Help with IB Interview Question


Recently got called in for my first IB Analyst interview and was posed with a question I’m not sure I answered correctly. Would be grateful to hear your opinions on what the right answer is… Q) Am I right in saying that discounting projected unlevered FCF’s leads you to Enterprise Value, and discounting levered FCF’s leads you to Equity Value.

A) Yes.

Q) And can we obtain Equity Value from EV or vice versa and how?

A) Yes. EV = Eq. Value - Cash + Debt+ Minority Interest + Pref Stock + Other Liabilities

Q) When is it appropriate to use which of these two above methods to obtain Eq. Value. And which is more accurate? Would the answers obtained by the two methods converge? And if not, why?

This was the question I got confused with and stated that I believed they would yield the same answer irrespective of the method used to obtain Eq. Value i.e. 1) whether we started with discounting unlevered FCF to obtain EV and used the financial statements to get Eq. Val or 2) Whether we discounted Eq. Value directly.

The answers converge when the full intrinsic value of the various parts of the capital structure are fairly valued by the market. Otherwise, DCF will be very sensitive to whatever assumptions you make on future projections whereas your second computation of EV is pulled from the balance sheet.

The other thing you should have mentioned (if you hadn’t done so) is that you need to discount FCFF by WACC and FCFE by the cost of equity.

The formula you used for EV is slightly incorrect. EV = Debt + Equity + Preferred + Non Controlling Interest - Cash

Other Liabilities are not included. We are obtaining the total value of the firm. Debt is the only “liability” we are concerned about. This why we use multiples like EV/Sales, EV/EBITDA, and EV/EBIT because it doesn’t incapsulate capital structure decisions and the removal of interest like the P/E ratio.

Your answer related to the relationship between EV and Equity value is correct. We can use either one to derive the other; however, it’s important to note that the Treasury Stock Method and Conversion Method should be considered for the Equity Value. Many people ignore the impacts of convertible preferred stock, convertible bonds, and employee stock options when developing the Equity Value, which is not only wrong but leads to incorrect valuations and multiples.

Unlevered Cash Flow is synonymous with FCFF and Levered is Cash Flow is synonymous with FCFE. So, yes you are correct. FCFF is discounted by WACC an FCFE is discounted by the Cost of Equity (CAPM, Fama French, Build Up Method, Multi Factor Models, etc).

Yes, theoritically both methods should yield the same result. FCFF will be chosen over FCFE if the capital structure is unstable. Also, most PE and IB guys like FCFF because you ultimately want to know the value of the firm not just the equity.

The bold is incorrect.

No, discounting unlevered FCFs does not lead you to enterprise value. You might argue that, but that depends on your definition of EV. The one I prefer is that EV is the value of whole firm, and the market value of equity should reflect that as well.

Going by the previous definition of enterprise value, the correct formula should be EV = Eq. Value + Debt+ Minority Interest + Pref Stock + Other Liabilities

Accuracy here completely depends on your assumptions. The type of firm you’re valuing ultimatley determines which method of valuation you should use, normally FCFE should be used directly to value equity, but changes in capital structure and volatile financing mix can make it difficult to project FCFE properly. They both should yield the same result, on paper of course.

Talk to anyone in IB or PE, read the CFA Level II material, which you obviously haven’t done, google search Enterprise Value, take a finance course, and you will realize how incorrect you are about your formulas and statements. First, cash and cash equivalents are subtracted, which you don’t include. Second, other liabilities have nothing to do with EV. EV is only concerned with the market value of debt. Do you even know what the other liabilities line item on the balance sheet includes?? You might want to do your due dilligence before you start calling out people. Third, the Treasury Stock Method and Conversion Method are necessary in the event of convertible preferred stock, convertible bonds, and employee stock options because they impact shares outstanding from a dilution perspective. This should make sense if you understand how to calculate the market value of equity, which is a component of EV. Last, EV reflects market value not book value, which further clarifies the formula and your other liabilities comment.

You are talking as if the CFA curriculum is somehow complete, or more correct than any other material. Are you serious? I have no idea why would someone subtract cash in the EV forumla, or add them to get to equity value, unless a takeover or liquidation takes place. Which isn’t the case for a valuing the equity of a going concern company. Of course EV here means gross enterprise value, and not only core operating value. Other liabilities include all claims and obligations on the firm’s assets, even off-balance sheet items are included.

The treasury stock method and conversion, as would probably be included in your all knowing CFAI material, is improper for use in valuations, for several reasons. I never said employee obligations, nor pension liabilities should not be acconted for, I was more critical about your methodology for valuation.

I know that EV represents market value, obviously. Where have I implied otherwise?

EV is supposed to be what you would pay for the company. So you certainly need to adjust for debt and cash.

Yes, but why is that measure of EV relevant then? It’s not a PE deal. We are instead trying to derive equity value per share, remember?

You subtract cash in the EV formula because otherwise you’re paying cash for cash. Rather, it’s used to reduce the EV value and the current equity holders retain the cash.

Actually the concept was cash is subtracted to pay off debt, so it can be written as EV = Equity + Net Debt + Other obligations. Only in the case of cash exceeding debt, that equity holders can retain the cash (the takeover party in this case). But this is not the correct way of valuing equity, a firm’s liquidation value and it’s value as a going concern are very different! This EV definition should only be used to derive approximate purchase price for takeovers, typically M&As and LBOs. Not estimating intrinsic equity value per share!

Mr Smart:

Enterprise Value = Market Value of Debt + Market Value of Equity + Preferred Equity at Market Value + Non Controlling Interest - Cash - Cash Equivalents (I would also include Investment in Associates)

I would potentially consider adding Unfunded Pension Liabilities, but we are only concerned with interest bearing liabilities; however, it depends on the valuation.

Cash is subtracted from the Enterprise Value formula because when cash is used to pay down debt or pay out dividends after the purchase it reduces the net cost to the potential purchaser of the firm. Moreover, cash is a non-operating asset and cash is already implictly accounted for in the equity value. Essentially, cash is lowering the purchase price of the firm. Ultimately, we are trying to get to the market value of the firm as a whole.

Your explanation is now changing. Off Balance Sheet items are implictly considered in the Market Value of Debt component. Sorry, for not explictly stating this. If this is your understanding of “Other Liabilities” then I would recommend revisiting your accounting curriculum. These two terms are not synonymous. Moreover, other liabilities can be short-term or long-term and consist of items such as deferred liabilities, tax liabilities, commitments and contingencies, or other items that are not interest bearing. Meaning, other liabilities may include items that should not be incorporated in the Enterprise Value formula.

Your statement regarding my comment related to the CFAI curriculum is flawed and nothing more than an assumption and logical fallacy.

Equity Value = Diluted Shared Outstanding x Current Stock Price

Hence, Treasury Stock Method and Conversion Method ARE REQUIRED if you want to calculate a correct Equity Value. Moreover, I had a discussion about this with an MD who worked for JP Morgan, Houlihan Lokey, and a few other top IB firms, and he completed some of the biggest M&A and LBO transactions in history and he agreed that the Treasury Stock Method and Conversion Method must be considered for valuation. If that’s not enough for you, I can go grab more resources to show why these methods need to be considered for the Equity Value.

Are you trying to approximate takeover price, or estimate intrinsic equity value? They both have different inputs!

YOUR calculation of EV is tailored for acquisitions, it uses the CURRENT market value of equity. While reverse engineering gross enterprise value with all other non-common equity obligations and claims gives you the estimated fair value of equity!

That is the whole misunderstanding in a nutshell. Enterprise value for an asset manager will be different than for an investment banker. One is interested in the liquidation value, and the other is interested in it’s net present value as a going concern! Unfunded pension liabilities, ESOs, provisions, restructuring, contingencies, capitalized leases, these all go into the calculation of enterprise value because they are part of the firm’s performance, and essentially, should be accounted for when deriving the intrinsic value of equity!

What do you mean cash is implicitly accounted for in equity value? It is not! Only operating cash is, which represents a small part of total cash and it’s equivalents.

The other common liabilities that should be included are already outlined above. They are debt and equity equivalents and should be accounted for. Again, you’re thinking in terms of acquitring the firm and only paying off senior claimholders, while restructring the firm for only operating assets.

The CFAI curriculum does have some deviations from proper practice. You can’t deny it.

Equity value = Undiluted Shares Outstanding x Stock price !!!

The TSO and conversion method is improper for valuation use! What IS required is that you account for any and all hybrid securities and options. But using a proper option pricing model !!!

TSO will always underestimate the value of options granted and overestimate value of equity per share, and using the what-if method will overestimate the value of options granted and underestimate equity! They both fail to consider the time premium on the options and dealing with vesting! Both provide an upper and lower boundry, but the best estimate of value should be in the middle, using an option pricing model! Once you’ve seperately valued all hybrid securities, THEN you divide by the undiluted shares outstanding to get PPS!!!

LOL, you’re framing everything in reference to asset management. The OP asked about IB, which is what we all addressed!! Why are you attempting to deviate from the OP?! The discussion obviously revolves around M&A, LBOs, etc. because it’s IB!!! You are just trying to argue for the sake of arguing, which is annoying. I know I’m correct, so that’s all I’m going to say. Yes, you are correct about some of the items you mentioned; however, you are attempting to mix apples and oranges. End of story homie.

It doesn’t matter!!! I’m addressing corporate valuation, whether for an investor or a CFO, you still need to account for the same valuation methadologies in deriving the intrinsic value of equity!!! Wasn’t this the OP’s second and third question?!

Thank you numi. That clears things up.

And yes, I did mention about the FCFF being discounted by WACC and FCFE by Ke. :slight_smile:

By other liabilities I mean “unfunded pension obligations” and “capital leases” . I’m sure those are to be included… ?

Are you trying to calculate net EV, or the fair value of equity?

This is a pretty epic brawl.

To be honest I don’t know where one would use net EV over EV. Or that fair equity value is not a synonym for EV.

Net EV (or core operating value), calculates the takeover price of the firm in question using the MV of CS, D, PS, MI, and cash.

While EV is the total value of the firm in question, and is used to derive the fair value of common equity, then compare it to current MV to check for deviations from intrinsic value.

However, in most IB firms, they are only interested in M&A and therefore refer to net EV as simply EV. It is the more common definition to refer to acquisition price, rather than it’s total value as a going concern.