision for underfunded pensions).

8. How do you compute the debt‐like liability a firm may have related to its pension
obligations? How do you know if such liability benefits from a tax shield?
1. Check, if Defined Benefit Obligation > Fair value of the pension plan
2. Underfunded Pension Plan (“debt‐like” item) = Defined Benefit Obligation – Fair value of
the pension plan
3. Check, if the liability benefits from a tax shield:
o In parts of Europe unfunded plans are more common. In these cases the tax
deduction often applies when the cost is expensed rather than when the
payment is made and if this is so there is no argument for tax affecting the deficit
since the benefit has already been received by the business concerned.
o If the tax deduction applies when the actual payment is made, the liability
benefits from a tax shield (check the company’s annual report or the local
regulation)
4. If the liability benefits from a tax shield, adjust the underfunded pension plan:
o Pensions (“debt‐like” item) = Underfunded Pension Plan x (1 – Statutory Tax
Rate)

Page 6

Questions – Valuation part (Overview of valuation +DCF)
1. What are the valuation methods that lead you to a standalone value? What are the ones
that will provide you a “price” for an asset or what can be called a value for control? What
are the methods that provide you a maximum price that can be paid for an asset?
 Standalone values: Trading comps, DCF excl. synergies
 Value for control: Transaction comps, DCF with part/all synergies and/or part/all of value
for control, LBO analysis and historical premium paid (debatable as they are not
valuation methods per se),
 Maximum price that can be payed: LBO analysis and DCF with [100% synergies + value
for control]

2. Which valuation methods would you use in IPOs and which ones you would not?
 Idea: use methods that provide a standalone value, since in an IPO context, we want to
determine the price to acquire a minority stake in the firm
 Would use: DCF, DDM (for FIG), Trading comps, APV
 Would not use: transaction comps (because transaction comps will yield the value for
control), LBO and historical control premium (both of which are not valuation methods
anyway)

3. Why practitioners use more FCFF discounting than FCFE discounting as a valuation
method?
 FCFE are difficult to forecast when the company is expected to change its capital
structure going forward → Therefore, most practitioners use DCF (to Firm)
 DCF to Equity mostly used for financial institutions and insurance where regulatory
requirement (e.g. Basel, Solvency) are set on level of shareholders equity needed

4. Is the DCF a method that provides a standalone value (i.e. price to acquire a minority stake
in a firm) or a method that enables to value the price you would pay to control a firm?
 It depends on your point of view:
o If you simply input the current management’s business plan without any
adjustments or synergies, the DCF will yield a standalone value
o If you (i.e. the buyer) change the business plan according to your own
assumptions or expectations and / or include part/all synergies, the DCF yields
the price for control

5. How long should theoretically be the explicit forecast period in a DCF? In which case this
period can go up to 20 years? In which case it could be only 2‐3 yrs?
 The explicit forecast period should go until the company reaches a “steady state”.
Depending on the length of the management forecast (and predictability of the industry),
you may need to use a fading period between the end of the business plan period and
the time where the company reaches a steady state.; usually 5‐10 years or simply the
business plan length
o Could be 3 years for a business which is already in a mature state
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o Could be 20 years for a business that is very stable and can be reasonably
forecasted with a known terminal (liquidation) value (e.g. mines with a mining
plan)

6. Qualitatively, please provide 3 elements that will drive the level of Asset beta? What
additional element will drive equity beta vs. asset beta?
 The asset beta only takes into account the ‘business (aka operating) risk’ of a company;
it’s influenced by factors such as:
o Cyclicality (discretionary product and/or industry driven by supply/demand),
Operating leverage, uncertainty of the industry
 Financial leverage will as well drive equity beta (in addition to the elements above
mentioned for asset beta)
7. What Risk‐free rate most practitioners use? Such rate is really risk‐free?
 Government bond yield (assuming that the company bears the country risk: “country risk
premium”)
 10 year time horizon (easiest to find across countries – most used in practice)
 Not really risk‐free, because countries themselves are not risk‐free and might default on
their debt (e.g. Greece) – only risk‐free country assumed to be the US

8. What range of Equity risk premium would you take for a mature equity market?
 5‐7%

9. What is the best proxy of the cost of debt of a firm?
 Yield to Maturity (‘YTM’) of all company’s listed bond (ideally 10‐yr maturity) – need to
be sure that such listed bonds are representative of the overall credit risk of the firm

10. In which case(s) could you use “liquidation value” as a Terminal value in a DCF?
 In case a business is liquidated at the end of the forecast period (e.g. mines, were all the
ore has been extracted by the end of the forecast period)

11. When using a perpetuity growth method for the DCF terminal value, what maximum
growth rate can you use reasonably?
 Maximum growth rate: Worldwide GDP nominal long‐term growth rate (proxy for
worldwide LT growth can be Rf if we assume that real interest rate = GDP real growth in
the long term)
 Reason: If you grow faster than the market in perpetuity, you will eventually become the
market (i.e. not possible; therefore, worldwide LT growth is the maximum growth rate in
perpetuity)

12. When computing a DCF terminal value based on a perpetuity, what ratios you need to be
careful about when building the normative FCFF based on the last year forecasted FCFF?
 EBIT(DA) %: look at historical levels – any reason why it should reach a level higher than
historical?
 Capex/sales: in line with low growth phase
 Capex/D&A : usually at or slightly above 100% (never lower!) – will depend on g
 ΔWC/change in sales: steady level

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13. What is the most common method to compute Equity Beta of a listed firm? What are the
limitations of this method? What alternatives do you have?
 Most common method: Historical (observed) beta – pay attention to time horizon,
frequency of measurement and reference market index (usually 5 years, monthly
returns, broad index)
 Limitations:
o Can be distorted by noise in the market
o Does not reflect current capital structure (i.e. current financial risk) as average
risk over a period of time
o The business risk of the company can have changed over the period used for the
regression
o Comparably small sample of observed data → larger standard error
 Alternatives:
o Predicted beta: historical beta adjusted to reflect an expectation that beta will
revert to 1.0 over time (from Blum (1975) – used by Bloomberg)
o Industry beta or average/median of comparable companies beta: need to
unlever and relever the beta (will reduce standard error by a taking large sample
of observed beta)

14. How to compute the levered beta of a private company?
 To estimate the levered beta of private companies (which are not observable), it’s
possible to use the levered betas of comparable listed companies
1. For each comparable company, unlever their equity beta using the Hamada
formula to get their unlevered beta (“asset beta”)
2. Compute the average or median of the unlevered betas of the comparable
companies
3. Using the private company’s expected capital structure, relever the
average/median unlevered beta of the comparable companies to compute the
private company’s levered beta

15. When using a “target capital” structure to perform a DCF, what element(s), if any, should
be adapted in the WACC formula in addition to the current D/E ratio?
 Adjust the Kd to reflect the target D/E ratio
 Delever/relever beta to reflect the target D/E

16. When using the exit multiple method in a DCF: on what financial period will you base your
multiple? What elements will you look at when setting the level of multiple you will use?
What is the biggest drawback of using the exit multiple method in a DCF?
 Financial period is LTM as you will design a normalized EBITDA based on LTM EBITDA (at
the time of the terminal valuation) to compute your TV
 If we take the example of an EV/EBITDA exit multiple:
o Use normalized EBITDA which is adjusted from the last forecasted period EBITDA
→ it is therefore a LTM ﬁnancial
o Use LTM multiples from comparables as the normalized EBITDA is a LTM financial
 Choosing the appropriate level of multiple:
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oNeed to reflect a reasonable LTGR → Pick up the multiple where there is a
correlation between multiple level and future LT financial metric growth + pick
up the level of multiple corresponding to the LTGR you feel is reasonable
o Is the market too bullish or too bearish at the moment to take the current LTM
multiple ? Look at historical multiples and guess the historical average or
‘Through the Cycle’ level (for cyclical industries)
o Cross‐check different level of multiples to get a “view”
 Drawbacks:
o Introduces relative value with intrinsic approach → DCF becomes a forward
‘relative valuation method’
o Assumes that the current LTM multiple is equal to the LTM multiple at the end of
the forecast period

Page 10

Questions – Valuation part (Multiples)
1. How multiples level changes vs. interest rate level (in long trend over time)?
 Interest rates level:
o Lower interest rate level will offer cheaper cost of financing for firms, decreasing
WACC
o At the same time, lower interest rate should reflect medium term lower real
growth and inflation, reducing the future FCFF and so the multiple
o All in all, period of low interest rates have witnessed higher multiples

2. Please mention 4 drivers of multiples (excluding interest rate levels)
 Expected future growth ↗
 Expected profitability (ROCE for EV multiple and ROE for EqV multiple) ↗
 Length of sustainability of competitive advantage (i.e. excess return) ↗
 Operating risk  (and financial risk  for EqV multiple)

3. When using P/E ratio to compare firms what are the 5 elements to be careful about?
 Which EPS are you talking about (diluted, basic, pre‐ or post‐ exceptional)?
 Volatility of EPS
 Company having different capital structure will have different levered beta even if similar
business (i.e. leverage effect can bias results)
 Expected ROE level (itself impacted by the capital structure differences)
 Accounting differences / unusual items

4. When using EV/EBIT to compare listed companies in the same industry, what can justify
that a company has a higher level of multiple than the others?
Higher expected long term EBIT growth and/or higher ROCE level and/or lower Tax Rate (and/or
much larger in size) can explain higher multiple levels. We assume here that companies in the same
industry will have similar WACC
There can be as well some ‘one off’ specific reasons: company has been hit by bad news or scandal
recently (market over‐reaction), the company is an acquisition target (‘control premium’ embedded
into the share price)

5. Is EV/EBITDA multiple suited to compare companies in capital‐intensive industries? Please
explain
 No, because in capital‐intensive industries Capex and therefore D&A are quite large and
EBITDA does not capture these elements.
 Thus, EBITDA does not take into account different levels of reinvestment needs (Capex +
ΔWC) to sustain a given level of EBITDA growth
 Thus, use EV/EBIT instead of EBITDA/EV in capital‐intensive industries to take into
account the differences in D&A (and i.e. reinvestment needs and cashflow; watch out
that the D&A level reflects the ‘average’ level of Capex needed over time)

Page 11

6. In which case would you use EV/sales multiple? What is the biggest drawback of this
multiple?
 Use EV/sales multiple if no further breakdown of the financials (EBITDA, EBIT, NI, ..) is
available (e.g. for subsidiaries that don’t have to report detailed financials)
 Can be appropriate for sectors where profitability is very similar among different
companies
 USE EV/sales if other metrics such as EBITDA, EBIT, NI, etc. are negative (e.g. for start‐ups
or other companies that are not profitable yet) – in such case we make the assumption
that the company you value will have a long‐term profitability (EBITDA or EBIT %) similar
with the companies of your comparable set.
 Drawback: Profitability is not taken into account (and usually profitability drives
valuations!)

7. When using EV/EBIT, EV/EBITDA, EV/sales, P/E multiples in a given industry, with which
financial earnings/metrics do you find a linear correlation sometimes? Please be specific in
your answer
 For a given industry, with companies of similar size, we observe that multiples are mainly
driven by future growth and/or profitability, leading to the following correlations:
o EV/Salesn (year n) and EBITDA margin (year n)
o EV/EBITDAn and EBITDA future growth
o EV/EBIT vs. EBIT future growth
o P/En and EPS future growth
‘future growth’ above mentioned should reflect long‐term growth. In practice, we will take the 2‐3
years forward CAGR.

8. How do you deal with RSU when computing the market capitalization of a listed firm?
 Use the Treasury Stock Method to calculate the diluted number of shares outstanding
and treat RSU as options with a strike price of 0€
 Afterwards, use that diluted number of shares outstanding to calculate the market
capitalization

9. Please explain what is the Treasury Stock Method? What drawback does it have?
 Method for the computation of ‘Shares equivalent due to exercise of stock option’
 Treasury Stock method assumes the following:
o All ITM stock options (In The Money if P>K) will be converted into shares by the
holders (i.e. Key employees are rational investors)
o The company will use the proceeds from the exercise of the options to buyback
shares
 If we generalize to N stock options with a strike price K (P being the current share price):
o If P>K, share equivalent = N (1 – K/P)
o If P<K, the holder won’t exercise, therefore share equivalent = 0
 Drawback: TSM does not take into account time value of options!

10. What is the difference between the nb of shares outstanding and the number of shares
issued?
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The difference between the two corresponds to the Treasury shares, the shares issued bought back
by the firm which reduce the total amount of shares outstanding.
Basic shares outstanding = Shares issued – Treasury shares

11. When using the Treasury Stock Method, do you take the number of options outstanding or
exercisable?
You use the number of options outstanding to be “conservative” as it assumes that all options
become exercisable.
Page 13

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Ferdinand Petra HEC ‐ IB Elective 2019

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