Professional Documents
Culture Documents
Condensed Random Interview Questions
Condensed Random Interview Questions
I. Qualitative Questions
The opportunity to walk through your resume is your chance to talk about
your background and to make your case why you want to be an investment
banker. The most important thing is that you tell a story that makes sense to
the interviewer and shows a progression leading up to you being a banker.
Even if the choices that you’ve made (schools, degrees, jobs) don’t follow a
natural progression, you need to describe your experiences in a manner that
flows convincingly. Now, that isn’t to say that you necessarily need to find
commonality in everything you’ve done, or “weave a thread” through each
job, as long as you can demonstrate some sensible flow. For example,
highlight how each job enabled you to take more responsibility or required
more finance knowledge than the one before it. Even if you’ve switched
careers or reversed directions, talk about what you’ve learned from those
decisions that make you a good investment banking candidate.
Whatever responses you give, make sure that you can back them up with
actual stories and details from your experiences.
I love working all night…Yes, you can say you want to be challenged. But
NOBODY likes working on pitchbooks at 3:00 am and you won’t either.
If you have friends that work for this bank, say so, and mention that they are
really enjoying their experiences. If you are interviewing with a bulge
bracket bank, mention how you are excited about the prospect of getting a
broad experience and learning about different products or industries. If you
are interviewing with a boutique, talk about how you like the idea of a
smaller firm, where you might have more responsibility and more interaction
with clients and senior bankers. Without a doubt (unless this is the first
person with whom you’ve ever met), state how you’ve really liked all of the
people from this bank that you’ve met before.
If you have previously had the opportunity (for example, in prior interviews
or at recruiting receptions) to ask other bankers from this firm (or better
yet, this particular interviewer) why they like working at this bank, then by
all means recycle these answers! If they say the culture is great, you say you
want to work here because the culture is great. If they say dealflow is
strong, you say you want to work here because the dealflow is strong. You
get the idea…
However, even if you have little interest in the job, or if you’ve already had
all of your questions answered by the other 8 people with whom you
interviewed that day, you should always be prepared with 3-4 questions that
you can ask an interviewer. Here’s a few examples:
- How long have you been with the bank and how has your experience been?
- What do you like best about working here. Worst?- How do you compare
working here with other banks at which you have worked?- How is the
dealflow?- On what types of deals are you currently working?- What kind of
responsibility does the typical Analyst/Associate receive?- Can you tell me
about your training program?- How do Analysts/Associates get staffed?
Don’t get too stressed when asked a question like this. Just take it slowly,
one statement at a time.
Same question as the previous but the company finances the purchase of
equipment by issuing debt rather than paying cash.
First Year: Income Statement: No depreciation and no interest expense so
no change. Cash Flow Statement: No change to net income so no change to
cash flow from operations. Just like the previous question, we’ve got a $100
increase in capex so there is a $100 use of cash in cash flow from investing
activities. Now, however, in our cash flows from financing section, we’ve
got an increase in debt of $100 (source of cash). Net effect is no change to
cash. Balance Sheet: No change to cash (asset), PP&E (asset) up $100 and
debt (liability) up $100 so we balance.
B) Valuation
C) DCF Analysis
Walk me through a Discounted Cash Flow (“DCF”) analysis…
In order to do a DCF analysis, first we need to project free cash flow for a
period of time (say, five years). Free cash flow equals EBIT less taxes plus
D&A less capital expenditures less the change in working capital. Note that
this measure of free cash flow is unlevered or debt-free. This is because it
does not include interest and so is independent of debt and capital structure.
Next we need a way to predict the value of the company/assets for the years
beyond the projection period (5 years). This is known as the Terminal
Value. We can use one of two methods for calculating terminal value, either
the Gordon Growth (also called Perpetuity Growth) method or the Terminal
Multiple method. To use the Gordon Growth method, we must choose an
appropriate rate by which the company can grow forever. This growth rate
should be modest, for example, average long-term expected GDP growth or
inflation. To calculate terminal value we multiply the last year’s free cash
flow (year 5) by 1 plus the chosen growth rate, and then divide by the
discount rate less growth rate.
The second method, the Terminal Multiple method, is the one that is more
often used in banking. Here we take an operating metric for the last
projected period (year 5) and multiply it by an appropriate valuation
multiple. This most common metric to use is EBITDA. We typically select
the appropriate EBITDA multiple by taking what we concluded for
our comparable company analysis on a last twelve months (LTM) basis.
Now that we have our projections of free cash flows and terminal value, we
need to “present value” these at the appropriate discount rate, also known as
weighted average cost of capital (WACC). For discussion of calculating the
WACC, please read the next topic. Finally, summing up the present value
of the projected cash flows and the present value of the terminal value gives
us the DCF value. Note that because we used unlevered cash flows and
WACC as our discount rate, the DCF value is a representation of Enterprise
Value, not Equity Value.
To estimate the cost of equity, we will typically use the Capital Asset
Pricing Model (“CAPM”) (see the following topic). To estimate the cost of
debt, we can analyze the interest rates/yields on debt issued by similar
companies. Similar to the cost of debt, estimating the cost of preferred
requires us to analyze the dividend yields on preferred stock issued by
similar companies.
What is Beta?
Beta is a measure of the riskiness of a stock relative to the broader market
(for broader market, think S&P500, Wilshire 5000, etc). By definition the
“market” has a Beta of one (1.0). So a stock with a Beta above 1 is
perceived to be more risky than the market and a stock with a Beta of less
than 1 is perceived to be less risky. For example, if the market is expected
to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will be
expected to outperform by 11% while a stock with a Beta of 0.9 will be
expected to outperform by 9%. A stock with a Beta of -1.0 would be
expected to underperform the risk-free rate by 10%. Beta is used in the
capital asset pricing model (CAPM) for the purpose of calculating a
company’s cost of equity. For those few of you that remember your
statistics and like precision, Beta is calculated as the covariance
between a stock’s return and the market return divided by the variance of the
market return.
When using the CAPM for purposes of calculating WACC, why do you
have to unlever and then relever Beta?
In order to use the CAPM to calculate our cost of equity, we need to
estimate the appropriate Beta. We typically get the appropriate Beta from
our comparable companies (often the mean or median Beta). However
before we can use this “industry” Beta we must first unlever the Beta of each
of our comps. The Beta that we will get (say from Bloomberg or Barra) will
be a levered Beta.
Recall what Beta is: in simple terms, how risky a stock is relative to the
market. Other things being equal, stocks of companies that have debt are
somewhat more risky that stocks of companies without debt (or that have
less debt). This is because even a small amount of debt increases the risk of
bankruptcy and also because any obligation to pay interest represents funds
that cannot be used for running and growing the business. In other words,
debt reduces the flexibility of management which makes owning equity in
the company more risky.
Now, in order to use the Betas of the comps to conclude an appropriate Beta
for the company we are valuing, we must first strip out the impact of debt
from the comps’ Betas. This is known as unlevering Beta. After unlevering
the Betas, we can now use the appropriate “industry” Beta (e.g. the mean of
the comps’ unlevered Betas) and relever it for the appropriate capital
structure of the company being valued. After relevering, we can use the
levered Beta in the CAPM formula to calculate cost of equity.
D) LBO Analysis
The next step is to change the existing balance sheet of the company to
reflect the transaction and the new capital structure. This is known
as constructing the “proforma” balance sheet. In addition to the changes to
debt and equity, intangible assets such as goodwill and capitalized financing
fees will likely be created.
The third, and typically most substantial step is to create an integrated cash
flow model for the company. In other words, to project the company’s
income statement, balance sheet and cash flow statement for a period of time
(say, five years). The balance sheet must be projected based on the newly
created proforma balance sheet. Debt and interest must be projected based
on the post-transaction debt.
While the private equity firm’s IRR is usually the most important piece of
information that comes out of an LBO analysis, the analysis also has other
uses. By assuming the PE firm’s required IRR (amongst other things), we
can back into a purchase price for the company, thus using the analysis for
valuation purposes. In addition, we can utilize the LBO model to analyze
the trend of credit statistics (such as the leverage ratio and interest coverage
ratio) which is especially important from a lender’s perspective.
Let’s say you run an LBO analysis and the private equity firm’s return
is too low. What drivers to the model will increase the return?
Some of the key ways to increase the PE firm’s return (in theory, at least)
include:
• - reduce the purchase price that the PE firm has to pay for the company
• - increase the amount of leverage (debt) in the deal
• - increase the price for which the company sells when the PE firm exits its
investment (i.e. increase the assumed exit multiple)
• - increase the company’s growth rate in order to raise operating
income/cash flow/EBITDA in the projectionsdecrease the company’s
costs in order to raise operating income/cash flow/EBITDA in the
projections
What are some characteristics of a company that is a good LBO
candidate?
Notwithstanding the recent LBO boom where nearly all companies were
considered to be possible LBO candidates, characteristics of a good LBO
target include steady cash flows, limited business risk, limited need for
ongoing investment (e.g. capital expenditures or working capital), strong
management, opportunity for cost reductions and a high asset base (to use as
debt collateral). The most important trait is steady cash flows, as the
company must have the ability to generate the cash flow required to support
relatively high interest expense.
What is the difference between basic shares and fully diluted shares?
Basic shares represent the number of common shares that are outstanding
today (or as of the reporting date). Fully diluted shares equals basic shares
plus the potentially dilutive effect from any outstanding stock options,
warrants, convertible preferred stock or convertible debt. In calculating a
company’s market value of equity (MVE) we always want to use diluted
shares. Implicitly the market also uses diluted shares to value a company’s
stock.
Once we have this option information, we subtract the exercise price of the
options from the current share price (or per share purchase price for an
M&A analysis), divide by the share price (or purchase price) and multiply
by the number of options outstanding. We repeat this calculation for each
subset of options reported in the 10K (usually companies will report several
line items of options categorized by exercise price). Aggregating the
calculations gives us the amount of diluted shares. If the exercise price of an
option is greater than the share price (or purchase price) then the options are
out-of-the-money and have no dilutive effect.
The concept of the treasury stock method is that when employees exercise
options, the company has to issue the appropriate number of new shares but
also receives the exercise price of the options in cash. Implicitly, the
company can “use” this cash to offset the cost of issuing new shares. This is
why the diluted effect of exercising one option is not one full share of
dilution, but a fraction of a share equal to what the company does NOT
receive in cash divided by the share price.
Now, keep in mind that the main use for Enterprise Value is to create
valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take,
say, sales or EBITDA from the parent company’s financial statements, these
figures due to the accounting consolidation, will contain 100% of the sub’s
sales or EBITDA, even though the parent does not own 100%. In order to
counteract this, we must add to Enterprise Value, the value of the sub that
the parent company does not own (the minority interest). By doing this,
both the numerator and denominator of our valuation metric account for
100% of the sub, and we have a consistent (apples to apples) metric.
One might ask, instead of adding minority interest to Enterprise Value, why
don’t we just subtract the portion of sales or EBITDA that the parent does
NOT own. In theory, this would indeed work and may in fact be more
accurate. However, typically we do not have enough information about the
sub to do such an adjustment (minority owned subs are rarely, if ever, public
companies). Moreover, even if we had the financial information of the sub,
this method is clearly more time consuming.
E) M&A
Walk me through an accretion/dilution analysis…
The purpose of an accretion/dilution analysis (sometimes also referred to as
a quick-and-dirty merger analysis) is to project the impact of an acquisition
to the acquiror’s Earnings Per Share (EPS) and compare how the new EPS
(“proforma EPS”) compares to what the company’s EPS would have been
had it not executed the transaction.
The proforma share count reflects the acquiror’s share count plus the number
of shares to be created and used to finance the purchase (in a stock deal).
Dividing proforma net income by proforma shares gives us proforma EPS
which we can then compare to the acquiror’s original EPS to see if the
transaction results in an increase to EPS (accretion) or a decline in EPS
(dilution). Note also that we typically will perform this analysis using 1-
year and 2-year projected net income and also sometimes last twelve months
(LTM) proforma net income.
In practice, synergies are “easier said than done.” While cost synergies are
difficult to achieve, revenue synergies are even harder. The implication is
that many mergers fail to live up to expectations and wind up destroying
shareholder value rather than create it. Of course, this last fact never finds
its way into a banker’s M&A pitch
F) Markets Investing
Are markets efficient?
Let’s start with an easy one, albeit important one, albeit one that most
people, academics included, don’t really understand. And the answer is: it
depends on the market – but in most cases, for all practical purposes the
answer is yes. But before we can really answer this question, we need to
define market efficiency very clearly (and very simply). Forget what you’ve
learned about weak forms and strong forms and the other stuff coming out of
academia.
So which markets are efficient and which less so? For the most part, the
larger and more liquid the market, the more efficient. Large cap U.S. stocks,
U.S. treasuries, currency markets? All extremely efficient. Small to mid-
cap U.S. stocks? Still pretty efficient but certainly less so than large caps.
Microcap stocks and emerging market stocks – less efficient still.
The legal type would be any information not known by the broader investing
community that has not been obtained illegally (i.e. in violation of SEC or
other regulatory body regulations). For example, hedge funds that cover
retailers might send consultants to a retail store to count cars in the parking
lot or peak into stock rooms to count inventory levels, given them non-
public insight into the financial results of the retailer. Or perhaps a doctor,
due to his or her own specialty has indirect insight into the likely success or
failure of a new drug in clinical trials. Or maybe a mutual fund manager has
the ability to meet directly with a management team. Even if no non-public
information is disclosed by the CEO during that meeting, the fund manager
might have insight into the quality of the CEO that other market participants,
who do not have the ability to meet management, cannot have. Keep in
mind that often there is a very fine line between legally obtained non-public
information and illegal insider information.
The even shorter answer is, its nearly impossible for an individual investor
(or institutional investor such as a hedge fund) to outperform the market so
don’t even try.
If you say markets are efficient, then explain the dot-com bubble or the
real estate bubble.
Ah ha! You think you’ve got me, don’t you?
I still don’t get it. How can fundamental value change in such a short
period of time?
Now you’re thinking. Fundamental value doesn’t change because there is
no such thing as fundamental value. Let me repeat that again: there is no
such thing as fundamental value. This is perhaps the most important myth
of finance (and economics). There is only relative value. Those of you that
are on this site doing investment banking interview prep know that the way
you value a company is by comparing its value to other similar companies
(even our so called “intrinsic value” DCF analysis uses comparisons to come
up with forecasts, terminal values and WACC). So, if Amazon in 1999
trades at a 100x P/E ratio than why shouldn’t Ebay or Pets.com? Similarly,
if my neighbor’s ocean front Miami beach condo sells for $1 million
shouldn’t my identical one also be valued at $1 million? That there is no
such thing as fundamental value is true for not only financial assets but
applies to all assets.
How can you say that people are rational given all of the research that
seems to show otherwise in addition to all of the booms and busts
throughout history?
Okay, this is really important. To really understand this point, let’s first
understand how economists usually define rationality. An economic actor
(that is to say, a person) is rational if he or she always makes decisions
which will maximize his or her economic well being. Now, there is an
enormous body of research in psychology and behavioral economics (the
same field by the way – just that the economics know how to use statistics)
that shows otherwise. This we do not dispute in the least.
The second error in the definition of rationality is that people don’t seek to
maximize their economic being (that is to say, their wealth or income) but
their overall well being or their “utility”. (I have a lot more to say about the
definition utility but for now leave it as one’s overall well-being). Now
again, most economics would agree with this modification to the definition
but alas, fail to internalize the distinction. Understanding that many
decisions (even investing ones) are affected by things are than income or
wealth goes far to explain many of the experiments that claim to prove that
people are irrational. For example, many studies have shown that individual
investors trade too much even though they know that trading costs hurt their
overall investment performance. Therefore, they are irrational, right? Not
necessarily. Most individuals who trade in and out of stocks get other utility
out of their actions. That is to say, trading is fun, not unlike, say, going to
Las Vegas. In other words, the entertainment value of trading adds more to
their utility than the lost money due to trading costs subtracts. There is
nothing irrational about that.
The third and final error is probably the most important one and also the
least understood. Many experiments have shown that when faced with a
probability based decision many people make the wrong choice (that is one
that results in lower expected value) or given two sets of decisions, make
inconsistent choices. These types of experiments are used to demonstrate
the irrationality of human beings. But this is wrong. What they demonstrate
mostly is that humans are bad at probabilities (they demonstrate other things
as well – for example that most of us would rather not lose money than gain
money). Perhaps we’re all dumb, perhaps we all slept through statistics
class in college or perhaps our incentives are messed up. That we don’t fully
understand the question or that we didn’t bother (or don’t know how) to do
the expected value arithmetic does not demonstrate irrationality. So the
third distinction that we need to make to our definition of rationality is that
we make decisions to maximize the present value of our utility based on the
decision maker’s understanding of the decision and NOT the experimenter’s
understanding of the decision.
Assuming you’re still reading this and haven’t fallen asleep, you might be
wondering so what? Who cares if people are rational or not? Let’s talk
about that next.
If people are indeed rational, as you say, then how can bubbles arise
and persist for so long?
Oh, and one last thing: speculating is just a more acceptable synonym for
gambling.
I think all three are correct depending on how we define technical analysis.
Academics have known for about 15 years that stocks with positive
momentum tend to outperform stocks with negative momentum. Traders
and speculators have probably known this for centuries longer. If we define
technical analysis as using information contained in historical prices (and
other information such as trading volume) to predict future prices than there
is no question the answer is yes, technical analysis does work. Most
quantitative trading methods (including high frequency trading) is based on
this sort of analysis. In fact, I would go as far as to say that much of what
people view as fundamental analysis is actually technical analysis. I would
argue that much of value investing (e.g. buying stocks with low Price/Book
Value ratios or Price/Earnings ratios is actually a reflection of technical
factors (the stock has gone down in the past) than it is of fundamental factors
such as its book value or earnings.