Investment Banking
Free Downloadable Investment Bank Recruiting Prep Materials
Jeopardy for Investment Banking
So so so many veterans are interested in Finance without any real knowledge about what actually goes in an investment bank. I don’t blame them, I was once one. The raw truth is that investment banking is a brutal profession that eats people alive. You thought the Army sucked? Well don’t think this is an “easy” offramp. Working in Investment Banking is like being deployed 24/7 a year with a couple short week breaks. Year…after year..after year.
The other raw truth is that the skills you gain in investment banking will rocket your career into the moon. You will develop very valuable tangible skills that are transferable to almost any large business or other professional service easily. In short, you will escape the “stink” of the military. There will be no question that you can handle corporate work and the pace of life. There is a real concern for a lot of elite employers that demand a lot from their employees. They want to make sure you can take it. As they say in the Mandalorian…this is the way.
Check out my professional reading list on Investment Banking here.
What is an Investment Bank
An investment bank is really a market intermediary that connects the suppliers of money (investors) to the users of money (corporations, governments, clients). Investment banks perform a combination of the four functions below:
Raise capital for corporations and governments through issuance of equity (stock), debt (loans/bonds), or hybrid securities (Post-MBA role)
Provide financial and strategic advisory services, including merger and acquisitions, restructuring, and divestitures (spinoffs) (Post-MBA role)
Buying and selling of stocks, bonds, and other securities
Manage individual wealth and investments (Post-MBA role via private wealth management)
General Organization of an Investment Bank
Within this section, we will focus on the " investment banking'' functional area. However, it is important to know the general organization of an investment bank. Please note that different investment banks are organized differently and may not have all the functional areas, or organize the same functional areas within their investment banking divisions. For example, while JP Morgan has their M&A team as part of their product groups, Goldman Sachs has their M&A team embedded in each coverage group . More on product versus coverage groups later.
Investment Banking Function
Investment banking is a functional area/division within an investment bank. This functional area has two responsibilities: (I) Raise capital for corporations and governments through issuance of equity (stock), debt loans/bonds), and hybrid securities and (2) provide financial and strategic advisory services, including merger and acquisitions, restructuring, and divestitures (spinoffs).
For some investment banks, their investment banking function is called "corporate finance". This should not be confused with what MBA students call corporate finance, which is working in the finance function of a corporation.
Investment banks are divided into coverage groups and product groups.
Coverage groups are essentially "industry experts" that are responsible for deal origination via ongoing conversations with companies in a specific industry group. Additionally, most coverage groups execute transactions in conjunction with product group partners.
Product groups execute one specific type of transaction for companies across industries (at the junior banker level). Product groups include Equity Capital Markets (ECM), Debt Capital Markets (DCM), Syndicated and Leveraged Finance (SLF or Lev Fin), and Mergers and Acquisitions (M&A).
For example, a deal team for a sell-side M&A transaction may include a Managing Director (MD) from the coverage group who maintains the firm' s relationship with the client, a vice president from M&A to provide execution expertise, and an Associate and Analyst from the coverage group to perform most of the execution, such as financial modeling, document drafting, preparation and maintenance of the buyer log, and assembly of the data room for due diligence.
Types of Investment Banks
Full service investment banks are mostly clustered in New York City. These include the pure-play investment banks (Goldman Sachs, Jefferies, Morgan Stanley, Lazard), the financial money-center or "universal'' banks (Bank of America Merrill Lynch, Citi, JP Morgan, Wells Fargo), and large foreign banks (Barclays Capital, Credit Suisse, Deutsche Bank, UBS).
Investment banks are also further classified into three categories based on the breadth of their services, client base, and size: (1) bulge bracket, (2) middle market, and (3) boutique.
All of these firms hire large classes of Summer Associates in NYC and have structured summer programs. Other financial centers include San Francisco, London, and Hong Kong. Tepper MBA students have had high levels of success getting placed into those regions.
There are smaller, specialized investment banks in New York with summer programs. Regional investment banks also often have summer positions in areas such as Boston, Chicago, Cleveland, Philadelphia and Washington, DC. Regional firms generally work with smaller clients, but the skill set is basically the same.
Major Players
Similar to other types of firms, investment bank performance is measured on metrics such as revenue, profits, and market share. However, one series of metrics that are widely used in the industry are the league tables.
League tables can be accessed from various financial information resources such as Thomson Reuters Deals Intelligence or Dealogic. The league tables data can be sliced in various ways, such as Global M&A Rankings in Deals Announced and Global Investment Banking Fees.
As mentioned earlier, investment banks are also further classified into three categories based on the breadth of their services, client base, and size: bulge bracket, middle market, and boutique. Bulge bracket traditionally refers to the largest investment banks. The term stems from the way investment banks are listed on the tombstone, or public notification of a deal, as their banks names are listed with larger font, seemingly "bulging" out from the page.
Middle market investment banks typically focus on smaller deal sizes and smaller cap clients.
Boutique banks typically focus on a specific industry like healthcare or a specific product or service, Iike restructuring.
Keep in mind that each investment bank has its own strength, which can be within a certain industry, certain types of product, or certain key client relationships. So when you are recruiting and evaluating firms, look beyond the league tables and rankings.
2019 Global M&A League Table
Internship Structures
Different banks have different structures for their summer programs. There are three main types of internship structures:
Group Specific/Direct Placement: Summer interns are placed directly into a coverage or product group, and remain there for the entire summer. Most investment banks have this structure.
Generalist Program: Summer interns are put in a general pool and work on deals and projects from various groups. Jefferies and Rothschild are two of the noteworthy banks that have generalist summer programs.
Rotational Program: Summer interns rotate through two or three different coverage and/or coverage groups. Deutsche Bank's summer associate program is rotational, where interns rotate between one coverage and one product group.
There are several advantages and disadvantages for each internship structure and is a good topic to talk about during your informational interviews or bank visits.
The Associate Position
Graduating MBA students are offered the position of Associate. First-year MBA students are offered the position of Summer Associate. There are four levels on the investment banking management ladder: the lowest is Analyst, followed by Associate, Vice President (VP), and Director/Managing Director (MD) in increasing level of seniority.
Analysts do not have MBA degrees and typically join the firm directly from undergrad. Associates are either MBAs who joined the firm after business school or former Analysts who have been promoted (they are known as "A-to-A's"). VPs staff internal projects, handle client relationships, and provide internal institutional knowledge. MDs typically focus on one industry (if within a product group), develop and maintain relationships among management teams of companies in the industry by meeting with these companies on a regular basis.
Although the associate is the second most junior member on the banking team, the Associate is the essentially the project manager and analytical overseer for the daily work on the investment banking teams. While the Associate will need to know how to execute all the financial and analytical tasks, the Associate will also need to be able see the bigger picture and have ultimate accountability of the work product being used by senior people and corporate decision makers.
Associates are responsible for deal execution and the preparation of books for meetings. Associates are responsible for making sure that the Analyst's work is correct and may work on projects with no analyst, in which case the Associate is responsible for financial modeling and page creation, and must make sure that his or her own work is correct. In this business, attention to detail is extremely important.
The Investment Banking Lifestyle
What you hear from friends and read on blogs about investment banking hours is generally true. Investment bankers, especially Analysts and Associates, spend tremendous amounts of time in the office. It is not unusual for junior bankers to be at their desks past 2 AM. All-nighters happen occasionally. At most of the investment banks, Sundays (and, sometimes Saturdays if you are working on something live) are workdays just like any other day of the week. When out of the office, bankers are expected to be responsive to email and their voicemail. As a junior banker, your schedule will be largely unpredictable. It is not uncommon to have no idea when you will be able to leave the office on a give n night which may require you to cancel personal plans.
The demanding work schedule is the result of demanding clients. Investment bankers are paid large fees for the work they do, so clients expect tremendous amounts of work. As an Associate, you will often find yourself waiting in the office for comments on your work from a senior banker. You will then have to "tum" these comments by the next morning. This can be very aggravating as there is nothing you can do but wait, and senior bankers often have limited regard for your sleep schedule.
Generally, bankers in product groups other than M&A have slightly more balanced lifestyles than bankers in coverage groups. However, all investment banking hours are demanding.
Why Investment Banking?
Investment banking is a fundamentally hard job. People who are attracted to the field enjoy the variety of work, the fast pace, and the exceptionally good compensation. First year associates at bulge bracket banks have the opportunity to make total compensation approaching $250,000 and the pay increases rapidly as one moves up the scale. High-producing Managing Directors make several million dollars per year.
The job can be entrepreneurial and offers the opportunity to work on lots of projects simultaneously. There is a tremendous amount of information to learn, so it is attractive to people that like to be slightly out of their comfort zone. Generally, investment bankers tend to be highly motivated and hard working.
In addition, investment banking offers a breadth of exit opportunities. Not everyone who starts out as an Associate in investment banking becomes a Managing Director. Junior bankers develop highly transferable skills that often lead to positions in private equity, business development/corporate finance/treasury roles at large corporations, and hedge funds.
Different Tasks and Roles in Investment Banking
Financial Modeling, Valuation, and Analysis
As an Associate, you will need to be able to do all the financial modeling, valuation, and analysis required on the deal or project. On some deals, you will have Analyst support, whereas on other deals, you will be the most junior banker on the team and therefore will be responsible for building the financial models and analysis.
Regardless of whether you get analyst support or now, as an Associate, you are ultimately accountable for the accuracy of the valuation and analysis. Specifically, as an Associate, you will be required to:
Understand company financials , operations, competitive landscape, and macroeconomic conditions
Understand the various valuation methods (DCF, Comparables), determine what analysis is required, and build valuation models
Check models worked on by Analysts and perform some more complicated modeling and analysis (accretion/dilution, LBO)
Communication and Materials
As an Associate, you will also be spending a lot of your time creating pitch books. Pitch books are essentially marketing materials that senior bankers use with clients to discuss strategic opportunities with an objective to secure a business, such as representing the client in an IPO or M&A deal.
In addition to creating pitch books you will be required to draft information memorandums , prepare client presentations, and serve as the communication hub between senior bankers, clients, junior bankers, and other internal/external groups. Be prepared to do a lot of company and industry research, such as reading through I0-Qs, listening to analyst calls, understanding research reports, and more.
Meeting Preparation and Support
As an Associate, you will have opportunities to attend internal and client meetings. During meetings, your role will primarily be a support role. You will be expected to take detailed notes during meetings, coordinate meetings if needed, and answer any supporting questions on the materials and/or analysis.
Investment Banking Informational Interviews
The Informational Interview
The informational interview (often referred to as an "informational") is a CRITICAL part in the investment banking recruiting process. The most difficult part about getting an investment banking internship is getting an interview. Not all banks recruit at every school, so the best way to get an interview is through informational interviews, starting with second years, then with alumni, personal networks that work at an investment bank, and connections built through career fairs and bank visits.
There are two goals in an informational interview: First, this is an excellent opportunity for you to learn more about your bank of interest and collect information on the firm that you can utilize during your formal interviews. Second, an informational interview is an opportunity for you to express your interests and create a strong positive impression with the banker. Networking is a numbers game. The more positive impressions you build at the bank, the more you will increase your chances on landing a first-round interview.
Although informational interviews are different from formal interviews, you should treat these meetings like formal interviews. Expect these meetings to last 20 to 30 minutes, and you should be leading the conversation with thoughtful questions. In most informational interviews, the banker will do most of the talking. With that said, informational interviews can tum into difficult real interviews, where the banker turns the table and asks you questions typically expected during formal interviews. Therefore, before going into an informational interview , you MUST be ready, which means having your story down and be able to answer some basic to mid level technical questions. Going into an informational interview unprepared can drastically backfire and reduce, if not eliminate, your chances of landing a first-round interview with the bank.
How to Arrange an Informational Interview
Before setting up informational interviews with bankers, it is essential to do mock informational interviews with other people who have real world financial experience. This will allow you to practice telling your story, get real-time feedback, and polish your responses. There are several key steps in setting up an informational interview:
Initial Email Request: Email the alum or personal connection to request a 20 minute in-person discussion. You can also email HR and request to have an informational interview set up for you. Emails need to be short and concise. In fact, the best practice is to ensure the email fits on a Blackberry screen. The email should start with a brief introduction of who you are, a reminder about a previous conversation you have had with the person, state your interest, and end with an ASK, usually along the lines of "Would it be possible to meet you for a quick 20 minute informational the next time I am in NYC?"
Follow Up: If you do not hear back from the contact in about 4-7 days, write a short email to remind them. Reply to the previous email to use it as a reference point. Keep the maximum number of emails to 5. If after 5 emails the contact still has not responded , drop the contact and focus your time and energy on other contacts.
Confirm Appointment: If the contact responds positively and agree s to an informational interview, Confirm the appointment the day before the meeting date by sending them a confirmation email. This should be kept short, along the lines of "Thank you again for taking the time to speak with me, I look forward to our appointment tomorrow at 3PM. l will meet you in the lobby. Please email or call me if anything changes on your end."
Attend the Informational Interview: The attire for informational interviews is BUSINESS FORMAL. First impression counts! Also, please do not be late. For banks in NYC, some banks are located in lower Manhattan while others are in Midtown, so please plan accordingly and give yourself enough time buffer between informational interviews. The recommended number of informational interviews in one day is 4 -5. Taxis can be hard to get sometimes in NYC and subway systems can get confusing, so please give yourself enough time to get to your location.
Send Thank You Notes: After your informational interview, remember to send Thank You notes. Writing an email will suffice, but you can also supplement it with a handwritten Thank You card. As a best practice, send your Thank You notes within 24 hours of your meeting. Also, avoid sending them over weekends, wait until Monday morning. Bankers generally do not like to receive non-critical emails over the weekend or late at night. Again, Thank You notes should be short and concise, but the key here is to try to have him/her refer you to another contact. This can be something along the lines of "Thank you very much for taking the time to speak with me earlier today. I learned a great deal about the bank and your experiences, especially about XXX, which continues to reinforce my desire to work at [bank XXX). Thank you again and please let me know if I can speak with someone else on your group to learn more about the group".
Conducting an Informational Interview
As mentioned earlier, in most cases, you will be the one leading the informational interview with thoughtful questions. The general flow is as follows:
Briefly introduce yourself and walk them through your story
Ask them about their background
Ask them questions like "w hy they chose banking", "why firm XXX", "why group YYY"
You want to understand what an associate does. What makes a good associate. Ask them about the challenges of their job. What they like/dislike? What makes them successful?
Additional questions you have specific to the firm, like "I read about this deal on the news, did you work on it and can you tell me more about it?"
Time check, and wrap up asking for any additional advice the banker can give in terms of recruiting or making yourself stand out/become more prepared. Always ask for feedback.
Although you will be asking the questions, be prepared to provide polished responses to the following questions (also know as the "big 4"). These are the questions that the banker will almost always ask at each informational interview, and you are being evaluated on the quality of the responses.
Why do you want to do investment banking?
Why do you want to work at our bank?
Why should we hire you?
Why did you choose xxx MBA school or undergrad?
Sample Informational Interview Questions
What is your background?
Have you always been in the investment banking industry? If not, what did you do before transitioning into investment banking and why?
How do you spend your time (percentage breakdown, mode lin g, meet-and-gr eet, pitching a deal)?
Which product groups (M&A, Leveraged Finance, Debt /Equity capital markets, etc.) do you work with the most?
What was the most memorable deal you have done?
What do you know now about the summer internship process that you wish you would have known?
What mistakes did you make as a summer intern?
What drew you to xxx (Coverage Group, Product Group)?
What attracted you to bank xxx?
If you were in my place, how would you select a group (Industry, Geographic, or Product)?
Why choose Coverage Group over Product Group?
What new lines of business (groups) within at XXX do you see really taking off over the next five years?
What do you read/listen to daily to stay up to speed/learn about new deals? (Dealbook, etc.)
What can I do to better prepare myself in a investment banking career?
Investment Banking Sample Interview Questions
Conceptually, how does a firm create value?
A firm creates value by generating return on invested capital, growth, and positive cash flows. A firm should earn a return on its invested capital greater than the opportunity cost of capital. A positive NPV implies adding value to the firm.
What is a P/E ratio and why do analysts use it?
. . P/E ratio = Price per Share/Annual earnings per share
Also sometimes known as "price multiple" or "earnings multiple." The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding.
Example: If a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the PIE ratio for the stock would be 22x ($43/$1.95).
The P/E ratio can also be calculated by dividing the company's market capitalization by its total annual earnings. The P/E ratio has units of "years", which can be interpreted as number of years of earnings to pay back purchase price.
EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
P/E multiples are used to compare the relative attractiveness of stocks. It gives investors an idea of how much the market is paying for a company's earning power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting. A P/E multiple above 20x generally implies high growth.
Historically, the P/E of the S&P 500 is 15-l7x.
What is EBITDA?
EBITDA is a non-GAAP financial metric that refers to earnings before interest , taxes, depreciation, and amortization. EBITDA is an approximate measure of Free Cash Flow (FCF) - but it does NOT measure actual FCF! EBITDA is widely used in financial analysis and valuation.
What is EBIT?
EBIT is a non-GAAP term that refers to earnings before interest and taxes. EBlT is an approximate measure of operating income and a common measure of operating comparability. As EBIT does NOT include interest or taxes, it provides a measure of income independent of the firm's capitals structure.
Investment Banking: Interview Questions
What is the difference between common stock vs. preferred stock?
Preferred stock, similar to debt, has a guaranteed dividend; common stock does not have a guaranteed dividend.
Preferred has a higher claim on the assets and earnings of a company than common stock.
Calculate Earnings Per Share (EPS)
Net EPS is the portion of a company's net earnings allocated to each share of stock. It is calculated by dividing net earnings by common shares outstanding adjusted for the assumed conversion of ALL potentially dilutive securities. Only the " in-the-money" dilutive instruments are included in calculating adjusted common shares outstanding. These potentially dilutive securities include: convertible debentures, warrants, options, and convertible preferred stock. EPS does NOT include preferred stock.
How do you calculate fully diluted shares?
Use the treasury stock method.
What happens to EPS when a company repurchases its stock?
Assume all else remains constant, the EPS will increase as the total number of shares outstanding decreases (because the denominator gets smaller).
How do you go from Equity Value to Enterprise Value?
Equity Value: the value of the shareholders interest. Also commonly referred to as: Market Value, Offer Value, Market Capitalization
Enterprise Value: includes all forms of capital. Also commonly referred to as: Firm Value, Total Enterprise Value (TEV), Transaction Value, Aggregate Value, Adjusted Market Value.
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest (Net debt: Total Interest Bearing Debt minus Cash)
How would you value a company?
There are several ways to conduct this valuation. The most common 4 techniques are listed below:
Discounted Cash Flow (DCF)
A DCF is a technique used to provide us with an intrinsic value of a company, because it is based on the expected future cash flows of the company and is not market-based. DCF has a LOT of assumptions to include management's (sometimes optimistic) forecasts for future growth. Investment banks do not usually rely on DCF's for valuation.
Comparable Companies
Also called “public comps," this analysis yields a range of values based on similar, publicly-traded companies. The process for spreading comps is discussed later in this guide.
Precedent Transactions
Also called "M&A comps" or "acquisition comps," this analysis yields a range of values based on what similar companies were bought and sold for on the market. Because it includes a control premium, it tends to yield the highest valuation.
Leveraged Buyout (LBO)
An LBO valuation yields the value a financial buyer (i.e. private equity firm) would pay for the firm, given their high required rates of return (25% IRR or more) and capital structure. Given that and the fact that the analysis does not incorporate any synergies,the LBO valuation typically yields the lowest valuation range. Although in recent times, LBO has risen higher in the ranks of valuation analysis.
Which gives you a higher valuation - DCF or LBO? Why?
Discounted Cash Flow (DCF)
A DCF valuation is referred to as the intrinsic value of a company, because it is based on the cash flows of the company and is not market-based. Sometimes synergies are incorporated into the analysis, typically resulting in a higher value than the LBO analysis and, sometimes, higher than a comparable companies analysis.
Leveraged Buyout (LBO)
An LBO valuation yields the value a financial buyer (private equity firm) would pay for the firm, given its high required rates of return and capital structure .
High hurdle rate + no synergies = lowest valuation range.
What is Beta
Beta is a measure of volatility or systematic risk, for a security or portfolio in comparison to the market as a whole. Beta is used in the CAPM.
Mathematically: Beta = Covariance (Security, Market) / Variance (Market)
Beta of 1 indicates that the company moves in line with the market. If the beta is greater than 1 , the share is exaggerating the market's movements; less than 1 means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market.
How does Beta affect my DCF valuation?
Assuming that we use the CAPM to calculate the Cost of Equity (popular annotations: (re) or (ke)), and in tun use the WACC to calculate the discount rate for a DCF, changes to any of the inputs will ultimately affect our discount rate. A higher discount rate refers to a more risky security, portfolio, or project. This higher rate will result in a lower present value (PV).
Beta is used in the CAPM to derive the Cost of Equity (ke)
If all things remain equal ( i.e. risk-free rate and equity premium), a higher (more volatile) Beta will result in a higher (kc); and vice versa: lower (less volatile) Beta results in a lower (ka ), In turn, a higher (ke) will yield a higher discount rate (as calculated using the WACC). This higher discount rate signifies a more risky security or project, and results in a lower PV
There is a problem if you attempt this analysis using a negative value r the Beta (i.e . it doesn' t work).
What would a Beta be of a private company?
When you are analyzing a private company, whether it is a shoe store or otherwise, the simplest way is to use a Beta from comparable public companies. However, you have to account for differences in capital structure (i.e. the amount of debt (leverage) that these companies have). This requires un-levering the Betas from the public companies, calculating the average unlevered Betas (Bu-), and re-levering it based on the private company' s capital structure. Use the following formulas:
Unlevering Beta: Bu- = Bl / 1+ (1-t) *(D/E)]
Relevering Beta for the private company: Bl = Bu- / 1+ (1-t) *(D/E)]
What is unlevered free cash flow (FCF)?
FCF represents the cash that a company can generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that increase shareholder value. Without cash, it is tough to develop new products, make acquisitions, pay dividends, and reduce debt.
Why does DCF use unlevered cash flow?
DCF uses unlevered cash flows because these are cash flows that are generated by the firm' s real assets. Financing is considered in subsequent steps when discounting using either WACC (most common technique) or using the APV method (more academic). Therefore, if we were NOT using unlevered cash flows, when we discount the cash flows using WACC we would be "double-counting" the effects of financing (i.e. leverage).
How do you calculate unlevered FCF starting from Net Income?
[Net Income] + [interest expense*( l-t)] + [depreciation & amortization ] +/- [change in CAPEX] +/- [change in Working Capital] = [FCF to the company] - [ interest expense*(l-t)] - [principal repayments] = FCF to equity
How do you calculate unlevered FCF starting from EBITDA?
[EBITDA] - [depreciation & amortization] = EBIT - > EBIT* ( l-t) = Tax-adjusted EBlT, or NOPAT. NOPAT + [depreciation & amortization] +/- [change in CAPEX] +/- [change in Working Capital] = [FCF to the company] - [interest expense*(1-t )] - [ principal repayments] = FCF to equity
What is Terminal Value (fV)? How do you calculate it?
TV refers to the value at the end of a given projection period. TV can be calculated in several different ways. Below are the two most common techniques:
Perpetuity Growth (aka Gordon Growth model) takes the last year' s normalized net cash flow in the terminal year, multiplies it by 1 + growth rate and then divides it by the discount rate minus the growth rate: Cash * [( 1 +g) / ( discount rate - g)]. Perpetuity growth is highly sensitive to its input assumptions and accounts for the largest portion (up to 3/4) of the total cash flows estimated in a DCF. The growth rate (g) used in this calculation is somewhere between inflation and nominal GDP growth ( l-4%).
EBIT or EBITDA multiples assumes that the perpetual value will be in line with the multiple of the terminal year, or often even the current year. Using multiples takes out the uncertainty of determining the future growth rates. Additionally, multiples are more relevant when anticipating sale of a company to public markets - they project investors' willingness to pay relative to earnings. Investment banks usually use the multiples approach calculate TV.
What is CAPM? How do you calculate it?
CAPM = Cost of Equity (kc), also known as the Return on Equity (er ), ln general terms, you can think of CAPM from two major perspectives: The CAPM provides a natural benchmark to use to evaluate investments and managed portfolios. Investment analysis also teaches that investing in small-cap on average will beat the market.
The CAPM also tells us what the expected return on any investment should be: CAPM: ( re)= rr + * (rmarket - rr)
rr: Risk-Free rate, a.k.a. the rate of a riskless government security.
(rmarket - r-f): this term is known as the "Equity Risk Premium" or " Equity Premium." This signifies the amount of excess return that a company will provide investors over a risk-free rate. Higher risk companies will have a higher "premium."
What is WACC? How would you calculate it?
WACC is the Weighted Average Cost of Capital. It is the tax-affected (1-t), capital structure weighted, opportunity cost of capital. WACC is used as the discount rate for assigning present values (PV) to future unlevered free cash flows.
WACC = [(E/ (D + E)) * ke] + [(D / (D + E)) * kd * (1-t)]
ke = Cos t of Equity, or Return on Equity, which what you calculate using the CAPM.
ko = Cost of Debt, or Return on Debt; reflects the trading price of a company’s outstanding debti In the case that this information is not publicly available (i.e. in a private company), you can use an analysis of comparable public companies outstanding debt to get an average rate.
What is (1-t) and why is it in the WACC?
(1-t) is often referred to as the "tax shield". The interest paid on a finn's debt can be deducted from taxable income.
Why do we use EBIT for Free Cash Flow (FCF) instead of Net Income?
Earnings Before Interest and Taxes (EBIT) is a non-GAAP term that is a proxy for operating income before the effects of the financing and taxes (i.e. represents income that is independent of capital structure). As we demonstrated above, from a technical calculations standpoint, Free Cash Flow (FCF) can be calculated using either EBIT or Net Income (NI), but the order of the arithmetic changes. If you start with Nl, you have to add back the effect of interest and taxes.
The Beta on Yahoo! Finance, is it levered or unlevered?
The given Beta is levered.
What are deferred taxes?
It is important to remember that companies maintain two different " books": the accounting books and the tax books (money paid to the fRS) and they are NOT equal. The idea of deferred tax assets/liabilities is an accounting principle .
Deferred tax assets: occur when the accounting tax expense is less than the money paid to the IRS.
Deferred tax liabilities: occur when the accounting tax expense is higher than the money paid to the lRS.
What is depreciation in the steady state?
Steady state means that the company is not growing anymore. Therefore, Depreciation = CAPEX and PPE will remain constant. When building a DCF one should attempt to reach steady state in the final year before calculating TV.
What is working capital?
WC = Current Assets - Current Liabilities
Current Assets: Accounts Receivable (AR), inventory, other assets
Current Liabilities: Accounts Payable (AP), Accrued Liabilities, Deferred Taxes, other liabilities Positive working capital means that the company can pay off its short-term liabilities.
Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).
What is a capital expenditure (CAPEX)? Give me an example.
Funds used by a company to acquire or upgrade physical assets: Property, Plant, or Equipment (PPE). In terms of accounting, an expense is considered to be a CAPEX when the asset is a newly-purchased capital asset or an investment that improves the useful life of an existing capital asset. lf an expense is a CAPEX, it needs to be capitalized; this requires the company to spread the cost of the expenditure over the useful life of the asset.
If, however, the expense is one that maintains the asset at its current condition, the cost is deducted fully in the year of the expense.
Walk me through a DCF.
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 your tax-adjusted EBIT 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 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 a n 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 l 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. The 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). 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 .
How would a $100 increase in depreciation expense affect the financial statements?
Depreciation Expense = +$100
JS: Depreciation is a non-cash expense which lowers your net income by (1-t)*Depreciation. Pretax expenses increase $100, income tax decreases $30, and net income decreases by $70 (assume t = 30%)
BS: Depreciation measures the use of PPE; therefore an increase in Depreciation expense decreases your PPE value by the same amount. Depreciation expense increase of $100 = Increase in Accumulated Depreciation of
$100 = Net PPE decrease in $100. This affects the left hand side (LHS) of the BS. The right hand side (RHS) of the BS is affected as well. From above, we know that NI decreases by $70. NI is added to the Retained Earnings from the last period to get the new Retained Earnings of this period. Accordingly, the retained earnings will be reduced by $70. The $30 of disparity between the LHS and the RHS is accounted for by the increase in cash due to tax savings.
CFS: Start with the net income from the IS, in which case we are down $70. Add back $ I 00 of increased depreciation (since it is a non-cash expense). All other factors on the CFS remain constant, but the -$70 and +$100 results in a net cash increase of +$30. This final cash number flows to the LHS of the BS.
BS: LHS: Cash = +$30; PPE = -$100; NET= -$70 RHS: Retained Earnings: -$70
Bottom Line = Increase in Depreciation increases cash, and vice versa.
How would you perform a public comp?
Identify peer companies that have similar operations and financial aspects. These companies will be comparable in size, risk, and growth. You can determine this through previous analysis conducted by other bankers; peer group index; competition section of 10-K or IPO prospectus; Value Line; Bloomberg; etc.
To spread comps, first go into the company's 10-K to find the number of shares (this will be posted on the first page). Multiply the number of shares by the current stock price to arrive at equity value. Then log into Bloomberg or an alternative resource to find the data needed to convert equity value to enterprise value, including cash and equivalents, short-term debt, long-term debt, preferred stock and minority interest.
Bloomberg will also provide the information needed for the denominators of the public comp multiples , such as EBITDA and revenues.
What are some common ratios used to compare equity performance?
Price/ EPS
Market Value/ Net Income Market Value/ Book Value
Price to Earnings / Growth Rate ("PEG Ratio") applies growth to a multiple
What are some common ratios used to compare enterprise performance?
EV/ EBITDA
EV / EBIT
EV / Sales
The key difference is that Equity ratios use figures on the income statement that are " below the line" (below EBITDA) whereas Enterprise ratios use figures "above the line ." This is due to Enterprise value being owned by both equity and debt holders, and therefore it should not be deducted from one's calculation. Equity is the value owned by equity holders only, so one must calculate these metrics after removing interest expense.
Why arc some stock options relevant to valuation?
Unexercised, "in-the-money" options represent implicit equity value not reflected in the current market cap, but that should be included in your valuation.
What is Goodwill?
Goodwill arises when an acquiring company buys a target company and pays more money than the book value of a target company. This can be found in the assets portion of a company's balance sheet.
Why would two companies merge?
M&A is driven by three factors: revenue synergies , cost synergies, and strategic concerns.
Everyone cites "synergies" as a reason why precedent transactions have a higher valuation than comps. What is a synergy really?
A synergy is the idea that the value and performance of two companies combined will be greater than the sum of the separate individual parts.
Cost synergies refer to the opportunity of a combined corporate entity to reduce or eliminate expenses associated with running a business (i.e. huge cost-savings in COGS or SG&A by merging marketing, distributing, etc.).
Cost synergies are realized by eliminating positions that are viewed as duplicate within the merged entity. Examples include the headquarters office of one of the predecessor companies, certain executives, the human resources department, or other employees of the predecessor companies (overhead). Cost synergies are the most common type of synergies that are realized from M&A transactions.
Revenue synergies refer to the opportunity of a combined corporate entity to generate more revenue than its two predecessor stand alone companies would be able to generate. For example, if company A sells product X through its sales force, company B sells product Y, and company A decides to buy company B then the new company could use each sales per so n to sell products X and Y thereby increasing the revenue that each sales person generates for the company. (This is where I + I = 3).
***The above guide after the intro was heavily adapted from a business school finance club investment guide given out to students who are interested in investment banking**