Wallstreet Prep Valuation Test Questions and Answers
1. 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, the value of a company will be equal to the sum
of thepresent value of all the future cash flows it generates. Therefore, 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.
2. What is equity value and how is it calculated?: Often used interchangeably with the term
market capitalization ("market cap"), equity value represents a company's value to its equity
shareholders. A company's equity value is calculated by multiplying its latest closing share price
by its total diluted shares outstanding, as shown below:
Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding
3. How do you calculate the fully diluted number of shares outstanding?: The treasury stock
method ("TSM") is 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
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.
4. What is enterprise value and how do you calculate it?: Conceptually, en- terprise value
("EV") represents 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, unlike equity value, which is
affected by financing decisions.
Enterprise value is calculated by taking the company's equity value and adding net debt, preferred
stock, and minority interest.
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
5. How do you calculate equity value from enterprise value?: To get to equity value from
enterprise value, you would first subtract net debt, where net debt equals the company's gross
debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets.
Equity Value = Enterprise Value - Net Debt - Preferred Stock - Minority Interest
6. Which line items are included in the calculation of net debt?: The calcula- tion of net debt
accounts for all interest-bearing debt, such as short-term and long- term loans and bonds, as well
as non-equity financial claims such as preferred stock and non- controlling interests. From this
gross debt amount, cash and other non-operating assets such as short-term investments and
equity investments are subtracted to arrive at net debt.
Net Debt = Total Debt - Cash & Equivalents
7. When calculating enterprise value, why do we add net debt?: The underly- ing idea of net
debt is that the cash on a company's balance sheet could pay down the outstanding debt if needed.
For this reason, cash and cash equivalents are netted against the company's debt, and many
leverage ratios use net debt rather than the gross amount.
8. What is the difference between enterprise value and equity value?: En- terprise value
represents all stakeholders in a business, including equity share- holders, 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).
To tie this to a recent example, many investors were astonished that Zoom, a video conferencing
platform, had a higher market capitalization than seven of the largest airlines combined at one point.
The points being neglected were:
1. The equity values of the airline companies were temporarily deflated given the travel
restrictions, and the government bailout had not yet been announced.
2. The airlines are significantly more mature and have far more debt on their balance sheet (i.e.,
more non- equity stakeholders).
9. 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. In these cases, companies will have enterprise values lower than their equity value.
If it seems counter-intuitive that enterprise value can be lower than equity value, remember that
enterprise value represents the value of a company's operations, which excludes any nonoperating
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.
12. Why do we add minority interest to equity value in the calculation of enterprise value?:
Minority interest represents the portion of a subsidiary in which the parent company doesn't own.
Under US GAAP, if a company has ownership over 50% of another company but below 100%
(called a "minority interest"
or "non-controlling investment"), it must include 100% of the subsidiary's financials in their
financial statements despite not owning 100%.
When calculating multiples using EV, the numerator will be the consolidated metric, thus minority
interest must be added to enterprise value for the multiple to be compatible (i.e., no mismatch
between the numerator and denominator).
13. How are convertible bonds and preferred equity with a convertible feature accounted for
when calculating enterprise value?: If the convertible bonds and the preferred equities are "inthe-money"
on the notion that
current market values, which is called "trading comps," or by looking at the multiples of
comparable companies recently acquired, which is called "transaction comps."
15. What are the most common valuation methods used in finance?: Compa- rable Company
Analysis ("Trading Comps")
Comparable Transactions Analysis ("Transaction Comps") Discounted Cash Flow Analysis
Leveraged Buyout Analysis ("LBO") Liquidation Analysis
16. What is Comparable Company Analysis ("Trading Comps")?: Trading comps value a
company based on how similar publicly-traded companies are currently being valued at by the
17. What is Comparable Transactions Analysis ("Transaction Comps")?: - Transaction
comps value a company based on the amount buyers paid to acquire similar companies in recent
18. What is Discounted Cash Flow Analysis ("DCF")?: DCFs value a company based on the
premise that its value is a function of its projected cash flows, discounted at an appropriate rate
that reflects the risk of those cash flows.
19. What is Leveraged Buyout Analysis ("LBO")?: An LBO will look at a poten- tial acquisition
target under a highly leveraged scenario to determine the maximum purchase price the firm would
be willing to pay.
20. What is Liquidation Analysis?: Liquidation analysis is used for companies under (or near)
distress and values the assets of the company under a hypothetical, worst-case scenario liquidation.
21. 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.
22. 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 method- ologies. 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.
23. Contrast the discounted cash flow (DCF) approach to the trading comps approach.:
Discounted Cash Flow (DCF)
- The DCF values a company based on the company's forecasted cash flows.
- This approach is viewed as the most direct and academically rigorous way to measure value.
- Considered to be independent of the market and instead based on the fundamen- tals of the
- The DCF suffers from several drawbacks; most notably, it's very sensitive to assumptions.
- Forecasting the financial performance of a company is challenging, especially if the forecast
period is extended.
- Many criticize the use of beta in the calculation of WACC, as well as how the terminal value
comprises around three- quarters of the implied valuation.
- Trading comps value a company by looking at how the market values similar businesses.
- Thus, comps relies much more heavily on market pricing to determine the value of a company
(i.e., the most recent, actual prices paid in the public markets).
- In reality, there are very few truly comparable companies, so in effect, it's always an "apples and
- While the value derived from a comps analysis is viewed by many as a more realistic
assessment of how a company could expect to be priced, it's vulnerable to how the market is not
- Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company's
- Comps make just as many assumptions as a DCF, but they are made implicitly
(as opposed to being explicitly chosen assumptions like in a DCF).
24. How can you determine which valuation method to use?: Each valuation method has its
shortcomings; therefore, a combination of different valuation tech- niques 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). For example, an analyst valuing an
acquisition target may look at the past premiums and values paid on comparable transactions to
determine what the acquirer must realistically expect to pay. The analyst may also value the
company using a DCF to help show how far market prices are from intrinsic value estimates.
Another example of when the DCF and comps approaches can be used together is 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 (although it bears repeating that the DCF's sensitivity to assumptions is a frequent criticism).
25. Would you agree with the statement that relative valuation relies less on the
discretionary assumptions of individuals?: That could be argued as an inaccurate statement.
While a comps analysis often yields different valuations from a DCF, that's only because of
inconsistent implicit assumptions across both approaches. If the implicit assumptions of the
comps analysis were entirely con-
sistent with the explicit assumptions of the DCF analysis, the valuations using both approaches
would theoretically be equal.
When you apply a peer-derived multiple to value a business, you're still implicitly making
assumptions about future cash flows, cost of capital, and returns that you would make explicitly
when building a DCF. The difference is, you're relying on the assumptions used by others in the
So 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.
26. What does free cash flow (FCF) represent?: Free cash flow ("FCF") repre- sents a
company's discretionary cash flow, meaning the cash flow remaining after accounting for the
recurring expenditures to continue operating.
The simplest calculation of FCF is shown below:
Free Cash Flow (FCF) = Cash from Operations - Capex
The cash from investing section, other than capex, and the financing section are
excluded because these activities are optional and discretionary decisions up to management.
27. 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).
28. 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 a DCF analysis, the cash flows projected should be strictly from the business's
recurring operations, which would come from the sale of goods and services provided. A few
examples of non- operating income to exclude would be income from investments, dividends, or
an asset sale. Each example represents income that's non-recurring and from a discretionary
decision unrelated to the core operations.
- When performing comps, the core operations of the target and its comparables are
benchmarked. To make the comparison as close to "apples to apples" as pos- sible, non-core
operating income/(expenses) and any non-recurring items should be excluded.
29. Define free cash flow yield and compare it to dividend yield and P/E ratios.: The free
cash flow yield ("FCFY") is calculated as the FCF per share divided by the current share price.
For this calculation, FCF will be defined as cash from operations less capex.
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. Unlike dividend yield, however, 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).
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. This has the advantage of benchmarking prices against actual cash flows
as opposed to accrual profits. However, it has the
disadvantage that cash flows can be volatile, and period-specific swings in working capital and
deferred revenue can have a material impact on the multiple.
30. 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. Most companies'
capital structure consists of a mixture of debt and equity,
as each source of capital comes with its advantages and disadvantages. 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. Thus, it's ordinary to see leverage ratios increase in
proportion with the company's maturity.
31. Why would a company issue equity vs. debt (and vice versa)?: Equity
- No required payments, unlike debt, giving management more flexibility around repayment.
- Dividends to equity shareholders can be issued, but the timing and magnitude are at the board
and management's discretion.
- Another advantage of equity is that it gives companies access to a vast investor base and
- Issuing equity dilutes ownership, and equity is a high cost of capital.
- Public equity comes with more regulatory requirements, scrutiny from sharehold- ers and equity
analysts, and full disclosures of their financial statements.
- The management team could lose control over their company and be voted out by shareholders
if the company underperforms.
- The interest expense on debt is tax- deductible, unlike dividends to equity shareholders
(although recent tax reform rules limit the deduction for highly levered companies).
- Debt results in no ownership dilution for equity shareholders and has a lower cost of capital.
- Increased leverage forces discipline on management, resulting in risk-averse decision-making as
a side benefit.
- Required interest and principal payments that introduce the risk of default.
- Loss of flexibility from restrictive debt covenants prevents management from undertaking a
variety of activities such as raising more debt, issuing a dividend, or making an acquisition.
- Less room for errors in decision-making, therefore poor decisions by manage- ment come with
more severe consequences.
32. What are share buybacks and under which circumstances would they be most
appropriate?: A stock repurchase (or buyback program) is 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. The repurchase will be shown as a cash outflow on the cash flow statement and
be reflected on in the treasury stock line items on the balance sheet.
Ideally, the right time for a share repurchase to be done should be when the company believes the
market is undervaluing its shares. The impact is the reduced number of shares in circulation, which
immediately leads to a higher EPS and potentially a higher P/E ratio. The buyback can also be
interpreted as a positive signal by the market that the management is optimistic about future
33. Why would a company repurchase shares? What would the impact on the share price and
financial statements be?: A company buys back shares pri- marily 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
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. That said,
share buybacks can positively or negatively affect share price movement, depending on how the
market perceives the signal.
Cash-rich but otherwise risky companies could see artificially low share prices if investors
discount that cash in their valuations. Here, buybacks should lead to a higher share price, as the
upward share price impact of a lower denominator is greater than the downward share price
impact of a lower equity value numerator. Conversely, if shareholders view the buyback as a
signal that the company's investment prospects are not great (otherwise, why not pump the cash
into invest- ments?), the denominator impact will be more than offset by a lower equity value
(due to lower cash, lower perceived growth and investment prospects).
On the financials, the accounting treatment of the $100 million share buyback
would be treated as:
Cash is credited by $100 million Treasury stock is debited by $100 million
34. Why might a company prefer to repurchase shares over the issuance of a dividend?: - The
so-called "double taxation" when a company issues a dividend, in which the same income is taxed
at the corporate level (dividends are not
tax-deductible) and then again at the shareholder level.
- Share repurchases will artificially increase EPS by reducing the number of shares outstanding and
can potentially increase the company's share price.
- Many companies increasingly pay employees using stock-based compensation to conserve cash,
thus share buybacks can help counteract the dilutive impact of those shares.
- Share buybacks imply a company's management believes their shares are currently
undervalued, making the repurchase a potential positive signal to the market.
- Share repurchases can be one-time events unless stated otherwise, whereas div- idends are typically
meant to be long-term payouts indicating a transition internally within a company.
- Cutting a dividend can be interpreted very negatively by the market, as investors will assume the
worst and expect future profits to decrease (hence, dividends are rarely cut once implemented).
35. 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
- Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15.0 x $90 million)
Although there's a tax impact since interest is mostly deductible, it can be ignored for interviewing
purposes. That's a $150 million drop in equity value. However,
shareholders are immediately getting $200 million.So ignoring any tax impact, there's a net
benefit of $50 million ($200 million - $150 million) to shareholders. The assumptions we made
about taxes, the cost of debt and the multiple staying the same all affect the result. If any of those
variables were different - for example, if the cost of debt was higher - the equity value might be
wiped out in light of
this move. A key assumption in getting the answer here was that P/E ratios would remain the
same at 15x. A company's P/E multiple is a function of its growth prospects, ROE, and cost of
equity. Hence, borrowing more with no compensatory increase in investment or growth raises the
cost of equity via a higher beta, which will pressure the P/E multiple down.
While it appears based on our assumptions that this is a decent idea, it could easily be a bad idea
given a different set of assumptions. It's possible that borrowing for the sake of issuing dividends
is unsustainable indefinitely because eventually, debt levels will rise to a point where the cost of
capital and P/E ratios are adversely affected. Broadly, debt should support investments and
activities that will lead to firm and shareholder value creation rather than extract cash from the
36. When would it be most appropriate for a company to distribute divi- dends?: 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 longterm
38. What is the difference between CAGR and IRR?: The compound annual growth rate
(CAGR) and internal rate of return (IRR) are both used to measure the return on an investment.
However, the calculation of CAGR involves only three inputs: the investment's beginning and
ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can handle
more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of
the multiple cash flows) accounted for, rather than just smoothing out the investment returns.
CAGR is usually for assessing historical data (e.g., past revenue growth), whereas
IRR is used more often for investment decision-making.
39. How would you evaluate the buy vs. rent decision in NYC?: - First, I would have to make
assumptions to allow for a proper comparison, such as having