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Wall Street Prep Study Guide
Assets - ✔️resources a company uses to operate its business includes cash, A/R, PP&E Liabilities - ✔️represents the company's contractual obligations and includes A/P, debt, accrued expenses Shareholder's equity - ✔is the residual the value of the business available to the owners (shareholders) after debts have been paid off Income statement - ✔️illustrates the profitability of the company over a specified period of time broad sense: shows revenue-expenses Balance sheet - ✔️snapshot of the company economic resources and funding for those resources at a given point in time (A = L + SE) Revenue - ✔️"top-line" represents the sale of goods and services it is recorded when earned (even though cash might not have been received at the time of transaction) Expenses - ✔️netted against revenue to arrive at net income COGS (directly associate with good production), SG&A (indirectly associated with production), interest expense (expense related to paying debt holders periodic payments), taxes, depreciation expense (non-cash expense accounting for the use of PP&E, often imbedded within COGS and SG&A) Net income - ✔️"bottom-line" revenue-expenses
the profitability available to common shareholder's after debt payments have been made (interest expense) EPS (earnings per share) - ✔️portion of a company's profit allocated to each outstanding share of common stock EPS = (net income - dividends on preferred stock)/weighted average shares outstanding Cash flow statement - ✔️While cash is not necessarily received when a sale occurs, the income statement still records the sale. As a result, the income statement captures all the economic transactions of the business. The cash flow statement is needed because the income statement uses what is called accrual accounting. In accrual accounting, revenues are recorded when earned regardless of when cash is received (revenue includes sales using cash and made on credit A/R) Since we also want to have a clear understanding of the cash position of a company, we need the statement of cash flows to reconcile the income statement to cash inflows and outflows. "cash position of the company" cash from operating activities, cash from investing activities, and cash from financing activities Cash from operating activities - ✔️mostly indirect method starts with net income and includes the cash effects of transactions involved in calculating net income. reconciliation of net income. Net income (income statement)
- non-cash gains
- period on period increases in working capital assets
- period on period increases in working capital liability = CF from operations *for stable, mature, plain vanilla companies, a positive cash flow from operating activities is desirable Cash from investing activities - ✔️cash related to investments in the business (additional capex or sales of assets) for stable, mature, plain vanilla a negative cash flow from investing activities is desirable as this indicates that the company is trying to grow by buying assets
How is it possible for a company to show positive net income but go bankrupt? - ✔️Two examples include deterioration of working capital (i.e. increasing accounts receivable, lowering accounts payable), and financial shenanigans. I buy a piece of equipment, walk me through the impact on the 3 financial statements. - ✔️Initially, there is no impact (income statement); cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement) Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement). Why are increases in accounts receivable a cash reduction on the cash flow statement? - ✔️Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds. How is the income statement linked to the balance sheet? - ✔️Net income flows into retained earnings. What is goodwill? - ✔️Goodwill is an asset that captures excess of the purchase price over fair market value of an acquired business. Let's walk through the following example: Acquirer buys Target for $500m in cash. Target has 1 asset: PPE with book value of $100, debt of $50m, and equity of $50m = book value (A-L) of $50m. Acquirer records cash decline of $500 to finance acquisition Acquirer's PP&E increases by $100m Acquirer's debt increases by $50m Acquirer records goodwill of $450m What is a deferred tax liability and why might one be created? - ✔️Deferred tax liability is a tax expense amount reported on a company's income statement that is not actually paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences in income between the two, which ultimately leads to differences in tax expense reported in the financial statements and taxes payable to the IRS. What is a deferred tax asset and why might one be created? - ✔️Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an expense on their income statement in a reporting period.
Differences in revenue recognition, expense recognition (such as warranty expense), and net operating losses (NOLs) can create deferred tax assets. Walk me through 3 financial statements. - ✔️The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year." How are the financial statements linked together? - ✔️The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period. In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period. "Why is the cash flow statement important and how does it compare to the income statement?" - ✔️The income statement shows a company's accounting-based profitability. It illustrates a company's revenues, expenses, and net income. Income statement accounting uses what is called accrual accounting. Accrual accounting requires that businesses record revenue when earned and expenses when incurred.
"Company A has $100 of assets while company B has $200 of assets. Which company should have a higher value?" - ✔️On the face of it, we simply don't have enough information to answer this question. We need certain efficiency and profitability ratios to understand how the companies are using assets to generate revenues. You: Given that we only know the total amount of assets for both company A and B and nothing else, it is impossible to say whether A or B is more valuable. Would I be able to ask you some questions about both companies? Interviewer: Sure You: Would you be able to tell me what industry these two companies operate in? Interviewer: They are both consumer products companies. You: Can I assume that both companies have similar expected asset turnover (revenue/assets), leverage, return on asset, re-investment rates and profit margins? Interviewer: Yes, let's assume this is correct. You: Okay, thank you. Based on this information, it appears that we are comparing two companies with similar returns on capital, long term growth rates, and costs of capital. Since these elements are the primary drivers of value for a business, as long as both companies generate returns above their cost of capital, the firm with the larger assets deserves a higher valuation because they are both effectively "converting" their assets into profitability with equal efficiency, given similar risks and expected growth. How do you value a company? - ✔️Intrinsic value (DCF): This approach is the more academically respected approach. The DCF says that the value of a productive asset equals the present value of its cash flows. The answer should run along the line of "project free cash flows for 5-20 years, depending on the availability and reliability of information, and then calculate a terminal value. Discount both the free cash flow projections and terminal value by an appropriate cost of capital (weighted average cost of capital for unlevered DCF and cost of equity for levered DCF). In an unlevered DCF (the more common approach) this will yield the company's enterprise value (aka firm and transaction value), from which we need to subtract net debt to arrive at equity value. Divide equity value by diluted shares outstanding to arrive at equity value per share. Relative valuation (Multiples): The second approach involves determining a comparable peer group - companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics. Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. Calculate appropriate industry multiples. Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation. Common multiples are EV/Rev, EV/EBITDA, P/E, P/Book, although some industries place more emphasis on some multiples vs. others, while other industries use different valuation multiples altogether. It is not a bad idea to
research an industry or two (the easiest way is to read an industry report by a sell- side analyst) before the interview to anticipate a follow-up question like "tell me about a particular industry you are interested in and the valuation multiples commonly used." What is the appropriate discount rate to use in an unlevered DCF analysis? - ✔️Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company's cash flows as if it had no debt - so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity). The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate. Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP's DCF module for a detailed analysis of calculating the cost of equity). What is typically higher - the cost of debt or the cost of equity? - ✔️The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation. How do you calculate the cost of equity? - ✔️There are several competing models for estimating the cost of equity, however, the capital asset pricing model (CAPM) is predominantly used on the street. The CAPM links the expected return of a security to its sensitivity the overall market basket (often proxied using the S&P 500). The formula is: Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf ) Risk free rate: The risk free rate should theoretically reflect yield to maturity of a default-free government bonds of equivalent maturity to the duration of each cash flows being discounted. In practice, lack of liquidity in long term bonds have made the current yield on 10-year U.S. Treasury bonds as the preferred proxy for the risk- free rate for US companies. Market risk premium: The market risk premium (rm-rf) represents the excess returns of investing in stocks over the risk free rate. Practitioners often use the historical excess returns method, and compare historical spreads between S&P 500 returns and the yield on 10 year treasury bonds. Beta (β): Beta provides a method to estimate the degree of an asset's systematic (non-diversifiable) risk. Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market. A company whose equity has a beta of 1.0 is "as risky" as the overall stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the stock market. A company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop twice as fast as the overall market.
would have been 3.5. In fact, I have continued to improve every year and over the last year I have maintained a 3.8 GPA." how comfortable do you feel working with numbers? - ✔️"Even though my university doesn't offer any finance or accounting courses, I have taken numerous calculus, statistics, physics, and computer science courses to help me develop strong problem solving skills. In addition, as a member of the Rock Climbing Club, I work on budgeting and have budgeted the next 3 climbing trips to the dollar using a simple excel model that I created from scratch. I recognize that the position I am interviewing for is an analytical position, that is very much part of the appeal. I love analytical challenges and feel confident that I can handle the analytical rigor of investment banking." Telling a strategic anecdote in an investment banking interview (leadership anecdote) - ✔️Great responses to this question include ones that clearly depict you as a leader without sounding arrogant. You want to give responses like "took initiative to go to each dorm and market the event to dorm reps and bargained with vendors to get prices for food and drink - reducing original prices by 15%. The aggressive marketing coupled with reduction in prices allowed us to raise approximately $12,000 in funds for my class."
