Navigating an investment banking interview is a balancing act, where your knowledge of corporate finance can tip the scales in your favour. Unlike general behavioural questions, corporate finance-related queries dive into your comprehension of valuation and key financial terms like equity and enterprise value—core elements that investment bankers deal with regularly.
If you've already explored our previous article on accounting interview questions, you'll know the importance of having a strong foundation in accounting principles. Accounting is, after all, the backbone of financial analysis. If you haven't had a chance to read it yet, we strongly recommend you do by clicking on the link here.
In this article, we will guide you through some of the most common corporate finance questions you're likely to encounter in investment banking interviews.
What are the most common methodologies to value a company?
There are different methods to value a business, the most common ones are:
Multiple-based approaches (i.e. comparable company and precedent transaction analysis)
Yield-based approaches (e.g. dividend yield)
Discounted cash flow (“DCF”) method
Leveraged buyout (“LBO”) analysis
Out of all of these methods, the multiple-based approach is likely to be the most common one and applicable to a lot of different companies and industries. Calculating yields only make sense if the company is actually paying out a dividend. The DCF method works best for mature companies which are generating substantial cash flows because otherwise the terminal value becomes too large relative to the cash flows in the projection period. Note that the leveraged buyout analysis is not a standalone valuation exercise as an exit multiple needs to be assumed in order to calculate an entry valuation. In practise, the LBO calculation often frames the minimum valuation as this is what a financial sponsor, who is not able to realise any synergies, would be willing to pay for the business.
In a valuation exercise, the analyst aggregates the results from those different methods in a “football-field” which shows the valuation range for each method and helps to frame the overall valuation for the business.
In which two distinct ways can a revenue model be built and which one of the two is more common in investment banking?
You can create a revenue model either bottom-up or top-down. The bottom-up one is the more common one in practise because it’s more scientific and directly relates to the company whereas the top-down one depends on forecasting the size of the market and the company’s market share which is prone to mistakes.
Bottom-up: You start with the company’s revenue segmentation which might be the company’s individual products or services. For each product, you estimate volume as well as average selling price (“ASP”) for the forecast period. You then multiply these together for each product so that you have the revenue per product and then you simply need to add these different revenue streams up. For example, for Apple, you would forecast the volume and ASP for the iPad, iPhone, Macs, iCloud, and App Store revenues to then arrive at the total revenue.
Top-down: Start by calculating and projecting the overall size of the market and then forecast how the company’s market share is going to evolve to get to the company’s revenues.
Ideally, you use the bottom-up method to calculate the company’s revenues because it’s more scientific and allows for a better discussion because then you and your team can, for example, argue about why the price of an iPhone will go up by 5% p.a. while volume declines by 2% p.a., etc. Once you have these calculations, you can then cross-check them by back-solving the top-down approach to see how the market share is going to develop. If you find out that your projections lead to a significant market share increase / decrease, you then need good reasons to justify it or be willing to adjust your bottom-up projections. In general, the bottom-up method is more used for larger and mature companies so it’s common in investment banking and private equity. However, the top-down method does have a raison d'être in the start-up / venture capital world. For a start-up which is not even making revenues, it’s farfetched to start projecting out volumes and prices for products that have not even been brought to market, yet. It makes much more sense to estimate the size of the (untapped) market and then assume a certain penetration of the market to gauge how much revenue the company could make.
What is equity value?
The equity value denotes the market value of the equity capital of the business. If you acquire all outstanding shares, you control the operating business. However, even if you own all of the equity, you cannot necessarily freely use the cashflows of the business as there might still be other stakeholders such as debt investors. Hence, even if you own 100% of the equity, you don’t necessarily own 100% of the cash flows because you have to pay interest and debt amortization.
What is the difference between equity value and shareholders’ equity?
Whereas equity value describes the market value of the equity, shareholders’ equity describes the book value of the equity. The book value of the equity can be found on the balance sheet and can be both a positive or negative number. The value of the market equity of a publicly traded company is always a positive number. In general, you would expect a company’s market equity value to be above (and even a multiple of) its book equity value. The reason for this is that the market equity value is based on expectation about the future earnings power of the business whereas the book equity value reflects the historic net asset value of the business.
How do you define enterprise value?
Enterprise value is the value of the whole company – and therefore independent of capital structure – as defined by the core operating assets of the business. Non-core assets such as excess cash and subsidiaries are therefore not part of the enterprise value. You can think of the enterprise value as the value you need to pay to acquire all the cash flows of the business. In other words, if you pay the enterprise value (and thus acquire all of the equity and debt), then you will own all of the cash flows of the business.
What is the difference between equity value and enterprise value?
Whereas the equity value describes the value of just the equity, the enterprise value describes the value of the entire business and therefore includes all other capital providers. In very simple terms, enterprise value equals equity value plus net debt.
Assume you want to start your own AI company and the first thing you do is go to your parents and raise £1m in debt financing. What is the enterprise value of you company then?
Using the simple formula for enterprise value:
EV = Equity Value + Debt – Cash
Shows that the enterprise value of the business is zero because you now have £1m in debt and £1m in cash but no real operating company. With these kind of questions, keep in mind that changes in the company’s capital structure do not have an impact on the enterprise value.
Follow-up question: assume that you use the £1m in debt to purchase the latest AI-enabled chips from NVIDIA. Would that change your EV?
The answer is that EV goes up by £1m. Think again about the simple formula for EV:
EV = Equity Value + Debt – Cash
The only thing that changes is that cash goes down by £1m. Since cash is subtracted and it decreases, it increases the EV. Note that debt remains the same and also equity value remains the same because now you essentially have a company with £1m worth of assets and £1m worth of debt so the equity value is still zero.
In the above example, assume that after a couple of years you are able to pay back the £1m of debt that your parents lent you. How would that change the enterprise value?
It wouldn’t change the enterprise value because it just impacts the company’s capital structure, that is, the net change in debt and cash cancels each other out.
Follow-up question: A couple of years later, you decide to IPO the business. As part of the IPO, you issue £20m in additional equity. How does that impact your EV?
As this is just a financing choice, it doesn’t impact EV. What happens is that the equity value goes up by £20m, at the same time, cash also goes up by £20m so that the net effect is zero.
When valuing companies, what do investment bankers care more about – equity or enterprise value?
The enterprise value plays a more significant role in valuation than the equity value. Most companies trade on enterprise value multiples and the equity value is then derived through the enterprise to equity value bridge. A key reason for the dominance of enterprise value multiples is that they are independent of capital structures and therefore enable like-for-like comparison between two companies. To illustrate this, imagine you had two companies, A and B, which are exactly the same in terms of operations and business, but A does not have debt whereas B has 50% debt as part of its capital structure. A’s market cap (i.e. equity value) will then be twice as high as B’s, yet the two businesses are identical and as the buyer, you would not mind whether you buy A or B. If you buy A, you just buy out the entire equity and if you buy B, you buy out the equity and repay the debt – the cost is the same. Therefore, the enterprise value (and not the equity value) describes the true cost of acquiring a business.
Also, consider that if an acquirer buys out the equity of the business, then this triggers the ‘change of control’ clause of the debt which means that the buyer must repay the debt. He can repay the debt by either using further equity, or alternatively, refinancing the old debt with a new debt facility. In any case, the enterprise value shows the true cost of acquiring the whole business on a ‘cash free / debt free’ basis.
Besides net debt, what other items do you need to consider in the EV to equity value bridge?
A more comprehensive bridge looks like this:
(+) Financial debt
(+) Any other interest-bearing liabilities
(-) Excess cash
(-) Any non-core assets such as financial assets and non-core subsidiaries
(+) Preferred stock
(+) Non-controlling interest (“NCI”) formerly called minority interest
(+) Pension obligations (i.e. underfunded defined benefit schemes)
(+) Environmental and other non-financial liabilities
(+) Operating leases (note that those need to be converted to capital leases)
(+) capital leases if not already included under financial debt
= Enterprise Value
Why is cash deducted in the above formula for enterprise value?
First, note that cash is considered a non-operating asset and enterprise value assesses the value of the net operating assets of a business. Since the value of cash is already included in the equity value, it needs to be deducted in the equity-to-enterprise value bridge. You can also think about it this way: enterprise value is what the buyer needs to pay to command all the cash flows from the business. If the target company has cash on its balance sheet, then the acquirer can use that cash – once he acquires the business – to reduce the cost of acquiring all cash flows by using the cash immediately to pay back debt which was used to finance the transaction.
Why do you include non-controlling interest in enterprise value?
Non-controlling interest symbolizes the minority equity portion that other investors have in a subsidiary that the parent company fully consolidates in its books. Non-controlling interest is therefore not included in the market capitalization, because the equity value only reflects the value of the equity that is owned. However, the enterprise value is the value of the entire business and therefore, to own the entire business, you have to buy out the non-controlling interest which is why non-controlling interest is added to equity value in the equity-to-enterprise value bridge. Also, note that the non-controlling shareholders might have – similarly to the debtholders – a change of control clause which is triggered once the equity of the parent company changes ownership.
Furthermore, it is important to add back non-controlling interest to calculate like-for-like multiples. Subsidiaries which are majority owned are fully consolidated in the books of the controlling party. Therefore, the EBITDA of the controlling owner includes 100% of the EBITDA of the subsidiary even though the controlling owner might only own 51%. As the EBITDA accounts for 100% of the subsidiary in the denominator, the enterprise value in the nominator of an EV / EBITDA multiple thus also has to account for 100% of the business value in order to have a like-for-like comparison.
Assume that you have a reported EBITDA of £100m which includes the effect of a litigation provision of £10m, further you have net financial debt of £30m and you value the company at 10x EV / EBITDA. What is the enterprise and equity value of the business?
First, Note that it would be incorrect to apply the 10x multiple on the £100m of unadjusted EBITDA because that would assume that the litigation provision is a recurring event that happens every year. In general, please make sure to calculate your multiples based on adjusted financial figures so that exceptional and non-recurring items don’t distort the valuation of the company. Therefore, you first calculate the adjusted EBITDA which is £110m (i.e. £100m + £10m) and then you apply the 10x multiple to the adjusted EBITDA, giving you an enterprise value of £1,100m. To get from enterprise to equity value, you must deduct the provision of £10m and the net financial debt of £30m in the enterprise-to-equity bridge and then you arrive at an equity value of $1,060m.
If you value a company using trading multiples, precedent transactions, DCF, and LBO, which method typically yields the highest / lowest values?
In practise, the DCF and precedent transactions usually result in the highest valuation levels. The reason for this is that (a) the DCF is typically based on optimistic assumptions (e.g. the business plan by the management) and (b) precedent transactions contain a control premium and are therefore typically higher than current trading multiples (as long as the precedent transactions are not too old and current valuations have picked up in the meantime). LBO valuations typically result in lower values because they give the value of the company that a financial sponsor – who unlike a strategic cannot realise synergies – is willing to pay to still achieve an IRR of 20%. Strategics will typically not just only realize synergies, but they also don’t need to achieve 20% IRR with an investment and have generally lower cost of capital.