During an interview, you’re asked to assess two investment opportunities, company A and company B, and identify which one you thought was a “better investment.” You’re asked which one you thought was the “better investment opportunity,” and are expected to give an answer on the spot as opposed to running a DCF or LBO model. The details of the companies are as follows: Company A: $100M revenues in year 0 $20M EBITDA in year 0 5% annual revenue growth for the next five years Purchase price is 5x EBITDA (4x debt, 1x equity) Company B: $100M revenues in year 0 $20M EBITDA in year 0 10% annual revenue growth for the next five years Purchase price is 6x EBITDA (4x debt, 2x equity) **This is all the information you are provided with, and you are free to make whatever assumptions as you wish (provided you can back them up). No additional information is provided besides what was noted above.** How would you approach this question? Is there a definitive answer to the question, and would the purpose of such a question be? Your thoughts are much appreciated.
Maybe I am captain obvious but it seems to me they are getting at two things: -Paying a higher multiple for higher growth - is it worth it, and at what price is it justified -Leverage: both those companies have much different cap structures
I think one or the other can be good investments, as to which is better depends on a zillion other things not mentioned here. I would discuss the pros and cons about the 2 opportunities the more obvious ones being what drs said and more specifically more equity needed in B that could be used for other projects, if its a PE firm you would have to hold on longer to B (prob more than 5 years) to recuperate the higher multiple paid and maybe this is against firm’s guide lines.
Some suggestions are as follows: (1) Assume that both investments reflect 5-year time horizons, and exit strategy is irrelevant. These are private equity investments. (2) How do you think about FCF generation (and its relevant components, like WC and CAPEX and so forth) and cost of capital? As you consider the factors listed above, does your answer to this question depend entirely on what assumptions you make? How would you approach the question (step-by-step) if presented the question in an interview?
drs Wrote: ------------------------------------------------------- > -Leverage: both those companies have much > different cap structures Actually, for the sake of argument, let’s just assume that the current capital structures of the two firms are equal, but pro forma capitalization will be different as noted in the original question. How does this affect your view?
Not my area of expertise but some thoughts. You can’t assume same cap structures given the parenthetical purchase multiple info. You can use the parenthetical info on debt and equity multiples to get the cap structures of both. Company 2 uses more leverage, and also has a lower overall capitalization. Since debt costs less than equity, and the debt to EBITDA ratio is still very low in company two, and they are generating a higher return on total assets (assuming no other disproportional liabilities exist) to start combined with higher growth I would think that they are the better investment. But, as I said not my field so i could be totally wrong.
The problem is so ambiguous that I’m guessing what they’re looking for is evidence of education rather than finding the “right” answer. The former might be demonstrated simply by touching on as many relevant topics as you can in the time allowed, as opposed to getting bogged down in one myopic issue. Given the level of ambiguity maybe they just want you to list all the information that’s missing. So, just tossing off some perspectives to consider… + What are you buying here? Shares in the firm? The firm? If the latter, then you replace existing cap structure so the current one is irrelevant. + What are the given “purchase prices”? If you assume markets are efficient, then the prices are fair and someone has already valued these things for you. It’s a coin toss; or for diversification split your funds across the two. + Ignoring CS and those “price” things, all we have to work with is is EBITDA and growth rate. Without any indication of risk of cash flows it’s impossible to determine which firm is better from a risk-adjusted perspective. (If you accept the given prices you can back out a wacc with minimal algebra (5.2 and 10.2 respectively I think), but that leads to the above question: if prices are given then why are they asking us to compute prices?) + You can’t price these assets without knowing expected growth after year 5, so you’ll need to assume something here.
my 2 cents… Quick Calculation: Price Tag A $20mil Price Tag B $40mil Assumptions: -interest rate, tax rate, depreciation, amortization rates for 2 firms are the same -Companies are similar (same unlevered Beta) Somethings to blurt out to interviewer: -Investment B will have lower risk, due to lower total Beta -Assuming zero fixed cost leverage, you are effectively paying double for double the growth when investing in B, which makes the 2 investment equal in a GARP measure. But if there is some sort of fixed leverage, investment B will look cheaper on a GARP basis. -If this is structured like a private equity, then all I care about is cashflow generation. At current prevailing interests rates, interest coverage is ample for both firms, so I’m going to assume financial risk to be minimal. If this is the case, A is the better investment in terms of EBITDA return on equity: A) 100% on year 1 B) not even 100% even at end of year 5 (50% EBITDA return on equity on year 0, it will double until the 7th year) Don’t think there is a right or wrong answer. Just need to blurt out everything they want to hear in a valuation.
kevin0118 Wrote: ------------------------------------------------------- > my 2 cents… > > Quick Calculation: > Price Tag A $20mil > Price Tag B $40mil > Price tag is off. 5 times EBITDA is $100 for first, second is 6 times or $120
oops, I meant investment price (remaining will be funded by debt) Maybe I’m not getting the question right…I was assuming that A costs 100 mil, B costs 120 mil, but the firm can only raise 80 mil in debt thus defining the multiples… If we’re talking bout public stocks and ratios are derived from financial statements, then my previous post doesn’t apply.
DarienHacker Wrote: ------------------------------------------------------- > + What are you buying here? Shares in the firm? > The firm? If the latter, then you replace > existing cap structure so the current one is > irrelevant. Obviously you are buying a controlling interest in the firm so you are correct in that current capital structure is not particularly relevant (though not completely irrelevant because current capital structure still means something for the ratings and rates on their ongoing credit obligations…but since we don’t talk anything about current leverage ratios, I guess this doesn’t really matter anyway. Moving on…) > + What are the given “purchase prices”? If you > assume markets are efficient, then the prices are > fair and someone has already valued these things > for you. It’s a coin toss; or for diversification > split your funds across the two. No – you are buying the company and the investment opportunities are mutually exclusive. This is a buyout question. > + Ignoring CS and those “price” things, all we > have to work with is is EBITDA and growth rate. > Without any indication of risk of cash flows it’s > impossible to determine which firm is better from > a risk-adjusted perspective. (If you accept the > given prices you can back out a wacc with minimal > algebra (5.2 and 10.2 respectively I think), but > that leads to the above question: if prices are > given then why are they asking us to compute > prices?) No, because you don’t know what the cost of debt or equity are exactly – you can only think about them qualitatively, which is still useful. > > + You can’t price these assets without knowing > expected growth after year 5, so you’ll need to > assume something here. That’s fine, I should have mentioned earlier that you’re exiting the investment at year 5.
kevin0118 Wrote: ------------------------------------------------------- > my 2 cents… > > Quick Calculation: > Price Tag A $20mil > Price Tag B $40mil > > Assumptions: > -interest rate, tax rate, depreciation, > amortization rates for 2 firms are the same > -Companies are similar (same unlevered Beta) Fine > Somethings to blurt out to interviewer: > > -Investment B will have lower risk, due to lower > total Beta Interesting observation, but you still have to think about how this will translate into purchase price…remember the price you’re still looking at is 5x (80/20 D/E) for company A and 6x (67/33 D/E) for company B > -Assuming zero fixed cost leverage, you are > effectively paying double for double the growth > when investing in B, which makes the 2 investment > equal in a GARP measure. But if there is some > sort of fixed leverage, investment B will look > cheaper on a GARP basis. You’re onto something here. But the real question is, how do you really think about initial equity injection versus growth rates?! One is compounded and another isn’t. > -If this is structured like a private equity, then > all I care about is cashflow generation. At > current prevailing interests rates, interest > coverage is ample for both firms, so I’m going to > assume financial risk to be minimal. If this is > the case, A is the better investment in terms of > EBITDA return on equity: > > A) 100% on year 1 > B) not even 100% even at end of year 5 (50% EBITDA > return on equity on year 0, it will double until > the 7th year) No, remember you have to think about these types of investments based on your INITIAL equity investment, and then five years out you’re exiting the investment and collecting your equity value at that point. So, is the right metric really ROE…or is it something else? > Don’t think there is a right or wrong answer. > Just need to blurt out everything they want to > hear in a valuation. All of the posts above have had interesting insights, and actually a few things I hadn’t even really considered. Hopefully these suggestions help as I now have an understanding of what answer the banker was looking for – but obviously like you all noticed, there are so many ways to slice and dice the problem that it’s really much more about how you think about things. So yeah, I’ll keep putting out more ideas as they come and hopefully you guys can too.
I say “i’m the risk guy. How the heck should I know? All I care about is vol”
The idea is clearly to be able to back up your answer, rather than emphasizing which company you picked. I think it would be equally valid to answer like either of the following: (1) Pick company A, cite better leverage, more room to profit by increasing future growth rates, cheaper purchase price. Give reasons why these perks outweigh the superior revenue growth rates of company B. (2) Pick company B, cite the growth rate, maybe lower cost of capital in the debt market, explain why these outweigh getting less leverage.
Assuming that the costs increase as revenues and the EBITDA increases at 5% for FirmA and 10% for FirmB. Also assuming the debt doe sent cost anything, this will work as it is a consistent assumption for both companies as they both have the same debt. Given a paper and pen? I can see the return on equity as: Firm A(Purchase price: 100): Y0 = 20, (Debt, Equity)(16, 4) . . Y5 = 25.53, (16, 9.5) FirmB: Y0 = 20, (13.34, 6.66) . . Y5 = 32.21, (13.34, 18.87) My first intuition was Firm A, as it was more levered with less equity, but Firm B looks like it is a better option as it has a hypothetical ROE of 180% vs. 135% for FirmA (no cost of debt, is an assumption as the amount of debt is the same). Its all bout that what you make on the CASH you put in. Seems about right?
Since the market is very efficient, you should own the market. Hence, buy both along with the other 11,998 publicly traded companies. (Assuming these are public) :-)~
I am not sure what you guys are talking about (who are you people?). Here is my take on this, albeit I am not an expert in M&A stuff. For Company B, we would be paying twice more equity than for Company A ($40MM vs. $20MM) and in return just earn 5% of additional EBITDA growth (assuming margins don’t change). This results in a much bigger ROE for Company A over B. Cost of capital and equity does not really matter here unless cost of debt is dramatically higher for Company A due higher leverage. Think about it this way: For company A you are paying $20MM of equity for $21MM of EBITDA. For Company B it is $40MM for $22MM of EBITDA. Huge difference. Anyway discounting it back to present value, should not really make a HUGE difference. That is my take on this. Investing with other people’s money is always a better idea. Thanks for listening. Kide
You guys make me wonder how the hell I passed level III…
yea kide i know what you mean…i thought the exact same thing, but compounding works like magic; the extra 5% compounds and makes Firm B more profitable investment! Does my calculation make sense at all? am i missing something?
By Yr 5, EBITDA for Company B will be $32.21MM vs. $25.53MM for Company A. Again, if you compare that to equity investement of $40MM vs. $20MM, respectively, Company A is a much better investement in terms of ROE.