PE Interview Technical Question - Risk in Cash Flows
I got the below question in a PE interview and thought there really wasn't a right answer - you could argue both ways. Curious to what you all think the answer is ( I went with company A in interview).
If Company A has revenue stream of $100, $50, $100, $100, $100 and company B has revenue stream of $100, $98, $96, $94, $92 which one is riskier? Why?
I know this isn't scientific, but I'm wondering if they were hoping you'd bring up the point that B is riskier in this situation because A experienced a one time expense that may have allowed it to operate in a market where stable FCF can be generated into perpetuity whereas B is a continuously declining co. (for whatever reason, be it declining market share, margin pressure, etc). Without any other context I'd likely go with B
Had the same thought as you, but these are revenues rather than FCF, so we can't point to a possible one-time expense.
I also don't see a "right" answer here. Your immediate reaction should be to want more information on Company A - i.e., what the hell happened 4 years ago? Absent this, we have to start guessing at what could cause a 50% one-year blip like that and, based on those educated guesses, how likely such a blip is to recur. One possible narrative that comes to my mind is a company that works with large contracts, such that one cancellation or lost customer could very materially impact the top line. Or perhaps its so cyclical/volatile that a bad environment can crush Company A. Or maybe it's just a timing issue with revenue recording - maybe they used to bill customers on 6/30 and 12/31, but four years ago they started billing customers one day later on 7/1 and 1/1. The first two narratives are troubling - the third (admittedly wild hypothetical) can be laughed off.
Company B looks much more straightforward, but again you would ideally want more information. Is it market size or market share that has decreased so steadily? Is this an industry that has declined but will obviously find a bottom soon, or does this company sell VCRs and fax machines? Or is the industry growing and our company just can't compete?
As with most of these types of questions, demonstrating your thought process and how you would go about looking for information to confidently answer should be more important than which company you pick.
I would say A is riskier due to the massive dip, indicating revenues could be volatile and there is an added element of unpredictability. A dip that big can follow with significant issues.
Company B's revenue is declining, which there is risk that it could keep declining, however the decline is relatively consistent YoY and the risk can be quantified and analysed accurately.
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