Investment Banking Interview Action Plan

Investment Banking Interview Guide Access the Rest of the Interview Guide

Table of Contents – Interview In terview Action Action Plan P lan (Summary Version Version of Guide) Before and After the Interv I nterview iew and an d Qualitative Qualitative Questions Questions ................... ............. ...... 3 Before the Interview: Interview: How to Prepare ........................ ............ ........................ ......................... ............... 3 Resume / CV Questions & Example Answers ........................ ............ ....................... ........... 14 Strengths and an d Weaknesses Questions Questions & Example E xample Answers ............ 29 Teamwork Teamwork / Leadership Questions & Example Answers Answers ................ ... ............. 44 “Warren Buffett” Questions Q uestions & Example Example Answers ......................... ............ ................ ... 57 After the Intervi I nterview: ew: Questions and Thank You Notes ..................... ................. .... 73 Accounting Accounting Overview & Key Rules of Thumb ........................ ............ ........................ .............. 81 Key Rule #1: The Income Statement ................................. ..................... ......................... .................. ..... 81 Key Rule #2: The Balance Sheet ........................ ........... ......................... ........................ ....................... ........... 84 Key Rule #3: The Cash Flow Statement ........................ ........... ......................... ...................... .......... 87 Key Rule #4: How to Link the 3 Statements......................... ............ ......................... ................ 89 Key Rule #5: Changes on the Statements ......................... ............ ......................... .................. ...... 90 Equity & Enterprise Value Va lue Overview and Key Rules of Thumb ........ 97 Key Rule #1: Equity Value and What It Means .............................. .................. ............... ... 97 Key Rule #2: Enterprise Enterprise Value Va lue and What It Means ........................ ........... ................ ... 98 Key Rule #3: Diluted Shares Outstanding ....................... ........... ......................... ................... ...... 99 Key Rule #4: Items I tems That Go Into Enterprise Value....................... Value.......... ................ ... 101 Key Rule #5: Which One to Use? ....................... ........... ......................... ......................... ................... ....... 104 Valuation Valuation Overview and Key Rules of Thumb ........................ ............ ....................... ........... 106 Key Rule #1: How H ow Do You Value a Company? C ompany? ........................ ............ ................... ....... 107 Key Rule #2: Which Metrics and Multiples Do You Use? .............. 113 Key Rule #3: What Does a Valuation Mean?........................... Mean?............... ..................... ......... 117 Key Rule #4: Trade-Offs Trade-Offs and Correlations Correlations ................................... ....................... ................ .... 119 Key Rule #5: Valuation in the Real World...................... World......... ......................... .................. ...... 123 DCF Overview Overview and Key Rules of Thumb........................ ........... ......................... .................... ........ 125 Key Rule #1: DCF Concept and Walking Through It ...................... ............ .......... 126 Key Rule #2: Calculating C alculating and Projecting Projecting Free Cash Flow (FCF) .... 128 Key Rule #3: Discount Discount Rates and WACC ......................... ............ ......................... ................ .... 134

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Key Rule #4: Calculating Terminal Value .................................. ...................... .................. ...... 142 Key Rule #5: Factor Fa ctorss That Impact a DCF and WACC..................... ........... .......... 145 Merger Model Overview Overview and Key Rules of Thumb ........................ ........... ................ ... 148 Key Rule #1: Why Buy Another Another Company?.................. Company?...... ......................... ................... ...... 149 Key Rule #2: How H ow Does a Merger Model Work? ................... ...... ...................... ......... 152 Key Rule #3: How H ow Does the th e Payment Method Affect the Deal? .... 160 Key Rule #4: Acquisition Acquisition Effects and Synergies ......................... ............. ................. ..... 165 Key Rule #5: M&A in the Real World ......................... ............. ........................ ...................... .......... 168 LBO Model Overview Overview and an d Key Rules of Thumb ......................... ............. ................... ....... 171 Key Rule #1: What Is an LBO and Why Wh y Does It Work? Work? .................. ............ ...... 172 Key Rule #2: How to Make Basic Model Assumptions .................. ............ ...... 176 Key Rule #3: How H ow to Project the t he Statements and Pay Off Debt Debt ..... 180 Key Rule #4: How H ow to Calculate Calculate Returns ......................... ............. ........................ .................. ...... 184

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Key Rule #4: Calculating Terminal Value .................................. ...................... .................. ...... 142 Key Rule #5: Factor Fa ctorss That Impact a DCF and WACC..................... ........... .......... 145 Merger Model Overview Overview and Key Rules of Thumb ........................ ........... ................ ... 148 Key Rule #1: Why Buy Another Another Company?.................. Company?...... ......................... ................... ...... 149 Key Rule #2: How H ow Does a Merger Model Work? ................... ...... ...................... ......... 152 Key Rule #3: How H ow Does the th e Payment Method Affect the Deal? .... 160 Key Rule #4: Acquisition Acquisition Effects and Synergies ......................... ............. ................. ..... 165 Key Rule #5: M&A in the Real World ......................... ............. ........................ ...................... .......... 168 LBO Model Overview Overview and an d Key Rules of Thumb ......................... ............. ................... ....... 171 Key Rule #1: What Is an LBO and Why Wh y Does It Work? Work? .................. ............ ...... 172 Key Rule #2: How to Make Basic Model Assumptions .................. ............ ...... 176 Key Rule #3: How H ow to Project the t he Statements and Pay Off Debt Debt ..... 180 Key Rule #4: How H ow to Calculate Calculate Returns ......................... ............. ........................ .................. ...... 184

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Before and After the Interview and Qualitative Questions Before the Interview: How to Prepare If you want to experience serious success in finance interviews, you need to start preparing well in advance of advance of your interviews. Even if you only have a matter of hours or a day before your interview, you can still do preparation that will make a huge difference. And if you have more time than that, you’ll be able to truly stand out above everyone else. We’ve divided this section into several categories, some of which are more important or less important depending on your background, the level of roles that you’re interviewing for, and other factors. You should always take always take the time to think through your resume / CV and prepare to discuss the items on there – even if you only have 15 minutes to think about it – but the rest of this list is optional and depends on how much time you have available. How to Prepare to Discuss Your Resume / CV With limited time, this is by far the most important task. Take a look at each work / leadership experience on your resume / CV and come up with the following points: •

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Summary of What You Did (ex: Did (ex: “I assisted financial advisors with analyzing client portfolios, making recommendations on asset allocation, and helping clients to earn higher returns.”) Top 3 Results / Projects / Clients (ex: Clients (ex: You saved them 10 hours per week of time with a new process you invented, you helped one client earn a 15% return rather than a 10% return with your new strategy, and you improved client retention by 10% via an email marketing campaign you set up.)

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What You Learned and How It Relates to Banking (ex: You learned how to analyze numbers more effectively, make recommendations to clients, and work in a team of 5 to achieve results on tight deadlines.)

You should also know your rationale for attending each educational institution on your resume / CV, what you achieved there, and how it prepared you for banking, using the same points above. Once you have all these, you need to outline your “story” – your answer to the “Walk me through your resume” or “Tell me about yourself” question – and make sure that’s solid. Please see the dedicated section of this guide for more details on telling your story and review the dozens of templates and tutorials we have on this topic. Even if you only have 30 minutes to prepare for the interview, you need to do everything above or you’ll have no chance of winning an offer. Answering the “Fit” Questions There are dozens, if not hundreds, of possible “fit” questions, and countless more variations that interviewers could come up with. We cover the most common and most important ones extensively in this guide, and provide example “good” answers for all of them – and show you how to prepare for each question category and structure your answers. With limited time, though, you need to focus on specific categories: •

Resume , Team / Leadership , and Strengths / Weaknesses questions will always come up regardless of your background, so take the time to review these and prepare solid answers.

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“Warren Buffett” questions are also very likely regardless of your background, so do spend time on those and come up with a few examples of interesting companies, deals, trends, and stock pitches. Questions about Your Future and Why Banking are also very common, but they are not difficult to answer as long as you have already developed a solid “story” using our templates. Analytical , Career Changer , and Understanding Banking questions are much more likely if you’re moving in from a different industry. So if you’ve already had a lot of finance experience, do not go crazy with reviewing these. Culture , International , and “Failure” questions are case-by-case; these are more important if you have something specific that you know they’ll ask about, such as a gap on your resume, why you didn’t receive a return offer from your internship, or why you moved from China to the UK when you were 15. Outside the Box and Recruiting Process questions are much more common if you’re an undergrad or recent graduate. Neither should require a whole lot of preparation.

The bottom-line: with limited time, focus on preparing examples for Resume, Team / Leadership, and Strength / Weakness questions. On your resume, you should select 3-4 different experiences you can use and re-use to answer all of these questions and more. These stories can come from both work experience and student groups / organizations, but if you’ve already worked full-time they should come from your work experience primarily. We provide detailed, step-by-step guidance on how to prepare and what to say for each question category in the guide – but here are the 4 most important points with all “Fit” questions: 1. Structure – Good structure can turn a weak or decent answer into a great answer. If you answer questions in a structured way, it implies that you have good communication skills and can explain concepts clearly. 2. Story – An answer with a supporting story or anecdote, even something very brief, is far better

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than an answer without a supporting story. You don’t need to come up with a riveting, page-turning novel here – just something that’s not generic. 3. Synthesis – After you give your answer and support it with a story (or other specific example), explain how it relates to banking and gives you the skills required to succeed. 4. “Short” – Finally, resist the temptation to ramble on and on for “fit” responses. If you can keep it under 30 seconds, great. 60 seconds is pushing it, but may work if it’s something more complex. Anything beyond that means that you’re rambling. Yes, we do provide sample answers here that would go beyond 30-60 seconds if you recite them – but we’re doing that so that you can get ideas for how to structure your own answers and explain in more detail what a “good answer” means. In real life, you should shorten your responses and be as concise as possible. Learning the Technical Side With limited time, you don’t have weeks to spend learning every technical detail indepth. And that’s why we provide Key Rules of Thumb and quick overview tutorials in this edition of the guide for all the technical topics you could be asked about in interviews. The 6 core topics are Accounting, Equity Value & Enterprise Value, Valuation, Discounted Cash Flow (DCF), Merger Model, and the LBO Model. With extreme time limitations, do not look at the actual questions and answers in these sections – just review the tutorials in the beginning instead. If you have more time than that (at least a few days) and you really need to brush up on the technical side, then you should practice with the interactive quizzes we provide; if you have even more time than that, you can look at the Q&As in the guide itself as well as the sample Excel models and video tutorials. Do not ignore qualitative questions and focus exclusively on technical questions.

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Yes, technical questions are harder to prepare for, and yes, they have become more important in recent years… but most of your success in interviews will be determined by your “story” and by what you say in the first few minutes. And if you really want to learn the technical side in-depth and you have at least a few weeks to prepare, click here to check out our Financial Modeling Fundamentals course. You receive a $50 discount as a Breaking Into Wall Street member, and you get 20+ hours of video tutorials along with several bonus case studies on real M&A deals and leveraged buyouts. It has been one of our most popular courses year after year, and it’s a great way to extend your knowledge of accounting and prepare for interviews even more effectively. Rehearse, But Not Too Much One of the most common interview tips given in other guides and is: “Practice! Always rehearse what you’re going to say and plan it out!” I don’t disagree with that, but you need to be careful with how much you rehearse. If you memorize answers word-for-word and try to script out everything, you’ll sound artificial and unconvincing in actual interviews – and if you get a question on something that you haven’t scripted out, you’ll get flustered and confused. You should definitely outline your “story” and answers to the most important Team / Leadership and Strength / Weakness questions, as well as anything else specific to your background, but beyond that you should not memorize answers word-for-word. Once you’ve outlined these answers, practice in front of a mirror or with a friend, but don’t get too carried away with these rehearsals.

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This entire guide (the questions and answers, technical tutorials, Excel files, videos, interactive quizzes, and story templates) will be far more helpful for you because you can only cover so much ground in a 30-minute practice interview. Always Scan the News in the Morning You don’t need to know as much about the markets as traders do, but you still need to be aware of recent, major news: • • • • • •

Financial scandals? Banks or other companies failing and being bailed out? A recent election? Important legal rulings? Massive M&A deals or IPOs? General economic news, such as the unemployment rate, GDP growth, and so on.

You should already be reading The Wall Street Journal and/or Financial Times , so on the day of the interview you just need to scan them quickly and make sure that you have a handle on all major news. I’ve seen cases where someone goes in for an interview and he/she gets rejected or receives a poor response because he/she seems out of touch and does not know about recent news. Researching Stocks and Companies This is extremely important for equity research and hedge fund interviews, but you also need to know about stocks, deals, and interesting companies and trends for IB and PE interviews. You don’t need to go crazy with this and spend days researching them, but it’s worthwhile to take a few hours out of your day and come up with 2-3 interesting companies, 1-2 recent deals, and 1-2 industry trends to talk about.

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Click here to get a complete guide and video tutorial on how to do all that and more . Again, these are much more important on the equity research, asset management, and hedge fund side, but it’s worthwhile to spend some time on it even for investment banking and private equity interviews. How to Research the Bank and Your Interviewers Spend time on this only if you have the extra time to spend. If this is a last-minute interview and you only have a few hours, skip this and do the bare minimum necessary – i.e. go to the bank’s website and make sure you understand what they do and a few deals they’ve advised on recently. If you have more time available, look up the firm on LinkedIn and see who works there, what types of backgrounds they came from, and where they went to school. If you’re lucky enough to get a list of interviewers in advance, do all the usual LinkedIn and Google research on all of them and learn as much as you possibly can. You might be able to figure out in advance, for example, that one interviewer is from a liberal arts background, just like you – so maybe you can point that out in the interview and “bond” over that shared experience. And if one of the interviewers comes from a very technical background (e.g. he worked in FIG, distressed debt investing, and Special Situations), then you know in advance that he may ask you more detailed technical questions. The bottom-line: If you have time on your hands, find out as much as possible in advance. If you do not have time, do the bare minimum research and make sure you understand what the firm does and a few recent deals / investments they have worked on. What to Wear on Interview Day

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Business formal. If you’re male, this means a suit and tie – and not something that looks like a hand-me-down from your older brother. You don’t need to spend a fortune on a suit, but it’s worth getting at least a moderately priced one that fits you well and that implies that you’re taking the interview seriously. If you’re female, “business formal” also means “wear a suit” – do not wear a dress or go in looking like you’re auditioning to be a pole dancer. Yes, if you’re attractive you may be able to “convince” some male bankers that you’re an exceptional candidate, but this is generally a horrible idea that will almost always backfire. If you’re male and you don’t know how to tie a tie, look it up on YouTube or get a friend to help you – if you walk in without a properly tied tie, interviewers might rightly think, “OK, this kid either has no friends and therefore no social skills, or he cannot use a search engine… and clearly he cannot work in investment banking if either of those is true.” Similarly, make sure your shirt is wrinkle-free and either iron it yourself or pay for dry cleaning. What to Bring With You Physically Just bring a nice-looking folder with hard copies of your resume / CV, a few extra sheets of paper, and a pen or pencil (in case you get questions where you need to write something down). There’s no point in bringing a calculator because they won’t let you use it for math tests or case studies anyway, and because it’s not even necessary for the questions you’ll receive. Mindset and What to Expect Walking Into the Interview

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Always maintain low expectations in interviews. If you walk in expecting nothing , you’ll never be disappointed. When you walk in, all you should think is: “I view this as an opportunity to improve my performance for the next interview.” Some people suggest that you should expect to be grilled or receive insanely hard questions in order to prepare yourself properly. I think that’s going overboard and isn’t really necessary. But on the flip-side, you definitely do not want to walk in and expect that you’ll win an offer immediately, especially if it’s your first interview or it’s relatively early in the process and you haven’t spoken to many different firms yet. How the Process Works This one depends on the region you’re in: North America is different from Europe, which in turn may be slightly different from Asia, Australia, and so on. Here’s how it works in North America: 1. Submit your resume online and/or win an interview via networking; 2. Go through a first round interview , which may be on the phone or may be done on campus if you’re at a school where banks typically recruit; 3. Move to the next round – the Superday – at the bank’s offices, and meet with between 5 and 10 bankers at all levels; 4. If they like you, you receive an offer , or you may come back in for even more interviews over an extended period. If you have more work experience, if you’re interviewing for lateral positions, or if you’re interviewing for buy-side roles, this process will drag on for longer and there may not be an official “ending” even after many rounds of interviews. But that’s the general progression: resume submission, quick phone interview, and then multiple interviews across all different levels, in-person, at the bank.

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In many cases, you’ll get more technical questions in the earlier interview rounds, but as you progress toward the end the questions will become more qualitative because they care more about “fit” at that stage. Outside of North America (Europe, the Middle East, and sometimes other regions such as Australia and Asia) the process differs in several ways: 1. In addition to submitting your CV and cover letter online, you also have to submit competency questions – basically written versions of answers to “fit” questions. You can apply all the strategies for “fit” questions in this guide to these questions. 2. Rather than Superday interviews, banks use assessment centers where you have to participate in group exercises, case studies, interviews, presentations, and more. 3. There may also be aptitude tests in this process that test your numerical, verbal, and reasoning abilities. Answering competency questions is not much different from answering normal “fit” questions, so you can use all of the strategies outlined in this guide for those. Just make sure you keep your responses concise and within the word count they give you. We don’t cover aptitude tests here, but there are plenty of sources for that online – one good site is Assessment Day, where you can sign up for dozens of real practice tests. For more tips on interviews and recruiting outside of North America, please see these articles on M&I: • •

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IB Assessment Centers and Competency Questions: Overview EMEA Recruitment, Part 1 – Overview, Competency Questions, and Aptitude Tests EMEA Recruitment, Part 2 – Assessment Centers Investment Banking Case Studies – Bonus Section of the Interview Guide

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I’ve gone back and forth on whether to include more material on assessment centers, competency questions, and aptitude tests in this guide, and I may do that in the future. However, there is a lot of overlap with everything else covered here – from the “fit” questions to the technical topics. So it would be quite repetitive to include even more coverage and make 80% of it very similar to what’s already here. The bottom-line on recruiting in Europe and other regions: Yes, you need to do well on these aptitude tests and perform well at assessment centers, but you can already do that by following this guide and the case study coverage here, and by signing up for a few practice tests online. And we’ll add more formal coverage of case studies to this guide in the near future. Return to Top.

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Resume / CV Questions & Example Answers Questions about your resume are among the most important ones because you’ll get them regardless of your work experience or education level. The single most important question in any interview is “Walk me through your resume” (otherwise known as “Tell me about yourself,” among other names) and it’s also the single most problematic one – so make sure you review the dedicated section of the guide and all our templates and tutorials for that one. You need to know EVERYTHING on your resume very well. Anything you write about is fair game – so if you don’t know much about it or cannot explain it well, take it off. I’ve seen people get grilled on small details and lose out on offers when they don’t remember the experience that well. This can become a real problem if you have 5-10+ years of work experience but can’t remember the details for everything. For each work experience entry, you need to give not only a good summary of the experience, but also more detailed accounts such as particularly noteworthy assignments you worked on. To prepare, go through all work/leadership experience entries and create a summary statement for each one along with a 3-point outline of the most important projects / clients / deals for each entry. Finally, if you have deal or investment experience, please see the section of the guide on how to discuss your transactions for more detail on that. Preparing Examples in Advance First, use our Resume Walkthrough templates and video tutorials (in the dedicated section of the guide) to prepare your response to the resume walkthrough / tell me about yourself question.

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Then, look at each work/leadership experience entry on your resume and create an outline for it with the following points: •

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A Summary of what you did overall (e.g. “In this wealth management internship, I supported the financial advisors by analyzing client portfolios, researching new markets, and improving internal processes”). The 3 most impressive results from the experience (e.g. “I provided data and analysis that led to 2 clients improving their returns by over 5%, found 2 new promising real estate assets to invest in, and made our recommendation process 10% more efficient, saving 5 hours per week”). Synthesis – how the skills / experience you gained apply to finance (e.g. “I learned how to work in a team as both a leader and team member, gained analytical skills, learned about the markets in-depth, and learned how to work with clients”).

If you can’t do all of this for minor entries, just worry about creating a summary statement for each one. Anything on your resume is fair game – it’s better to delete something entirely rather than leaving it in and explaining it poorly or not at all. Structuring Your Response The 3-point structure works well for most of these questions – you just apply it differently depending on whether they’re asking about a single entry on your resume or multiple entries: 1. Summary (for a single entry) or brief description (if asked about multiple entries). 2. 3 most impressive results (for a single entry) or more detail on the entries (if asked about multiple entries). 3. Synthesis – how the skills you gained in that entry, or in multiple entries, have prepared you for finance. This structure doesn’t necessarily apply to all these questions because a few of them are asking for very specific things – so keep it in mind, but don’t try to apply it if it makes no sense.

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Other questions here may include queries about why you did or didn’t receive offers from previous internships, and why you quit previous jobs. The structure above doesn’t necessarily make sense for those questions, but you can still apply the basics – summary, supporting details, and why the firm you’re interviewing at is a much better fit for you than previous companies. Discussing Your Resume 1. Walk me through your resume. / Tell me about yourself. Yes, these are both the same question. And this is the single most important question in any interview – if you screw this up, interviewers will stop paying attention within the first 2 minutes of the interview. The single biggest mistakes here are 1) To literally walk the interviewer through your resume; and/or 2) To tell him/her about yourself as if you were meeting a new friend. Instead, you need to tell a story about how all your experience up to this point has led you here, where you’re going in the future, and how this job or internship will get you there. You should go through the relevant lessons, templates, and video tutorials on telling your “story” right here first: •

How to Tell Your Story

The 5 key components to your story: •

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The “Beginning” – Where you grew up or where you went to university / business school. The “Spark” – How you initially became interested in business / finance; the more specific the anecdote, the better.

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•

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Your Growing Interest – How did this interest change and develop via internships and jobs over the years? You should name something you liked and something you did not like about each one, and show you how’ve progressively moved closer to finance each time. Why You’re Here Today – You need to state explicitly why you are interviewing for this role (e.g. You want to combine your accounting and analytical skills with the ability to advise companies on major transactions). There is no such thing as over-emphasizing this point. Your Future – Where are you going in the future, and how does this role fit in? For example, maybe you want to become a “trusted advisor” to companies and work with management teams over the long-term, or become an investor in a certain industry, and this is the best path to getting there.

Shorter is better when it comes to this question – 2-3 minutes can work, but 60 seconds is better if you can cut it down to that length. People in finance have ADD and often get bored if you talk for too long, even if you have an amazing story. Never look at your resume when going through your “story.” What are other common mistakes with the “Walk me through your resume” question? 1. Going out of order chronologically. Sorry, this is not a Quentin Tarantino film. 2. Too much exposition – don’t start off by saying, “I’ve had a lot of great experiences.” 3. Being too short (30 seconds) or too long (over 5 minutes). 4. Not sounding certain that you want to do banking/finance. 5. Listing your experiences rather than giving a logical transition between each one. Again, you really should go through the dozens of video tutorials and templates that address this very question – because your “story” is the most important part of any interview and will literally make or break your chances: •

How to Tell Your Story

We have everything there, from what you should say as an undergrad finance major or non-finance major to the MBA level to beyond that – including specific scenarios such

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as transitioning from Big 4 Accounting to banking and moving from investment banking to private equity. 2. What are the 3 most important things I should know from your resume? This is a twist on the traditional “Walk me through your resume” question, and you should not actually go through an extended story for this one. Instead, pick the 3 entries with the most impressive RESULTS that you have – it can be mix of activities and work experience, but it should be all work experience if you’ve been out of school for at least 2-3 years. The three best types of results to point out: 1. How you increased revenue / sold more / earned high returns. 2. How you saved money by reducing expenses. 3. How you saved time by improving processes. If you don’t have those, run with what you have and link your experience back to other “soft” skills they’ll look for – such as teamwork, leadership, communication skills, and more. First, summarize the three experiences, and then elaborate on each one by pointing out the RESULT you accomplished in that experience/activity. Finally, tie your answer to finance in some way at the end. You may have increased membership in your school club by 150%, but unless you can point out how that’s relevant for the job, your response is unhelpful to the interviewer. Sample “Good” Answer: “The three most important things you should know from my resume are that I served as the Vice President of my school’s Investing Club, I worked at the New York Comptroller’s Office, and I worked at Acme Tech Company.

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My position as Vice President of my school’s Investing Club is significant because I increased club membership by 150% via new promotional and outreach efforts – and I improved our operations by resolving interpersonal conflicts. It’s important to resolve those conflicts when working in a team in the finance industry, and to recruit good people to the firm. My experience at the New York Comptroller’s Office is important because I worked extensively on a case which led to massive overhaul of several divisions of New York State’s Department of Labor. The case required many late-nights and weekends spent at the office to analyze all of the financial report of the New York Department of Labor, but the end result was worth it since my work led to significantly reduced spending. I could bring this same dedication and ability to cut costs and improve processes to your firm. Finally, my work at Acme Tech Company is important because I personally created a computer program which greatly increased the efficiency of the company’s accounting department. I created the program when I noticed that the previous program we used for entering data was outdated and cumbersome. This new program saved the company over $5,000 – and I could bring the same skills to your firm and improve processes there as well.” Why It’s a Good Answer: The interviewee starts off by stating the three important things that the interviewer should know from his resume, and then goes on to briefly describe his significant accomplishment in each of the experiences/activities. Notice how: 1) The interviewer always ties back his results to finance and how he could deliver a similar result for the bank/firm/company he is interviewing at. 2) He can’t point to increased revenue or sales, but he can point out how he improved processes and reduced expenses , and how he worked long hours and resolved conflicts. 3) He doesn’t follow our recommended structure exactly, and that’s OK. As long as each experience is linked back to finance, he doesn’t need an explicit summary at the end.

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It would be slightly better here if the interviewee had more business-related experience to speak to, but he gets away without it since the skills he gained are highly relevant anyway. 3. What's the single most impressive experience on your resume? This question is similar to the previous one, but now you have to state the single best / most relevant entry, give 3 supporting reasons why it was so impressive, and then summarize it and show how skills apply to finance at the end. It’s unlikely that you’ll get this question in addition to the previous one, but if that happens, elaborate on one of the previous entries you had described. Sample “Good” Answer: “The single most impressive experience on my resume is my experience at the New York Comptroller’s Office, since I multi-tasked successfully, had to approach work with great attention to detail, and achieved real results by helping to reduce spending. During my time there, I worked on numerous different government investigations so I had to multi-task very well – I even created a system for scheduling and prioritizing my assignments. Also, because I approached my work with great attention-to-detail, I was given a great amount of responsibility for a data analyst. A big part of my job was going through financial reports and spreadsheets taken from various branches of the New York government, and I had to analyze these reports with a critical eye. The smallest error could make a huge difference in the accuracy and validity of a financial report, and since I did that well, I received work that usually was reserved for senior analysts and investigators. Finally, this experience is the single most impressive one I’ve had because my division conducted some of its investigations into government waste and funds misappropriation at the time, and I put in long hours going through all the paperwork. Many of the cases required us to analyze hundreds of different financial reports and spreadsheets, and only by working late nights and weekends at the office were we able to finish all the analysis on time.

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Not only did I gain highly relevant skills at the Comptroller’s office – multi-tasking ability, analytical skills, attention-to-detail, and the ability to work long hours, but I also helped the team achieve real results and significantly reduced misappropriations and excess spending.” Why It’s a Good Answer: The interviewee provides three solid, supporting reasons for why his experience at the Comptroller’s Office was the most impressive one on his resume. Also, by making each of his reasons highly relevant to working in finance, the interviewee demonstrates that he could deliver the same results for the finance firm he’s interviewing with. 4. Can you tell me about [Internship Experience / Full-Time Work Experience]? What did you do? The biggest mistake with this question is to simply state what you did – for example, “I worked directly with clients and helped them plan their advertising campaigns.” But that’s not enough. You should tell the interviewer, in addition to your actual responsibilities, what you accomplished during the experience and link everything back to the results. So you can start out with a statement like the one above, but then you need to explain how you helped the clients win more sales, save money, or save time. When you give your response, first summarize the main tasks you performed, then give the 3 most impressive results, and then explain how the skills you gained translate over to finance. Sample “Good” Answer: “Sure, as a statistician for the Census Bureau, my duties were split between office and field work. In the office, I would spent a lot of time developing and designing questionnaires, as well as analyzing data collected from the field. Outside the office, I interviewed homeowners, businesses, and institutions for data such as the number of rooms in a building or the ethnicities of residents living at a particular address.

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As a statistician, I gained much better analytical skills and learned a lot about economics and data analysis from my mentors; and from my work in the field, I learned how to work with all types of people, and had to sharpen my interpersonal skills to speak with people who had no desire to take time out to talk to me. Not only did I gain a great deal personally, but I also contributed substantially to the Census Bureau, streamlining one the Bureau’s questionnaires for multi-family dwellings by changing its design and wording to make it more understandable for the average person – and that questionnaire eventually became the standard for multifamily dwellings. Through the experience, I gained analytical, teamwork, and interpersonal skills, and made processes more efficient, also getting better results for the bureau in the process – and I could bring these same skills to your firm.” Why It’s a Good Answer: The answer does not focus so much on the daily tasks the interviewee did in his work experience. Instead, the interviewee focuses his response on what he accomplished and learned from his experience, and of course, he explains clearly to the interviewer at the end how his skills can translate over to finance. 5. I see you’ve listed [Finance Coursework / Training Programs / Other Certifications] on your resume – can you tell me about what you did for those? This is where you get to show off everything you’ve done outside of school and work to prepare for the job. And yes, you definitely want to list all coursework, training programs, and relevant certifications on your resume – otherwise, why did you even bother getting them? The same 3-point structure applies for the answer. I’ll be overly self-promotional for this one:

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Sample “Good” Answer: “Sure. I recently completed the Breaking Into Wall Street Advanced Financial Modeling course, which focused on a case study of Microsoft’s attempted $44 billion acquisition of Yahoo, one of the biggest potential tech deals ever. I completed 3 main parts: an operating model for Yahoo, a valuation, and a merger model between Microsoft and Yahoo. In the operating model, I learned how to build detailed revenue projections based on bottoms-up and tops-down methodologies, and create expense projections based on fixed and variable costs such as number of employees; I also created multiple scenarios for the model to correspond to the upside, base, and downside cases. In the valuation segments, I valued Yahoo using the standard methodologies but focused on the more advanced nuances such as calendarization, adjusting for nonrecurring charges, and stub periods and mid-year discounts in the DCF. I also used less common methodologies such as future share price analysis, liquidation valuation, and sum of the parts. Finally, in the merger model, I built a full 3-statement model that combined Microsoft and Yahoo’s statements and accounted for different scenarios for the acquisition structure – stock vs. asset vs. 338(h)(10) – and financing options. I also analyzed possible revenue and expense synergies and calculated what the accretion / dilution would be at different levels and what the breakeven synergies were. Overall, the case study included many of the tasks that you do as an investment banker and I feel very well-prepared and confident that I’ll be able to hit the ground running since I understand operating model projections, valuation, and merger models indepth.” Why It’s a Good Answer: He states the name and purpose of the case study, and then goes into more detail on the 3 areas he knows best (or would be most impressive to the interviewer). You have to be very careful with these questions because they can and will ask you for more detail on something if it’s very relevant. Here, for example, if you do not know the differences between stock vs. asset vs. 338(h)(10) deals that well, you should not bring up the topic.

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Case studies, competitions, and training programs like this will definitely help you in interviews, but only if you know the material well and can address the questions they’ll ask you. 6. I see you’ve listed [Hobby / Sport / Activity] on your resume. Can you tell me about it? You can use the same structure here, but you may have more difficulty in linking the skills back to finance. Sports are always good to discuss for this one because they require teamwork, focus over long periods of time, and constant hard work and practice. Sample “Good” Answer: “Sure. I got my black belt in Judo after almost 9 years of training. It was very difficult to attain, and receiving the black belt was a big personal accomplishment for me. Attaining the black belt was very difficult to achieve for several reasons: First, the amount of training required to reach that level was very extensive. I trained three days a week for 9 years and almost never took a week off. For three nights a week, I spent two hours at the dojo sparring with others and learning new techniques. It took a lot of self-discipline and commitment to pass up fun events and relaxation time to go to the dojo 3 nights a week. Also, the training itself tested my limits. At times, the physical pain and exhaustion of the training was so intense that I wanted to quit. One time, I tore my leg muscles when I performed a throw incorrectly and it took me a month to recover. Training in Judo for 9 years did wonders for my time-management and multi-tasking skills – I had other hobbies and a social life in addition to going to school full-time and eventually working a full-time job, but I always continued training in Judo no matter how busy things got. Even though sometimes I would sleep less or have less time to relax, I learned to prioritize my activities and arrange my schedule so that I would do everything I had to in addition to my work and Judo training.”

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Why It’s a Good Answer: Instead of giving a whimsical answer touching on some of the things he did to attain his black belt, the interviewee provides 3 reasons for why achieving his belt was so difficult. In those 3 reasons, the interviewee describes what he learned and the amount of dedication it required from him. Although he doesn’t explicitly state the connection to finance here, the link is obvious enough as is: long hours, intense training, focus, the ability to bounce back from everything, multi-tasking, and more. Sometimes you can “over-do it” if you try to explain too much, especially when the question is about your interests or activities. 7. I see you wrote here that you’re fluent in [Language]. Can you tell me about your most recent internship / job in [Language]? You’re setting yourself up for disaster if you list a language on your resume but can’t back it up – there is no way to “fake” your way through not knowing a language. So take it off if you can’t discuss business vocabulary, or keep it in but make sure you can explain everything on your resume in that language. You never know if an interviewer just happens to speak the language you put on your resume, so if you cannot speak it fluently enough to describe your resume in that language, leave it out. There’s no sample answer for this one because it would be the same as what we’ve covered above – only in a language other than English. The Results of Your Work Experience 8. I see you did a lot of good work at [Internship Name] – did you receive a return offer? If you did, this is an easy answer. If you did not, spin it in a favorable light by saying that it wasn’t what you were looking for or that you didn’t fit in with the culture of the firm… but that the specific reasons why it wasn’t for you do not apply

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here, and that the firm you’re interviewing with is a much better fit for you. Never blame a boss, co-workers, or say that the work itself was boring or anything negative like that. And don’t blame the economy. It’s only acceptable to blame something external if it’s a situation like an entire firm going bankrupt, or a firm laying off its entire division, and it’s very public news. Yes, it is harder to receive return offers in a poor economy but it still sounds like you’re making excuses if you say, “Well, the economy is bad so hardly anyone got return offers…” Do not lie about your offer status – bankers can easily discover if you lied, especially if your internship was at another bank. I have seen multiple people get rejected every year for lying about this sort of thing. Sample “Good” Answer: “No, I did not receive a return offer from my internship at Horizon Partners. I did well and got to work on several live deals there, and the team members commented that my technical skills were good and that I contributed a lot – but it was just not a good cultural fit for me. The main problem was that pretty much everyone there knew each other and had worked together in the same group for 10 years, and had also gone to the same 2 universities together. I tried to fit in as much as possible, but they even acknowledged that it was a tough environment to get used to, and mentioned that they had never hired an intern before for those reasons. I tend to perform better in settings where there’s a diverse group of people from all different backgrounds, and this is why I’m so excited about joining your firm – I’ve gotten along well with everyone I’ve met so far and have been really impressed with the different clients you advise.” Why It’s a Good Answer: This is a very tricky question to answer well, and this answer is certainly not “perfect” (just like the greatest weakness question, sometimes there are no “good” answers, just “less bad” ones).

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The key is that he points out that he performed well and that the team even appreciated his performance… but he didn’t fit in with the culture of the firm, and then explains specifically why. This “cultural fit” problem is rare at large banks, but it’s common at smaller firms. Then, he confirms that even they thought it was tough for him to fit in and further adds to his credibility by mentioning that they normally never hire interns. Finally, at the end he mentions how he gets along with a diverse group of people better (important at large banks) and how it’s important for both co-worker and client relations. 9. Why did you decide to quit your job at [Company Name]? It says here you had performed well and were promoted twice. 10. Why didn’t you accept a return offer from your internship? [NOTE: These questions are virtually identical so we’ve combined the instructions and the sample response below. There are a few small differences, which we’ll note in the last section.] This question is similar to the one above – point out the positives first and how you learned a lot and performed well, but ultimately, you wanted something different in terms of work experience and culture, so you made the difficult decision to leave and pursue something more aligned with your career goals, which is why you’re here today. The main difference is that you don’t need to tie this to an issue of “cultural fit” quite as much. It can be more about the work itself, and it’s a little more acceptable to point to external circumstances, because they have more of an impact on a full-time job over several years than they do on an internship experience (this reasoning doesn’t apply if they ask why you didn’t accept a return offer from an internship). Sample “Good” Answer: “I definitely enjoyed my time working as an accountant at Xen Tech. The company developed advanced computer technologies, and I learned a great deal in my time there on how to manage the finances of small and mid-sized businesses. I excelled at my job, got along well with all of my coworkers, and I earned those two promotions through my hard work in only a year’s time.

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Ultimately, though, I quit because I wanted to take on more responsibility and contribute more to our client-facing operations, and it became clear that they did not look favorably upon that. In addition to accounting, they also had a business development group that focused M&A deals and partnerships, and I was very interested in joining. Several members of the team actually pushed for me to join as well. Unfortunately, senior management had a very strict view about employees moving elsewhere, so they didn’t want me to do that. I had gotten more and more interested in deals over time, and decided that I would be better off by moving to a firm such as yours where I could contribute directly to deals and work with clients.” Why It’s a Good Answer: The interviewee begins his answer by speaking positively of his experience at his company. Then he explains that he quit because he became more and more interested in deal-related work, and that team members in that department even liked him and pushed for him to transfer, but senior management did not go along with it. At the end, he states why the firm he’s interviewing with right now will be a much better fit based on what he’s looking for. You can apply the same type of strategy for internships as well – the only difference is that you have to make it more about the type of work you wanted vs. what they actually did there, as opposed to saying that senior management didn’t want you to move over. Return to Top.

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Strengths and Weaknesses Questions & Example Answers Questions on your strengths and weaknesses are common for job interviews in any field – but you should not overlook these questions as being “filler” in finance interviews just because of that. Not only must your answers be more thoughtful and convincing in finance, but they must also demonstrate that you can do the job by highlighting the key qualities that interviewers are looking for. You must use also your responses to highlight your judgment , especially your ability to avoid saying something stupid for the “weakness” and “failure”-type questions. There are many bad answers to these questions, but not that many good answers. Arguably, there are only “less bad” answers. To answer these questions in the best way possible, prepare your examples in advance and structure your responses as described below: Preparing Examples in Advance In order to prepare for the strengths/weaknesses questions that an interviewer may ask, create a list of at least 3 strengths and 3 weaknesses , with each one supported by a specific story or work experience entry on your resume. Your strengths should all relate to qualities that bankers will be looking for. Examples: • • • •

The ability to work long hours over extended periods Attention to detail Communication skills Quantitative / analytical ability

The first three qualities are straightforward, but the last one deserves more explanation.

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Essentially, quantitative / analytical ability means that you can not only crunch numbers, but also interpret the meaning of numerical data. You may think that you lack this skill due to your liberal arts degree or because you have not calculated anything since your high school math class. But if you have worked in a position which requires extensive handling of money , whether as a dealer in a casino or as a teller in a bank, then you have a strong ability to work with numbers. Also, almost everyone who has worked in retail has had to work with numbers on the job. If you have calculated store inventory, selected items for marketing, or even just worked a cash register, then you have some degree of quantitative ability. And if you have a background in a science, engineering, architecture, or economics, you won’t have a problem demonstrating this ability at all. Your weaknesses should be “real” and substantive, but at the same time, not “too real.” If your greatest weakness is that you have trouble focusing for long periods or that you have tendency to miss deadlines, then you’re in trouble. Your weaknesses should be things that can be learned relatively easily, or things that could also be interpreted as strengths or spun around into sounding like strengths. Some examples of good weaknesses include: • • • • •

Getting nervous during public speaking Not being able to delegate tasks well Not much accounting / finance experience Sometimes not following up properly on your work Too determined to get a job done (all-nighters, skipping meals, exhausting yourself, etc.)

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Be careful when providing a weakness that could also be a strength, because some of those answers are far too clichéd (e.g. “I work too hard!” – that one didn’t work on university application essays, and it won’t work now). Saying something unrealistic or clichéd like that may also imply that you lack interpersonal or communication skills, which is a big problem since much of your time in finance will be spent convincing your superiors and clients of certain points. Structuring Your Response For strength questions, simply state your strength(s) upfront and give an example or two from your work experience or activity / leadership experience to support them. For the weakness questions, state your weakness(es) upfront and then give examples of how you’re actively working to improve them. For example, if your weakness was your public speaking ability, follow up by saying that you’ve joined Toastmasters or another club where you actively attempt to improve your public speaking ability. Or if you don’t delegate tasks well, say that you’ve taken a class on time management or that you’ve been working with a mentor who is helping you with your ability to delegate tasks to others. They key here is to stress that you are taking steps to correct your weakness. Convey to the interviewers that when you identify a problem, you actively take steps to rectify it since that is the kind of person you are. For mixed questions that ask about both traits, always start with your strengths, give one or two examples, and then move onto your “areas for improvement.” You do not have say these are “weaknesses” – just explain how you’re actively improving certain aspects of yourself.

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Strengths/weaknesses responses do not lend themselves quite as readily to the STAR structure that we’ve discussed elsewhere in the guide, so your success lies in coming up with great supporting examples from your experience. Discussing Your Strengths 1. What’s your greatest strength? For this question, try to tailor your response to the specific job you are applying for. The example strengths mentioned above are all suitable for general analyst / associate positions, but for certain positions which may require greater leadership or team collaboration skills, pick the strength that would be most valuable for the position. Examples that would be good to cite for your greatest strength: • • • •

Ability to get things done on-time and work long hours Communication / interpersonal skills Leadership and project management abilities Quantitative / analytical ability

Sample “Good” Answer: “My greatest strength is my communication skills. I work very well with all kinds of people from different backgrounds and ages. When I work with others, I make sure that I understand the different perspectives and objectives that each person brings to the table. At the same time, I am able to clearly communicate my goals and expectations to others to ensure that there are no misunderstandings later on in the project. For example, when I worked as the member of a 10-man marketing team in my last internship, the work we produced initially was poor. Although no one wanted to blame any particular person, I knew that there were several team members who were directly responsible for our poor work product, and I spoke to them directly to figure out what had gone wrong. It turned out that those team members had liberal arts background and were having trouble understanding a few economic concepts that were essential in our efforts. I sympathized with them, and I took the time out to explain to them those key concepts.

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I also discussed with them and the other team members how we should approach our task delegation given the backgrounds of everyone on our team. At the end, we were able to work out a good system where if the liberal arts team members were having trouble with more finance-related tasks, we would trade responsibilities to make sure that the final team product was optimal.” Why It’s a Good Answer: The interviewee states upfront his greatest strength and explains it in more detail afterward. Then, the interviewee provides a specific example that directly illustrates his greatest strength. In this case, the interviewee also uses the correct language to describe his communication skills through action words such as “sympathized,” “discussed,” and “explained.” Notice also how he uses the term “team members” rather than “people,” signaling that he views the team as more than just individuals – playing directly into the importance of teamwork in the business world. 2. Why should we hire you? This is a very direct interview question and one of the most important ones – if you can’t answer it, why should they hire you? It’s similar to the previous question on your greatest strength, but the key difference is that you need to focus more on the company’s needs and the requirements for this specific role in your answer rather than a generic strength. There are a couple ways to approach this one: 1. Point to the results you’ve achieved in the past – increased sales, reduced expenses, time savings – and how you can accomplish these for the firm you’re speaking with. 2. If you don’t have a lot of results to point to, stick to more general traits like the ability to get work done no matter what, your educational background, and how

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you’re also the type of person they’d want to spend time with (you pass the “airport test”). 3. Finish by stating that you can hit the ground running and running and that you’ve already learned a lot of the skills on your own, so they won’t have to spend much time training you. Or, you could use a combination of some or all of the points above: Sample “Good” Answer: “You should hire me because I have a track record of saving organizations time and money, I can get the job done no matter what the requirements or deadline is, and I’ve already learned a lot of the key accounting and finance skills required on the job, so I can hit the ground running and start contributing immediately. As one example, when I worked at the New York City Department of Finance, I often had to work long hours to finish urgent projects that my supervisor assigned to me. Because the City’s Department of Finance was in the midst of revising the City’s tax laws, the office had an unusual amount of work while I worked there, and often we had last-minute deadlines that required precise analysis and attention to detail. I ended up saving the department over $50,000 in administrative costs by improving the tax filing process – in just 3 months – and I could deliver those same results for your firm as well. I’ve also earned top grades and led several student groups at the University of Michigan, and I’ve taken several finance and accounting classes and have enrolled in financial modeling classes so that I can immediately make myself valuable and start contributing to your firm once I join. So I’m confident that I can do the work no matter what, that I’ll deliver great results for you, and that you’ll start seeing those results from very early on.” Why It’s a Good Answer: The Answer: The interviewee starts off by stating strengths that are relevant to the needs of the company and the position he is applying for. He gives a specific example of how he saved time and money for an organization in the past and had to work long hours and be very attentive to detail in the process, both of which are important for finance roles. After he gives a specific example to support this point, he then mentions his educational background (“selling” his intelligence) and his people skills – plus, ho w he can start

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contributing immediately, unlike other candidates that might require more in-depth training. Employers hire people who generate positive ROI for them – them – if you can show evidence of this (make them more money, save them time, or reduce their expenses), you’ll be far ahead of other candidates. 3. How would your best friend describe you in three words? Resist the urge to give a humorous or casual answer. This interview question is far less common than the previous two, but it’s no less important. Interviewers ask this question or some variation of it to elicit an interesting response from interviewees – but regardless of how they ask it, just refer back to your list of 3 strengths and use it to produce an answer. However, try not to use more formal words like “astute” or “team-player.” The interviewer will be gauging your response, and the more realistic your response is (i.e. does it sound like what a real person would say?), the better it reflects your judgment. For each word you list you should also give 1-2 sentences to back up what you say, using a specific example for each one. Sample “Good” Answer: “Hardworking, careful, and outgoing. My best friend would describe me as hardworking because whether it’s a small task that my friend asks me to do, or a big project at work, I always put my full effort in it to do it right. She would also say that I am a careful person because I put a lot of thought into details and I think things through before making important decisions and going through with actions. Finally, she would consider me outgoing because I am very friendly and easy to get along with, and I always like to start conversations and get to know people better.” Why It’s a Good Answer: These are the interviewee’s strengths, and they tie in directly to what you need to succeed in finance and in business more generally.

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If you were to casually ask your friend what they thought of you, this would not be interviewer were to call up your friends their answer in most cases… But what if the interviewer were and asked them to describe you in three words? If they were good friends, hopefully they would state three of your strengths in a similar fashion. But since you’re the one being asked this question, a straightforward response such as the one here with more casual words is a good approach. You still emphasize the same qualities, but you don’t need to sound quite as formal. Discussing Your Weaknesses and Failures 4. What’s your greatest weakness? From your list of at least 3 weaknesses, pick the one that is least relevant least relevant to the position you are applying for. If the job description requires you to give the occasional presentation to clients or in board meetings, then do not mention public speaking as your greatest weakness. This question highlights a particular shortcoming in your abilities, and even if you follow up by describing how you are working to improve this area, it’s better not to let it stick in the interviewer’s mind. not want to state something As we discussed above, you do not want clichéd here such as “I work too much!” because it sounds stupid and the interviewer will just laugh at you. Instead, pick something real but not something critical that will sink your chances. Once you state the weakness, give a specific instance when it came up, and then explain what you’re learned and how you’re improving upon it. Sample “Good” Answer: “My greatest weakness is that I’m sometimes not good at delegating work in organizations and in team project scenarios. I am somewhat of a perfectionist, so I like to make sure that every single detail is correct.

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On one project in my Finance class last year, I knew that a few team members were from engineering backgrounds and didn’t understand some of the concepts quite as well, so I didn’t divide the work well enough and we didn’t have enough time beforehand to double-check everything. But I’ve been working to improve that by better assessing everyone’s strengths and abilities upfront, and then deciding early on who will be completing specific tasks on projects. For example, when I submitted a report to my team supervisor during my internship earlier this year, everyone contributed more equally and we had plenty of time to factcheck and error-check everything in advance, which resulted in a much higher-quality final product.” Why It’s a Good Answer: This answer is good because not being able to delegate well is a legitimate weakness, but not something that will sink your chances as a junior-level employee at a bank – and as we suggest, the interviewee gives a specific example, points out how he’s working to improve himself, and give an example to support that. You do not want all 3 of your weaknesses to sound like this one because they will sound insincere. So mix it up and give some weaknesses that are more or less serious than others, if you are asked to name multiple weaknesses. See also: http://www.mergersandinquisitions.com/weakness-interview-question/ There are some good tips there on this question, but watch out for the comments – there are some really bad suggestions and ideas, so don’t take everything mentioned in the comments literally. The suggested weaknesses at the top of this section of the guide are better than some of the suggestions in that article as well. 5. What is your biggest failure? Although this question is similar to the one above, it is different in that you should focus on a specific story – such as an exam where you did not do well, a project that did not go as planned, or a work situation that did not turn out well – and you should

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highlight what you learned from it and how you’ve improved since then. Don’t say something like, “My greatest failure was getting into Yale, Princeton, and Cambridge, but not Harvard!” On the other hand, you don’t want to list something really serious such as getting arrested, failing a class, or getting fired for embezzling money. It’s better to say something relatively real and then show how you’ve used the failure to develop. Even if your failure here is relevant to the position, is not as problematic since your main focus is not on the failure itself, but on how you’ve learned from it, improved, and turned it into one of your strengths. Sample “Good” Answer: “My biggest failure was my lack of communication in a team project I worked on in college in an engineering class. The professor assigned each person to a group of 5, but after we discussed which part of the project we would each work on, I just took my assigned portion and worked on it myself. On the day before the project was due, I showed up at the team meeting with my part completed, but it was then that we all found out, to our horror, that one person got sick the week before, and as a result, his part of the project was sloppy and done incorrectly. The project was rushed and incomplete, and I received the worst grade of my entire time at university as a result. Since then, I’ve learned that in every team project that I work on, communication between team members is just as important as the work itself. I’ve found that even if I’m not the team leader or even if people prefer to work on their own, I have to check in with all of the team members to make sure that everyone is on track with their work. When I worked as a member of a sales team last summer, I made sure to talk with everyone several days in advance before a big presentation. One time, I found out 3 days before a major presentation to potential investors that a team member was having trouble finishing his part because of personal problems at home. Because I found this out 3 days in advance, I was able to contact the other members of the sales team to get them to cover for him and make sure that our final product was perfect.”

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Why It’s a Good Answer: The interviewee’s response is “real,” but he makes the failure seem to be a thing of the past. Although the interviewee reveals a true weakness, it is now a strength because he learned from the experience and improved on that area (communication), never making the mistake again. And of course, the interviewee provides an example at the end to back up his statement that he has improved and learned from this mistake. Another subtle but significant point here is how this failure occurred in the context of an engineering class, which interviewers might assume is less relevant for finance since engineering is much more technical. So although the weakness and the failure are real, interviewers might subconsciously view them as “less significant” because the failure didn’t occur in an accounting/finance/business setting. 6. Why would we NOT give you an offer today? This one is tricky because it’s so direct. You could make a joke out of this one and say something like, “If you decided you weren’t hiring at all!” but that may not go over well if your interviewer doesn’t appreciate humor. Otherwise, the best response may be to turn this around and say, “I see no reason why you wouldn’t – I’m your best choice because….” and then give your strengths instead. Then at the end, you can admit a weakness and point out how you’ve been working to improve upon it, incorporating elements of the other questions and sample responses above. Sample “Good” Answer: “I see no reason why you would not give me an offer. I believe I am your best choice because I’m a great fit for this job – this position requires a keen attention to detail and the ability to follow instructions precisely, and those are my strengths. During my previous internship at Bank of America, I had to do exactly that, and my supervisor was very pleased with my work and wrote a great recommendation for me.

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I’ve also completed my undergraduate degree and earned top grades at Boston College and did my Master’s in Finance at LSE. Plus, I’ve worked on similar deals and with similar clients at BoA and can start contributing immediately. If you did not give me an offer today, it might be because I don’t always have the best presentation skills. While I performed well in school and in my previous jobs, I would sometimes get nervous when giving presentations or making announcements at social functions. However, during my time at MasterCard, my supervisor often asked me to create PowerPoint presentations for my division’s weekly section meetings. As a result of those weekly PowerPoint presentations, I became much more comfortable with public speaking and presentations, and I’m still working to improve those skills today.” Why It’s a Good Answer: The interviewee confidently states upfront that there’s no reason they would not hire her due to her strengths, previous work experience, and educational background. But then at the end, she admits that sometimes her presentation skills are not as good as other peoples’, which is a legitimate weakness and something that can hurt you in interviews… but she has been working to improve them over time. Discussing Both Strengths and Weaknesses 7. What feedback did you receive from your internship this past summer? / What kind of performance review did you receive from your job? The most common mistake here is being vague and saying you performed well and they liked you, and then failing to give weaknesses or areas for improvement. The right way to answer this question is to state specific qualities about you that they liked – such as ambition, drive, attention to detail, or willingness to go the extra mile for the team – and then give specific examples of times when you demonstrated those qualities.

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Your all-nighters, the time you stayed the weekend working on a presentation, or the time you caught mistakes that someone else above you missed are all good to mention. The other critical part is mentioning weaknesses / areas for improvement as well – talk about real weaknesses and how you’ve worked to improve them, using a structure similar to what we have recommended and used above. Sample “Good” Answer: “On the last day of my internship at MasterCard, my supervisor told me that he admired the enthusiasm I had for my work and that I was one of the hardest working interns he had ever had. He said that he really appreciated how I showed a lot of energy when I came into work every day and that I showed a lot of initiative in going around offering my help to any member of the office who had extra work. Also, he said that my willingness to work long hours and to get the job done no matter how tight of a deadline was very rare in his experience. My supervisor mentioned, however, that one area I could improve on is my follow-up on assignments. Although I was very enthusiastic about my work and eagerly accepted my assignments, I had a tendency to leave the work behind once it was done and throw myself into the next project. Despite the good quality of my work, my supervisor told me that sometimes the recipient may still want to give feedback or suggestions. I have since learned that it is important to follow up on my work to show that I’m responsible and care about what happens to my work product after I send it out. I now make it a regular habit to follow up on my assignments to make sure that everything is perfect and to get feedback from the recipient.” Why It’s a Good Answer: The interviewee gives specific qualities/strengths that he backs up with examples which demonstrate those qualities. Furthermore, the interviewee willingly states an area where he wasn’t as strong during his internship/job, but which he has since improved on.

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By describing in detail those specific qualities and area(s) for improvement, the interviewee conveys not only his work ethic to the interviewer, but also shows that he recognizes his shortcomings and is willing to acknowledge and improve them. 8. How would a former co-worker describe you? This question is similar to the one that asked how your best friend would describe you in three words. The difference here is that you are not just stating your strengths, but also your flaws – “former co-worker” rather than “best friend” implies that it’s someone who didn’t view you in a 100% positive light. Of course, you will still highlight your strengths. Follow the same format as the previous question by first describing your strengths. After that, discuss an area which you could have improved on during your work experience and describe what you have done since then to improve yourself. Sample “Good” Answer: “My former co-workers during my job at Facebook would describe me as one of the most enthusiastic and hard-working people they had ever worked with. Every day when I came into the office, I would always have a lot of energy and would be willing to help out wherever I can. My co-workers noted this and often called upon to help them out with tasks they had trouble with – which was really important at a company like that, because your responsibilities aren’t strictly defined and can change at any time. Whenever my coworkers had to work late hours to finish projects, I would always stay behind to help them out, and they mentioned that I was a huge help on several occasions. However, some of my co-workers may say that I need to work on my follow-up skills. Oftentimes, after I finish an assignment, I’ll eagerly rush on to the next one. But releasing a product or delivering an advertising campaign to a client is never the end of the road – one co-worker commented to me that he wished I could leave out some time after finishing a project to follow up with the recipient and ask if there was anything else I could have done for him on the project. Since then, I have made it a habit of always following up with the person who I submitted an assignment to in order to make sure that everything is perfect before I focus all of my efforts on upcoming projects.”

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Why It’s a Good Answer: The interviewee is not using this question solely to praise himself, but also to name concrete strengths and explain what he did well and not so well – he candidly acknowledges an area where he needed improvement, but ends by describing how he has since learned and improved in this area. He also subtly mentions in the beginning that his responsibilities were not “strictly defined,” which sells the interviewer on his ability to deal with “random work” and last-minute requests, which are very common in finance. Although Facebook and other tech companies may be perceived as very different from banks, by making this point the interviewee helps to overcome this objection in advance. Return to Top.

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Teamwork / Leadership Questions & Example Answers Teamwork and leadership abilities are highly valued traits in the finance industry, since you always work in a team. Interviewers will assess how well you work with others, both as a leader and team member, by asking you questions related to your past work experience. These questions often center on a specific instance in your past work experience through which interviewers can determine your teamwork and leadership qualities. Interviewers will often begin by asking “Tell me about time when…” followed by an instance when you dealt with a difficult coworker or led a team in a challenging project. You can answer these questions most effectively by preparing your examples in advance and structuring your responses in a concise manner. Preparing Examples in Advance The best approach for teamwork/leadership questions is to pull 2-3 examples from your resume that you can re-use for everything. The examples can be from any type of substantive experience, such as full-time jobs, internships, volunteer experiences, leadership positions in student clubs, and so on. But regardless of which experience you pull your examples from, the key is to focus on specific projects/clients/initiatives that clearly demonstrate your teamwork/leadership qualities. When you are picking the 2-3 examples from your resume, remember to prepare at least one example that demonstrates each of the following abilities: • • •

Your ability to work in a team. Your ability to lead a team. Your ability to resolve a problem, either as a leader or as a team member.

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We’ve all worked in a team at some point in our lives, but what if you’ve never actually worked as the official “leader” of a team? Think creatively and find a case where you were responsible for just a portion of a project or event and use that – maybe you weren’t the President of the club, but you led one recruiting event or you organized a welcome event for new members. You may have not been the bona fide project manager, but if there was a section of the project where you delegated tasks and oversaw the completion of the tasks, then assumed a leadership role in that instance. Here are some examples you might be able to use: •

•

A social event for your student club that you planned. You may not have been named the “leader” of the event planning, but you assigned one person the task of booking the venue, another with buying the decorations and food, and others with the setup. Throughout the event, you made sure things were running smoothly and dealt with problems that arose. From this simple event, you can easily point to several examples of your leadership qualities. You volunteered at a youth community center and started a sports program. To implement the program, you relied on other volunteers and the teens at the center to distribute flyers, acquire funding, buy equipment, and set up the facilities. The volunteers and teens may not have been official members of your “team,” but in this instance, you demonstrated leadership abilities and you were the person responsible for the implementation of the program.

Structuring Your Response You should follow the STAR structure for your responses here: 1. Situation – Who was on your team, and what was the internship / job / activity where you had this experience? 2. Task – What was the key challenge that you had to overcome? 3. Action – What did you do to confront this challenge? 4. Result – Did you succeed, and what impact did it have? Or if you didn’t, what did you learn and how did you change for the better?

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See the sample questions below for examples of how to apply this structure: Discussing Teamwork and Leadership Experience 1. Can you talk about a team project or some kind of group activity you’ve worked on before? This is a fundamental question that you need to be prepared for, as it almost always comes up in interviews in one form or another. Ideally, you will talk about something that was a success rather than a failure. Using the STAR structure, first describe the situation: set the background of the project by briefly describing which company/organization you were working for and the purpose of the project. Next, describe your particular task and how it fit into the project’s overall purpose. In doing so, be sure to describe your team briefly (how many people and who was doing what). Then, talk about the actions you took specifically to accomplish your task. Remember that the focus here should be less about the task and more about how well you worked in that team. For example, mentioning that you worked long hours, were attentive to detail, and/or you put in additional effort right at the end to save the team would all be good to point out. Finally, state the results of the team project and how your actions and teamwork contributed to a positive outcome. Sample “Good” Answer: “Sure. During my summer internship last year at the New York State Comptroller’s Office, I was assigned to work with a team of two attorneys, an investigator, and an analyst whose purpose was to investigate cases of financial waste and funds misappropriation. The largest case that we worked on during my internship was when we were investigating a public hospital. There were reports that government funds were being misused in the hospital, and our team’s lead attorney wanted us to conduct an

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investigation and produce a report for the State Comptroller. My role in the project was to work with the analyst in researching and analyzing the hospital’s financial reports. Throughout the project, I worked closely with the analyst in analyzing a huge amount of data. Because there were so many financial statements that we had to go through, I ended up spending long hours at the office to cover all of the data. Also, because the analyst was working on several other projects, I ended up taking on a large share of her work to complete the project in time. In our final report, we determined that there were several instances of funds misuse in a particular division of the hospital. Based on our report, the Comptroller’s Office withheld government funds until the hospital changed its financial policies and agreed to submit yearly reports to our office.” Why It’s a Good Answer: The interviewee describes a specific project where he worked in a team and structures his answer in a detailed and effective manner. By using the STAR structure, the interviewee conveys to the interviewer how he contributed to the team project. The interviewee’s skills and abilities to work in a team are highlighted through his long hours and willingness to cover for a team member to get the job done. It’s also good that he mentioned the bit about the financial statements, since it signals to the interviewer that he knows something about accounting / finance. 2. Can you describe a situation where a team did not work as intended? Whose fault was it? This is another variant of the “failure” question. You should describe a situation where your team did work as intended and talk about how it wasn’t working at first and what you did to fix it. In doing so, remember that you can never blame someone specific – instead, say that there were “personality conflicts” and that you worked to resolve them. Or you could simply state that it was no one’s fault but that it was due to extenuating circumstances.

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To make things even easier, you could re-use the story you told in question #1 but instead position it as a failed team situation that turned into a successful one. Sample “Good” Answer: “Sure. During my summer internship last year at the New York State Comptroller’s Office, I was assigned to work with a team of two attorneys, an investigator, and an analyst whose purpose was to investigate cases of government financial waste and funds misappropriation. My role in the team was to work with the analyst in analyzing financial reports. Although the analyst and I were given different collections of reports to analyze and we would eventually have to combine our analyses for the team, initially we could not meet deadlines because the analyst was overburdened with additional projects that she was given from the Comptroller’s Office. It was no one’s fault since the Comptroller’s Office was simply understaffed, but in the interest of completing our assignments on time, I would often take on the analyst’s report assignments for our team in order to meet the deadlines. As a result, our team was able to complete our investigations on schedule, and the lead attorney on our team was very happy with the work performance of the analyst and myself.” Why It’s a Good Answer: Not only does the interviewee turn a failed situation into a success, but he also highlights his teamwork capabilities. Furthermore, the interviewee does not blame anyone and places his coworkers in a positive light instead. When placing blame on “circumstances” beyond anyone’s control, be careful of the context: while government understaffing is a common problem, stating that the small business you worked at was understaffed may put your employers in a negative light and make interviewers wonder whether you’d think the same thing about their firms. 3. Can you tell me about a time you faced an ethical dilemma in a team or with a coworker? If you’ve already worked full-time, any ethical challenges you faced at work or any whistle-blowing you’ve done are best to discuss; otherwise, you could talk about how

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you stopped funds in a student group from being used inappropriately or how you caught someone cheating. Note that this does not have to be an example of something that was clearly wrong – it can just be a case where you thought the right course of action was different from what a co-worker thought. Just make sure you don’t over-dramatize it – your life is not a soap opera and you shouldn’t go on for 10 minutes about your internal conflict deciding whether to turn someone in for their wrongdoing. Although the task part of the STAR does not translate directly here, you can follow the rest of the structure by describing the situation, the actions you took, and the end result. Sample “Good” Answer: “Sure. When I worked as a teller for Bank of America last year, there was one time when I noticed that a co-worker had miscounted a customer’s deposit. I quietly pointed it out his mistake to him, but the co-worker did not respond. After the customer left, I pulled up the records and showed the co-worker his mistake. However, the co-worker dismissed it by saying that the correction would require too much paperwork and was not worth the effort. Nevertheless, I felt that the error was significant as it would cost the customer a substantial sum, and despite being on good terms with the co-worker, I told him that I would have to report his mistake. The co-worker was displeased, but despite my warning, he refused to change his mistake. After I reported the mistake, the co-worker was reprimanded and put on probation. My relationship with the co-worker was not the same afterward, but I felt that it was the right thing to do in that situation.” Why It’s a Good Answer: It’s easy to make this response too lengthy, but remember that the focus here is still on how well you work in a team and your ability to deal with an interpersonal conflict.

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The response here is concise and clearly states why he took the actions that he did. Also, the interviewee here makes an attempt to resolve the conflict by speaking directly with the co-worker before getting others involved in the situation, thus highlighting his reliability as both an employee and a team member. 4. What was the most difficult situation you faced as a leader and how did you respond? This question is very similar to the one above about a team situation that did not go as planned, but this one relates to a situation that occurred when you were in a leadership position. The key is to point out how you stayed calm and collected in the face of a challenging situation, and how your cool decision-making process led to a positive outcome. Maybe two of your subordinates couldn’t get along and you had to arbitrate; maybe you were 3 months behind on a project and had to get a team together to finish it in 2 weeks; maybe you were a staff member in a dorm and you had to prevent two residents from harassing each other. The difficulty of the situation will depend on your own experiences, but it’s best to find an instance in your background when you were in a leadership position, and where you encountered a significant challenge that would require most people to think and act carefully before proceeding. Once again, you should apply the STAR structure to answer this type of question: Sample “Good” Answer: “In my senior year of university, I was assigned to be the team leader of a marketing project that involved five students. Although we had agreed on who would handle each assignment, I was responsible for everyone getting their work done and for the completion of the final project.

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On the night before the project was due, one of the team members called me to say that he was very ill and had not done anything on his part, as he usually finished assignments at the last -minute, the day before the due date. Although the situation appeared hopeless at that point, I simply decided that we would do our best in with the time we had. I contacted the other team members and convinced them to pull an all-nighter with me to finish as much of the assignment as we could. Despite the last-minute and hurried work we put in, we not only passed, but received very positive feedback.” Why It’s a Good Answer: The interviewee highlights the difficulty of the situation and the actions he took to resolve it. Furthermore, the interviewee portrays his reaction to the difficult situation in a favorable light. Situations such as this one usually cause people’s emotions to run high, but the response here depicts the interviewee as a capable leader who is able to take on such situations without being stressed out. And, of course, last-minute troubles like this happen every other day in finance and all-nighters are quite common – so it’s good to remind the interviewer that you’re capable of dealing with it. 5. Can you tell me about a time when you stepped up and demonstrated leadership even when you were not in an official leadership role? Remember that interviewers are looking for the ability to recognize when leadership is needed, and NOT a team member who usurps the leader’s role. Think of an example where there was clearly a problem in a team project and when you went beyond your duties for the sake of the project. You may struggle to prepare for this question, but there is most likely some instance in your life when a team project ran into difficulty and you had to fix it. It could be something less dramatic such as taking on the work of a lazy co-worker, or something more interesting such as when a team leader shirked his responsibilities and you had to personally hold your team members accountable for finishing their parts.

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Think of a time when you took the initiative in a team setting and your actions greatly contributed to your team’s success. You can and should re-use other stories and responses you’ve prepared to answer this type of question – see our example below for more on how to do this: Sample “Good” Answer: “In my senior year of university, I was assigned to a marketing project that involved five students. Although the project did not have an official leader, we divided up assignments and agreed to hold each other accountable for finishing our respective assignments. However, the night before the project was due, one of the team members contacted everyone, saying that he was very ill and had not done anything on his part at all as he typically started and finished assignments the day before they were due. We could have tried to blame him by telling our professor about the situation, but I did not want resort to this. I contacted the other team members and convinced them to pull an all-nighter with me to finish as much of the assignment as we could. Despite the lastminute and hurried work we put in, we not only passed, but also received positive feedback and a good grade.” Why It’s a Good Answer: The interviewee demonstrates to the interviewer that he is willing to take the initiative and do more than his original assignment called for. Here, there is clearly a problem in a team project, and the interviewee’s actions in refusing to pass the buck and in rallying his team to finish the remainder of the project demonstrate solid leadership abilities even when they weren’t officially required of him. Also note that it’s perfectly fine to re-use the same story here as long as you haven’t mentioned it before, or as long as you focus on a different angle. 6. Do you work better as a leader or a follower? Resist the urge to say “leader,” and instead talk about how you can function as both a leader and another member of the team, depending on what the situation calls for. You don’t

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want to hog the spotlight and do everything, but if leadership is required, you can step up and handle it. You will have to do this all the time in finance, even at the entry-level: you deliver whatever senior bankers and Partners have asked for, but you may also give work to the support staff. Bankers do not want a “Managing Analyst” or “Managing Associate” who thinks he/she can abuse subordinates. You should start by stating that you can function well in either role and then give 2 examples to back up what you say, once again using the STAR structure. Sample “Good” Answer: “Depending on the situation, I can excel either as a leader or as a team player. In past projects, I have successfully followed instructions and executed my duties. But when leadership is required, I am more than capable of taking on a leadership role. For example, when I interned at a public interest advocacy organization last summer, I worked mainly as a team member since my supervisor gave me my assignments. I fulfilled all of my assignments to his satisfaction and I worked well with the other interns in projects that required teamwork. However, there was an instance when several interns and I were tasked with creating slogans for a new public outreach initiative. We all gathered in a room and began brainstorming various ideas. But after several hours of discussion, we hadn’t yet reached a consensus on our ideas, and it was at that point that I stood up and suggested that we take a different approach to our discussion: instead of continuing the endless debate on the merits of each idea, we could instead consolidate the ideas we had and rank our preferences for every idea from first to last. Afterward, we could tally the points for each idea and determine the most popular ones and go from there. My approach made our task a lot easier, and we quickly reached a verdict on the best slogans; for the remainder of the project, I assumed a leadership role in directing the discussions and organizing our ideas.” Why It’s a Good Answer: The interviewee stresses that he is flexible: he can be both a “team player” and a leader. Also, he backs up his statement with an example that

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demonstrates how he worked well as a team player and as a leader when the situation called for it. He does not go into as much depth in the first example given here, but that’s OK since it’s still a detailed answer overall. 7. What is your leadership style? A “moderate” answer works best here. You’re responsible and you can ensure that things get done, but at the same time you don’t annoy your teammates by micro-managing. If you’re interviewing for an Analyst or Associate position, you do want to be a bit more “hands-on” and point out that you often go in and correct mistakes to make sure everything’s perfect – since you’ll be spending so much of your time error-checking work and fixing problems. The suggested structure here is the same: state upfront what your leadership style is, and then give a specific example. You do not need to mention every step of the STAR structure, but it’s good to point out in general terms the situation at hand, what you did, and the overall results. Sample “Good” Answer: “I always view myself as responsible for the outcome of my team, so I use a ‘hands-on’ approach to checking the details and making sure that everything runs as smoothly as possible. At the same time, I like to give my team ample breathing space by giving them the freedom to accomplish their tasks as they see fit, as long as they meet expectations. For example, when I worked as the assistant manager of a Staples location near my hometown, I personally made sure that the entire inventory was accounted for, that every aspect of the store was maintained, and that all of the employees were courteous and helpful to the customers. Although I made clear to my shift team that I required a high standard of professionalism from all of them and that I would hold them accountable for the quality of their work, I also told them that I would not be a micro-manager who looks over

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their shoulders as they worked. This worked out very well, and customers we surveyed later indicated that they were extremely satisfied with the service we delivered. So I allow my team to work the way they want, but when I check their work and problems arise, I am quick to address the problem and fix it.” Why It’s a Good Answer: The interviewee conveys his ability to ensure the quality of his team’s work without coming across as a micro-manager. He states the answer upfront, then goes into a specific example and explains the situation, how he managed employees, and then states the results at the end. 8. Does the leader make the team? No, the team makes the team. The leader can provide direction and unify everyone, but one person alone is not a “team.” A leader can make things better and turn around a dysfunctional team, but it’s equally important for everyone to pull their own weight. You can often re-use some of your other “leadership” or “team” stories here and spin them differently. Think about a time when the leader was important to the project and its completion, but it was ultimately a team effort that made the project a success. Sample “Good” Answer: “The leader does not make the team. The leader can provide direction and unify everyone, but one person alone is not a ‘team.’ A leader can make things better and turn around a dysfunctional team, but everyone needs to pull their own weight. For example, when I worked as the assistant manager of a Staples location near my hometown, I personally made sure that the entire inventory was accounted for, that every aspect of the store was maintained, and that all of the employees were held to a high professional standard. Although I could ensure that the store ran as smoothly as possible by addressing problems and monitoring performance, the members of my team handled the actual running of the store. I could not check the entire store’s inventory, help all of the customers, and maintain the store by myself. All of these things had to be done by the

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collective effort of my team, and it was only when everyone worked their hardest and fulfilled their own tasks that the team succeeded. This approach worked very well, since our team earned the highest satisfaction ratings ever recorded from customers we surveyed during this period.” Why It’s a Good Answer: The interviewee credits the team and acknowledges the importance of teamwork. He gives a specific example here of how the team contributed and how both his own efforts and the team itself achieved a specific result. He doesn’t apply the STAR structure completely, but he still follows the basic outline. Return to Top.

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“Warren Buffett” Questions & Example Answers “Warren Buffett” questions are designed to test your “general business” knowledge about industry trends, companies / stocks, recent deals, and investment opportunities. They may seem less important than some of the other “fit” questions, such as telling your story, explaining experience on your resume, and demonstrating your teamwork and leadership skills… And that’s sort of true because you’re not guaranteed to get these questions in interviews. But if and when they come up, they will be extremely important. And unlike with obscure / advanced technical questions, you have no excuse not to be prepared for these questions since the question categories are simple: 1. 2. 3. 4. 5.

Discuss a recent industry trend or news story. Pitch me a stock or company you like. Tell me about an M&A (or other) deal that interested you recently. How would you invest $10 million? How would you start or sell a business?

Categories #1 – 3 are the most important, so you better have good answers for those prepared in advance. These questions will often turn into extended dialogues with the interviewer where you go back and forth and discuss various points. Preparing Examples in Advance Just follow what we’ve described above: 1. Come up with 1 industry trend. 2. Be able to discuss 1 recent news story. 3. Research 2 companies that you can pitch (ideally they will be public so you can combine this with the “Pitch me a stock” question).

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4. Know 1 recent M&A (or debt / equity financing) deal that you can speak to indepth. It’s more difficult to “prepare” for the questions about how to invest funds and how to start and sell a business, but it’s good to have general ideas about the types of businesses you might be interested in starting. Here are a few examples you might use for these points: 1. Industry Trend – Talk about a new technology that’s changing the economics of the energy industry, e.g. an increased focus on unconventional reserves. 2. New Story – Talk about the central bank’s decision to raise or lower interest rates, a coup d'état or war, or the real cause of rising income inequality in the developed world. 3. Companies to Pitch – You like EnergyX Holdings due to its strength in emerging markets and Commercial Bank A because of its above-average lifetime customer value and high-quality loan portfolio. 4. Recent (M&A) Deal – You found the acquisition of Gold Company X by Mining Company Y interesting because it was a cross-border deal under heavy regulatory scrutiny and the buyer paid an unprecedented 80% premium for the seller. These are just examples, and I’m intentionally avoiding real deals and companies here because you need to come up with your own examples. It is not at all difficult to find this information, and you can click here to view a full tutorial and get a free quick reference guide on how to do so . Structuring Your Response The structure here depends heavily on the question being asked: describing industry trends and news stories differs from pitching a stock or talking about an M&A deal. And those, in turn, differ from the questions about starting or selling a business and investing.

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To discuss a trend or news story, you should: 1. Summarize what it is upfront. 2. Explain why it’s happening or why it happened. 3. State how it’s impacting companies in the market and what’s changing as a result. 4. Say what your opinion is and how it differs from what everyone else is thinking. To pitch a stock or talk about an M&A deal, you should: 1. State the company name(s) and explain why you like it or found the deal interesting. 2. Summarize the financial information (revenue, profit margins, and growth). 3. Give 2-3 supporting reasons why you like the company/stock; for a deal, give 2-3 reasons why it happened. 4. For a company/stock, also state possible risks and how you could mitigate them; for a deal, talk about whether or not you think it was a good move by both sides. 5. Summarize your conclusions at the end. For questions about investing or starting / selling a business, you can use the same structure recommended elsewhere in the guide and give the key question you’d ask or the summary of your plan upfront, 2-3 supporting reasons, and summarize what you’ve said at the end. Your responses will be slightly different if you’re going for a sales & trading, asset management, hedge fund, or equity research-type role; there, you need to think through the entry and exit strategy (e.g. how many shares you buy and sell and when you do it over time) in more detail and better understand the stocks you pitch. In investment banking interviews, they’re unlikely to spend the entire 30 minutes discussing a single stock recommendation so we do not recommend spending hours or days preparing for this one. Discussing Companies, Stocks, Deals, and Trends

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1. We do most of our work with [Industry Name] companies. Can you talk about a recent industry trend? Follow the format above and make sure you pick something that’s recent and relevant , explain why it’s happening, cover how it impacts the financial performance of companies, and then give your own take at the end. This question is simple if you prepare in advance, but interviewees make a few common mistakes: 1. They describe a trend in an industry other than the one they asked you about. If you’re interviewing with a Real Estate group, um, make sure you name a trend in the real estate market… 2. They don’t explain the “why” – many real estate firms have shifted spending from development to acquisitions… because construction costs have been skyrocketing and so it’s easier to buy assets on the cheap. 3. They don’t explain its impact – as a result, real estate firms have been raising additional debt and equity to fund acquisitions and, in turn, driving up prices in key geographies. Sample “Good” Answer: “One recent trend in the real estate market is that large firms have been shifting their spending away from new property development to acquisitions of existing properties instead. They’re doing this because construction costs have skyrocketed over the past year due to disputes and arbitration with labor unions, and because the cost of natural resources and basic materials has been increasing. As a result, companies in the market have been raising more debt and equity to finance their operations and do these deals – that not only changes their Balance Sheets and leads to more business for the banks advising them, but it also means that they’ll have to refinance the debt in coming years as well. A side effect is that property acquisition prices have been climbing as well and are 5-10% higher than a year ago.

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What’s interesting about this, and what a lot of other people are overlooking, is how the trend differs depending on the real estate segment. Hotel companies, for example, haven’t shifted their spending much because the economy is booming and their new, higher-end hotels are doing well despite the rising costs. So I think the impact of this trend really depends on the industry segment.” Why It’s a Good Answer: He followed the exact structure we recommended: he states the trend upfront, explains why it’s happening, how it’s impacting company’s finances, and then gives his own opinion at the end and points out something that other people aren’t talking about. 2. Tell me about a news story you found interesting lately. This answer will be very similar to your answer for the previous question about industry trends. The difference is that this response doesn’t have to be a “trend,” and can be more general in nature. It should still be related to economics / business / finance – if you mention a new movie or some type of human rights story, interviews will think, “That’s nice, but does he/she actually know what’s going on in the world of business?” Good news items to talk about: • •

• •

Anything from the Opinion / Editorial section, ideally business-related. Financial crises and major announcements involving banks, bailouts, and central governments. New regulation that’s related to the finance industry. Major policy changes or macroeconomic news.

Sample “Good” Answer: “One interesting new item has been the implementation of the Basel III rules for commercial banks after they were first agreed upon years ago. Among other things, banks now have to keep more regulatory capital on-hand, they must comply with new liquidity coverage and net stable funding ratios, and there are additional conservation and countercyclical buffers.

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These rules were implemented mostly because of the extended financial crisis and the fallout from that – regulators felt that banks needed to be much more conservative with their lending practices and the leverage they used to prevent another catastrophe. Overall, the added requirements will reduce banks’ profits and Return on Equity (ROE) since they can no longer be so aggressive with lending. And it’s speculated that the new rules may slow down economic growth worldwide since companies won’t be able to borrow as easily anymore. My view is that not much will change, actually – the problem is that the Basel rules are still ‘risk by Excel’ and banks always find loopholes and ways around them. Some banks may earn lower profits, but I don’t think global economic growth will be impacted much, because the supply of capital already exceeds demand.” Why It’s a Good Answer: The same as usual: she states a major news story (it would help to be a bit more specific here, but we’ll forgive that), gives the summary, explains why the regulation is being implemented and what it can do, and then gives her opinion at the end. 3. Tell me about the market(s). This is a vague question, but it’s very common in interviews. It’s testing whether or not you follow basic news such as how the stock market has performed over the past year, what people are saying, and where you think things are heading in the future. You can still apply the same 4-point structure we recommended above to answer this question, but what you say will be slightly different depending on the region you’re in and the markets you follow. Sample “Good” Answer: “Overall, the stock market this year has been flat to down, with major indices like the Dow Jones down by 1-2%, others such as the S&P 500 up by 2-3%, and many others unchanged. There aren’t many IPOs going on and M&A activity is down about 30-40% over last year.

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That’s happening because the current recession has lasted far longer than expected, and there’s a lot of uncertainty on all sides: consumers don’t want to buy houses or make huge purchases because they’re afraid of losing their jobs, with unemployment still relatively high, and companies don’t want to do deals because they don’t want to use their cash. The weak markets are affecting everyone, but consumer-focused companies in the ‘midrange,’ i.e. between luxury retailers and consumer staples, have suffered the most, sometimes losing half their market caps, due to a severe decline in middle-class consumer spending. Other people are expecting a recovery by the end of the year, but I’m less optimistic: I think that unless there’s a major technological breakthrough or a new industry that drives job creation, we’re not likely to see much of uplift due to all the structural problems with the economy.” Why It’s a Good Answer: The same as above – notice here how he quotes a few numbers for stock market indices, deal activity, and stock prices in a specific industry. You should always have a general sense of those figures, as well as other important macro indicators like the GDP growth rate, inflation, and the unemployment rate before going into an interview. 4. Can you tell me about a company you admire? / Pitch me a stock. [NOTE: We are combining these two questions because they’re asking for the same thing, and because it saves you time when preparing if you simply come up with a list of “admirable companies” that also happen to be public.] This sounds like a simple question, but it’s one of the easiest to screw up in an interview. Let’s look at what not to do first: 1. Do not use a well-known or “hot” company like Google, Apple, or Facebook (or any new “hot” companies that join this list). Pick something

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lesser-known so that the interviewer cannot possibly know more about it than you. 2. Do not skip over the key financial metrics and data that make the company attractive – this takes 2 seconds to look up on Google Finance. 3. Do not focus on the company’s products or services and forget about their customers, their positioning, and how they stack up against their competitors. Also remember that we are now using a different 5-point structure for this question – you need to state the name upfront, summarize its financials, support why you like it with 2-3 reasons, give potential risks and how to mitigate them, and then summarize everything at the end. Sample “Good” Answer: “I like Aero Dynamix, a leading manufacturer of commercial aircraft engines. It has about $500 million revenue and $100 million in EBITDA and trades at around $20.00 per share, at a P/E of 10x, vs. 11-12x on average for its competitors. I like them and think the price could rise to $25.00 per share, for a P/E of 12x, in the next 12 months. Right now, they’re undervalued by about 20% vs. competitors because prices and demand have declined in some of their key markets in Europe. But they’ve just gotten started expanding in China, where there’s far more growth potential, and 10% of their revenue will come from there by the end of the year. Also, oil prices have fallen 15% in the past several months but that hasn’t been factored into their price yet. As those lower prices move through the system, air ticket prices are likely to decline, which should push up traffic and cause companies to invest in more aircraft, which will help the company. Finally, they operate at higher margins than the rest of the industry but haven’t received credit for that yet because the market over-reacted to bad news in one of their regions. The main downside risks are a general market decline, which could be hedged by shorting a broader index, and stagnation in emerging markets, which you could hedge by longing a defensive or blue-chip index or anything else not dependent on developing economies.

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Overall, I think they’re very-well positioned and could rise to $25.00 in the next 12 months for a 25% gain.” Why It’s a Good Answer: Not only does our interviewee follow the exact structure we outlined above, but she also provides lots of data and very specific numbers about the stock price she expects to see in the next 12 months. The reasons given for liking this stock are concrete and reasonable, and she also discusses how to hedge the risk by longing or shorting other securities. In a trading / equity research / asset management / hedge fund interview, you’d want to give more detail on the logistics of entering and exiting the position and how much time you would need to do everything. 5. Tell me about an M&A (or debt / equity) deal that interested you recently. There are fewer rules about what to avoid here. It’s still a good idea to mention a lesser-known deal so that you don’t get extremely in-depth questions, but it’s not the end of the world if you mention a massive $50 billion merger. The bigger issue here is that you need to research everything in detail before you start talking about the deal, and sometimes the information is tough to find. The best source is the WSJ Deal Blog, which has very useful “deal profiles” that summarize the key financial figures, metrics, and analyst commentary. Sample “Good” Answer: “One recent deal that interested me was Mid Energy Corp’s recent acquisition of Solar X Farms for $1.2 billion. Mid Energy mostly operates wind farms and geothermal power, and this is its first move into the solar power market – which may be a sign that the market for renewable energy is consolidating. Mid Energy had revenue of around $10 billion and EBITDA of $1 billion, while Solar X had revenue of $800 million and EBITDA of $100 million. Mid Energy was growing at around 5% per year and had 10% margins, while Solar X had slightly higher margins

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and was also growing at around 10%. The deal was done at a 12x EBITDA multiple and 1.5x revenue multiple. The deal happened for a few reasons: for one, Mid Energy wanted to expand into solar power given new breakthroughs there that have made costs more competitive. Also, it wanted to expand its geographic reach into Central and South America, where Solar X is strong. Finally, Mid Energy wanted to prevent its chief competitors from acquiring Solar X, so it was also a defensive play. Overall, I think it was a good move for them as diversification makes sense when the company grows to that stage, but I think they should have paid more like a 9-10x EBITDA multiple. The 12x multiple they paid represented over a 70% premium, and 3040% premiums have been more common in this market over the past year. In short, Mid Energy acquired Solar X mostly for strategic reasons: to diversify geographically and in industry focus, and as a defensive play. I think it will work out well, but that they also overpaid and could have done the deal for less.” Why It’s a Good Answer: The interviewee follows all our rules and structure above, and explains the rationale for the deal very well. The only problem is that saying a buyer “overpaid” for a seller is not always the best argument – chances are that it was already heavily negotiated, so further price reductions probably weren’t possible. Also, more detail on the deal process and how competitive it was (multiple bidders?) would have been good. But this is a good high-level summary of the deal and sometimes it’s better to leave out those details in your first response to a question like this. Discussing Investments and Starting and Selling Businesses 6. Let’s say that a client comes to you and indicates that he/she has $10 million USD to invest in anything. What would you advise him/her to do? Always ask for the investor’s goals first. Are they looking to earn big capital gains over 30-40 years? Are they looking for tax-free

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retirement income? What assets interest them, and what is their risk tolerance? There’s no one-size-fits-all answer for this one, but a few guidelines: •

•

•

If the investor is relatively young (20s, 30s), has a long time horizon, and can tolerate risk and fluctuations, a well-diversified portfolio and significant weighting in equities is best. As the investor gets older and has less and less time until retirement, the portfolio should shift more to fixed income (bonds) rather than equities, and you should focus more on capital preservation and income rather than capital gains. And for someone at retirement age, tax-efficiency, capital preservation, and generating a decent amount of income are the biggest concerns.

Sample “Good” Answer: “First off, I’d ask the investor what his/her goals are and then assess the best strategy best on his/her goals, risk tolerance, and the timeframe over which he/she plans to invest the capital. With this amount of money, regardless of the strategy, diversification is important because it is a substantial sum and no one wants to lose it all. For example, if the investor is relatively young – say, in the 25 – 35 age range – and can therefore go for high capital gains over a long timeframe, then I’d encourage a diversified strategy with a portfolio made up of mostly equities, maybe 70-80%, and also around 20-30% worth of fixed income. The equities could be spread across different market segments and geographies. If the investor is older and has different goals – for example, income generation or capital preservation – then I would recommend a heavier weighting toward fixed income, while still diversifying across specific bonds. And past a certain point, it might make more sense to focus on municipal bonds or real estate for the income generation and tax benefits. Overall, diversification is the most important point here regardless of the investor’s age and desired strategy. Going from $10 million to $20 million is nice, but not if there’s a 90% chance of losing everything and only a 10% chance of doubling your money – so on balance, I would be fairly conservative here.”

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Why It’s a Good Answer: He states the most important points upfront and then goes through a few example scenarios to support his points – and then reiterates the key fact at the end, which is that avoidance of loss is more important than producing huge gains in this case, since $10 million USD is an enormous sum to 99.9% of people. 7. Let’s say you could start any type of business you wanted, and you had $1 million USD in initial funds. What would you do? You’ll want to ask follow-up questions to see if the interviewer is looking for something more specific, because this one is wide open. Generally speaking , $1 million USD is actually not that much money for starting a business, so you’d have to do something that doesn’t require massive spending in the form of factories, distribution networks, and so on.

Potential ideas with this amount of capital: •

•

•

•

Anything Software / Internet-related because all you need are a programmer or two in the beginning. Some type of small business where you can lease the space required rather than making a huge upfront commitment and buying a property. Something service-based , like a consulting or accounting firm, that also requires little capital in the beginning. Anything that you can test very well early on before making a bigger financial commitment.

You also do not want to take on an established competitor in this scenario – competing directly with Microsoft, Facebook, Google, Exxon-Mobil, or Goldman Sachs would be foolish. So you should go after something more niche where there’s a still bit of competition (simply because that validates the market), but not so much that you would have trouble standing out.

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And, of course, it should be something that you’re interested in and know something about. If you have no experience with solar panels, starting a solar panel company is dumb even if it’s a “hot” area. Sample “Good” Answer: “First off, $1 million USD is actually not that much for starting a business, so I would focus on industries where not a lot of capital is required – for example, Software / Internet or something services-based. And I’d make sure that there was some competition in the market, but not too much, and that I was pursuing something that I was interested in and could take a different angle on compared to everyone else. As a specific example, I might target the mobile app market and create a smartphone or tablet app for health and fitness needs. While there are a lot of apps out there in that market, it’s still young enough that you can get noticed with the right product, the right marketing, and the right positioning. Plus, it’s easy to make an app for far less than $1 million – it might cost $50-100K for the initial development, which is all I would need to test the viability of the idea. I could do a lot of the marketing myself for no cost simply by offering to write content for major sites and promote the app like that. And it’s something I’ve been very passionate about for years, since I used to be a marathon runner in high school and since I’ve done a lot of web projects before. That’s why I’d choose this idea – it’s a commercially viable market but one that’s not saturated with competitors, the costs are relatively low, and I’m passionate about it.” Why It’s a Good Answer: She states upfront the key criteria she’d think about before starting the business, and then gives a specific example of a type of business she might start, and then explains how it satisfies all the criteria. At the end she summarizes the 3 most important points about this idea. 8. Let’s assume that you are going to start a laundry machine business. How would you analyze whether it’s viable? This question is more like a question you might receive in a consulting interview where they ask you to size the market or

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count the number of basketballs that would fit in the Empire State Building. To determine whether it’s “viable,” you need to see whether or not it will generate a profit and so you have to break it down into logical steps: 1. What are the upfront costs? You may not have exact numbers, but it’s safe to assume that buying dozens of laundry machines, plus the building itself, will cost at least a few hundred thousand dollars. 2. What’s the potential revenue? Think about how many potential customers there are nearby, how frequently they do laundry, and how much they pay each time. 3. What are the ongoing expenses? These are fairly low for a Laundromat since there are no (or few) employees, but it still costs something to run – utilities, interest / principal repayment from the loan, and maintenance for the machines. Overall, location plays the biggest role in the success of this type of business – if you build it next to an apartment complex where e veryone has laundry machines, you’re doomed from the beginning. Sample “Good” Answer: “To determine whether it’s viable, I’d look at the upfront costs, the potential revenue, and the ongoing expenses. I don’t know exactly how much laundry machines cost, but they’re not cheap. Let’s assume that there are 25 washers and 25 dryers, for a total of 50 machines, and that each one costs $5K. Then the land and building itself might cost $250K, or around $125 per square foot for a 250 square foot facility. So the upfront cost is $500K total, and I might put down $100K in cash and take out a loan for the rest. I’ll assume a 5% interest rate, but set the total expenses to 10% of the loan balance per year to account for principal repayment as well. For revenue, it’s hard to say exactly how many customers there will be, but you can look at it in terms of average ‘turns’ for a washing machine or dryer each day. If we say that the average is 5 per day, that’s 250 turns per day. At an assumed $2.00 per turn, that’s $500 per day in revenue. $1000 per day in revenue would be $365,000, so $500 per day is roughly $180,000. Loanrelated expenses would be around $40,000 per year initially, and if we assume one

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employee plus ongoing machine maintenance and repairs, that might add an additional $60,000 in expenses. It’s hard to estimate utilities and real estate taxes, but to be conservative we could say $2,000 in month for those expenses, for $24,000 per year. So in total, annual revenue is $180,000 and annual expenses are $124,000 per year, so annual profit would be $56,000, or between $50K and $60K in the first few years. Obviously we’d need more detailed data to estimate these numbers more precisely, but on the surface the average laundry machine business seems viable due to the low expense profile, and it only gets better over time as the debt is paid off. Of course, this depends on the location and if you build it in the wrong place, nothing here will work.” Why It’s a Good Answer: Almost conjuring up an image of a poor management consultant, the interviewee here breaks down each step logically and uses guesstimates where they make sense for both the revenue and expenses. He states upfront the 3 main categories to estimate, and then clearly lays out the upfront costs, what the potential revenue might be based on conservative assumptions, and the annual expenses, taking into account the debt. And then at the end he summarizes the analysis and points out that if the location is wrong, all of this is irrelevant. 9. If you owned a small business and were approached by a larger company about an acquisition, how would you think about the offer and how would you make a decision on what to do? The key terms to consider would be: 1. Price – the higher, the better, of course. 2. Form of payment – cash or stock. Cash can be better since… it’s cash, but you also pay taxes immediately. Whereas with stock, you only pay taxes when you sell and you get some upside if the company’s stock price appreciates. 3. Future plans for the company vis-à-vis your own plans – Will they let you leave? Or will they only acquire the company if you stick around for years?

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There’s no magical way to decide what the most important term is, or how you would actually make the decision, but you can explain these 3 criteria and how you’d weigh them to make a decision. Sample “Good” Answer: “The 3 most important criteria would be price, form of payment, and whether or not they’d want me to stay on for years, months, or leave whenever I wanted. Obviously a higher price is better, but beyond a certain range I would pay more attention to the other terms. Getting 5% more for the company would be great, but if it meant I had to stay there for 5 years I would prefer to get a lower price and be allowed to move on more quickly instead. The form of payment is also important because in some cases, cash is better – if the buyer is private or a public company with shaky past performance, for example. But in other cases, stock is better, especially if taxes are a concern or the buyer is a massive public company. Finally, future plans are very important – if they made me sign a ‘non-compete’ or made me stay on for years and years, I might negotiate for a lower price but less restrictive terms there. My view is that once you sell a business, it’s best to make a clean break and go on to do something else as soon as you can, so I personally would value that over a slightly higher price. Those are the 3 main factors I would consider: price, form of payment, and future plans. My bias is toward having the greatest flexibility possible in the future, and for reducing risk by negotiating a cash payment, if possible.” Why It’s a Good Answer: He gives the 3 main points upfront, and then explains the trade-offs of each one and the different options for price, form of payment, and future plans. Then at the end, he goes into his own preferences and what he would value most highly out of all these options.

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After the Interview: Questions and Thank You Notes What to do after the interview is considerably easier than what to do before the interview, because you usually just wait for them to get back to you. But there are a few points to keep in mind – both immediately after the interview and then several days to a week after the interview. “Do You Have Any Questions for Me?” This is what the interviewer will almost always say when he/she is finishing up the interview, and you always need to respond “Yes!” and then ask your questions. Saying “No” is not a wise move, because it indicates that you’re not particularly interested or engaged in the interview… which is not good if you want to receive an offer. The actual questions you ask do not matter that much as long as you avoid anything stupid, inappropriate, or questions that are easily answered elsewhere: •

•

•

“How much money do you make?” If you ask this question, you deserve to fail in life. “So what’s it like being an investment banker?” You can read all about this on M&I. “How many hours do you work each week?” See above.

Better questions to ask at the end: •

•

•

•

“Can you tell me about your background and how you got started in the industry?” (If they haven’t already explained this.) “What have you learned since you started working that you wish you knew when you were first getting started?” “What qualities have made previous interns / full-time hires successful or not successful?” “What was the most surprising part of this job when you first started working?”

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You can come up with endless variations on these. The point is to ask relatively thoughtful questions that aren’t controversial, but which show that you’re genuinely curious about the company, the role, and what you’ll be doing there. Some people recommend asking about very specific topics, but that is reading way too much into it – I’ve interviewed hundreds of candidates before and I never once thought, “Aha! This person asked such a great question at the end that we’ll definitely have to hire him / her!” Most of the time, hire / no hire decisions are made within the first few minutes of the interview and the rest of the interview, including the question at the end, is less significant than that initial interaction. One final point: if you’ve already spoken with many, many people and have been through several rounds of interviews in one day, it’s fine to say that you don’t have any questions because you’ve already gotten to ask everyone the questions that you’ve had. It’s better to still come up with something , but in this scenario it’s more acceptable to say that you don’t have anything that you want to ask about it. Ask for a Business Card Always ask for the interviewer’s business card at the end – you never know who will turn out to be helpful in the future, or if you’ll run into the person again. And it never hurts to follow-up and stay in touch, even if you end up not winning an offer at the firm. When you get the business card, put it in the folder that you’ve carried with you to the interview rather than crumpling it and putting it in your pocket or suit jacket. First impressions still matter, and you want to seem thoughtful when collecting business cards.

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Follow-Up Afterward There is mixed advice about sending “Thank You” emails after the interview; some people say they’re useless because investment bankers decide on candidates very quickly, while others say that they’re still worth sending because they might tip the scales in your favor. I’ve said before in articles on M&I and in some of the tutorials here that Thank You notes usually don’t make a big difference… And that’s true, but they’re still worth sending anyway because it takes 30 seconds to do so. Keep it very brief and do the following: • •

•

•

•

Email each person you met with individually – no group emails. Send an email with subject “Thanks for the Interview” or “Interview Today” or something like that. If you’re in a more conservative region like Asia, you can use “Dear Mr. / Ms. Soand-so,” but in North America you’re usually fine using his/her first name instead. Thank them for their time, say that you enjoyed speaking with them, and if anything interesting or specific to you came up (or you had a shared interest or experience), remind them of that. Say that you enjoyed meeting everyone at their firm and look forward to hearing from them soon.

Example “Thank You” Email: “Subject: Interview Today John, Thanks for taking the time out to interview me today – I really appreciate it. I enjoyed meeting you and everyone else on the team, and it was great hearing about your adventures mountain climbing – good luck on your trip this weekend!”

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Thanks again, and I look forward to hearing from you soon. Thanks, [Your Name and Contact Information]” Do not overthink this. If you’re spending hours and hours sending Thank You Emails, you’re doing something wrong. And if you don’t have anything unique or memorable from the interview, leave that part out. Ask For Feedback On Your Performance? Some interview guides and coaches recommend that you ask for feedback on your performance after the interview, either in these “Thank You” Emails or via follow-up phone calls afterward. I don’t think it’s a great idea to ask for feedback until after you hear back one way or the other – and if you win the offer, there’s no point in asking for feedback. If you ask for feedback before you hear back from the firm, you may come across as “begging” for the offer or trying too hard. The other problem is that bankers and other financiers are unlikely to give you an honest answer when you ask for feedback – few people will be so direct as to say, “You suck at technical questions and can’t do math, so we don’t want to hire you.” You’re more likely to get honest feedback in industries like consulting and tech startups where people are nicer and are more willing to be “real” with you. So you should only ask for feedback if they give you a definitive “No” and you genuinely don’t know what you did wrong or what you could improve upon. In this scenario, it’s fine to send a follow-up email asking for feedback and for ways to improve your performance.

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Stay In Touch Even If You Didn’t Win the Offer? This is fine, but don’t feel pressured to stay in touch with every single person you’ve met in the recruiting process just for the sake of “networking.” If you hit it off very well with one or two of the interviewers, then definitely stay in touch and keep them updated on your progress as you move along with interviews elsewhere. Positive results (e.g. you win an offer at a firm that’s at a similar or higher “prestige level”) are especially good to report back to them. It’s just like how if you start dating a supermodel, all other members of the opposite sex will suddenly become more “interested” in you: now you’ve got social proof and evidence that other people “see something” in you (yes, adult life is just like high school all over again). Bottom-line: yes, stay in touch with interviewers, especially with any that you got along with quite well – and report back positive results when possible. When Will You Hear Back? It depends on the type of bank (or other firm) you’re interviewing at, the level of the role you’re interviewing for, and how much experience you have. The simplest case is when you’re interviewing at a bulge bracket (or elite boutique, or middle market) bank as an undergraduate or MBA. In this scenario, you’ll almost always hear back quickly – often within a few hours or 1 day of the interview. If you don’t hear back within one week, it means that you didn’t get the offer, or that they’ve been delayed in their decision-making.

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It gets much harder to predict when you’ll hear back when: 1) You have significantly more work experience (e.g. you’ve been working full-time for 3 years and are interviewing as a lateral hire); or 2) You’re interviewing at very small firms – boutiques with 10 or fewer people, for example; or 3) You’re interviewing for buy-side roles at private equity firms or hedge funds , and they’re NOT mega-funds (i.e. $100 million USD in assets under management (AUM) up to a few billion USD in AUM). In all these cases, there’s little pressure for the firm to respond quickly because they can afford to take their time. At larger investment banks, hiring decisions for entry-level Analysts and Associates must be made quickly because candidates may receive competing offers in a short timeframe. But that is less true for buy-side roles and if you have significantly more work experience – if you’ve already worked full-time for 5 years, you have no chance of suddenly receiving 2 competing job offers on the same day and ditching the firm you’ve already been speaking with. In private equity and at hedge funds, the process may drag on for months and months because firms are small and you will sometimes speak with everyone there, multiple times, before decisions are made. So the most likely outcome following interviews is not hearing anything for a few days up to a few weeks. The Non-Response If you don’t hear back, your only 2 options are:

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1) Follow-up up each week, continue to express your enthusiasm, and switch to the phone if they do not respond via email or if they become unresponsive. 2) Bring them news of other job offers you’ve received and indicate that you need to respond by a certain deadline, so you need a decision from them. #2 is the only leverage you have in the entire recruiting process and the only way to “force” a decision from them. For many buy-side roles, they won’t necessarily give you an offer until you’ve already agreed to accept it. So bringing news of other job offers may not be too effective – this strategy tends to work better for undergrads, MBAs, and recent graduates. Never lie about receiving an offer somewhere else – it’s guaranteed to come back to haunt you. The Negative Response If you hear back from the firm and they tell you, “Thanks, but we’re not giving you an offer,” most people would say that it’s time to give up there. And most of the time, there is truth to that – a firm “no” means that you have a low chance of changing their minds. Sometimes , though, you do have a chance at changing their minds and going back in for interviews and/or winning offers.

Generally you only want to do this if you feel there’s a specific reason you were misjudged and/or that you can significantly improve your performance the next time around. For example, maybe you couldn’t explain why your most recent job was relevant and after the interviews, you went through your project and client experience and found more points that were finance-related.

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If, on the other hand, they were looking for someone very specific and you did not match the job requirements at all (e.g. they wanted someone with 5 years of experience in distressed debt investing, but you only worked on tech M&A deals), then it’s usually not worth the effort. So there’s no universal rule on whether or not you should plead your case and ask for a second chance. This tactic tends to work better for students and those with less full-time experience, and does not work as well if you are going for higher-level roles – by that stage, it’s highly unlikely that you got nervous and didn’t present yourself effectively. Return to Top.

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Accounting Overview & Key Rules of Thumb Accounting interview questions never go out of style, and for good reason: they’re the quickest way to tell if you understand the bare minimum required to work in finance. There are a few categories of questions to know about when it comes to Accounting: 1. Conceptual Questions (“What’s the difference between Accounts Receivable and Deferred Revenue?”) 2. Single-Step Scenarios (“What happens on the 3 statements when Depreciation goes up by $10?”) 3. Multi-Step Scenarios (“Walk me through what happens when you buy inventory using debt, turn it into products, and then sell the products.”) 4. More Advanced Accounting (“Walk me through what happens when you acquire a 70% stake in another company and pay $70 for it.”) This guide is divided into Basic and Advanced questions and then several categories within both of those – Conceptual, Single-Step Changes, and Multi-Step Scenarios. The Advanced section is more focused on Conceptual questions because at that level, interviewers assume that you know how the 3 statements link together. Before jumping into these questions and answers, you need to understand key Accounting rules. You could always get questions that aren’t covered here – but if you understand the rules, you’ll be able to answer them anyway.

Key Rule #1: The Income Statement The Income Statement lists a company’s revenue , expenses , and taxes , with its after-tax profit at the very bottom, over a period of time (one quarter, one month, or one year). To appear on the Income Statement, each item must meet the following criteria:

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1. It must correspond to the period shown on the Income Statement only – if you’re paying for an asset that will last for 10-20 years, it would not appear on a 1-year Income Statement. 2. It must affect the company’s taxes. For example, interest paid on debt is taxdeductible so it appears on the Income Statement… but repaying debt principal is not tax-deductible, so it does not appear on the Income Statement. To the right, you can see a screenshot demonstrating common items on the Income Statement. The 4 main sections to be aware of:

Income Statement

Revenue: Cost of Goods Sold (COGS): Gross Profit: Operating Expenses:

Year 1

Year 2

$ 1,300 100 1,200

$ 1,500 150 1,350

200

250

1. Revenue and Cost of Goods Sold Depreciation: 20 25 (COGS): Revenue is the value of the Stock-Based Compensation: 10 15 products/services that a company Amortization of Intangibles: 15 20 sells in the period (Year 1 or Year 2), Operating Income: 955 1,040 and COGS represents the expenses Interest Income: 5 6 (Interest Expense): (3) (4) that are linked directly to the sale of Gain / (Loss) on Sale of PP&E: 1 those products/services. Other Income / (Expense): 2 3 2. Operating Expenses: Items that are Pre-Tax Income: 960 1,045 Income Tax Provision: 384 418 not directly linked to product sales – employee salaries, rent, marketing, Net Income: $ 576 $ 627 research and development, as well as non-cash expenses like Depreciation and Amortization. 3. Other Income and Expenses: This goes between Operating Income and Pre-Tax Income. Interest shows up here, as well as items such as Gains and Losses when Assets are sold, Impairment Charges, Write-Downs, and anything else that is not part of the company’s core business operations. 4. Taxes and Net Income: Net Income represents the company’s “bottom line” – how much in after-tax profits it has earned. Net Income = Revenue – Expenses – Taxes. A few points on Income Statement revenue, expenses, and taxes:

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1. They do not need not need to be related to a company’s operational activities – Gains and Losses on asset sales, Depreciation, and Interest Expense still appear on the IS but are not related to everyday business. expenses (or cash revenue) – for example, 2. They do not need to be cash expenses (or Depreciation and Amortization are both non-cash expenses. Also, companies often record revenue and expenses here before they receive or pay them in cash. 3. Sometimes, items may be embedded in other items – items – for example, sometimes Depreciation is included in COGS or Operating Expenses; other times it is a separate item. Here are more rules of thumb about what appears on the Income Statement: •

•

Always Appears: Revenue, Appears: Revenue, COGS, Operating Expenses, Depreciation, Amortization, Stock-Based Compensation, Interest, Gains / (Losses), WriteDowns, Other Income / (Expens ( Expenses) es) Never Appears: Capital Appears: Capital Expenditures, Purchasing or Selling Investments and PP&E (Plants, Property & Equipment), Dividends, Issuing or Repaying Debt Principal, Issuing or Repurchasing Shares, Changes to Balance Sheet Items such as Cash, Debt, Accounts Receivable, Accounts Payable, and so on.

The items on the “Always Appears” list meet the criteria above because: do affect the company’s taxes (e.g. paying an employee’s salary reduces the 1. They do affect company’s taxable income); and shown on the Income Statement (e.g. revenue in 2. They correspond to the period shown on Year 1 refers to all sales to customers in Year 1… not Year 2). The items on the “Never Appears” list fail the criteria above because: not affect the company’s taxes (e.g. Dividends or Purchasing Inventory); 1. They do not affect or not correspond to the period listed on the Income Statement (e.g. 2. Because they do not correspond Capital Expenditures refers to purchasing Assets that often last for 10-20 or more years).

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Key Rule #2: The Balance Sheet resources – its The Balance Sheet shows the company’s resources – acquired those resources – its Assets – and how it acquired those Liabilities & Equity – at a specific point in time. time. Think about what a personal Balance Sheet might look like: maybe you’ve invested $50K in the stock market, you have $30K in cash in your bank account, and you own a house that’s worth $500K. Those are your Assets because Assets because they can all be sold for cash, and they may even increase in value over time, which would result in more money for you. How did you get that cash, your house, and your investments? job – you’ve saved $200K, Part of it’s from your saved up, after-tax earnings from your job – cumulatively, after taxes, over the years. debt in the form of the mortgage on your house, which And then part of it is also from debt in is worth $380K. • • •

Your Assets = Assets = $50K in Investments + $30K in Cash + $500K House = $580K Your Liabilities = Liabilities = $380K Mortgage Mortgage Your Equity = Equity = $200K in After-Tax, Saved Up Job Earnings

Assets are worth $580K, and so are your Liabilities + Equity – Equity – that’s no Your Assets are coincidence, because both your personal Balance Sheet and companies’ Balance Sheets must always remain in balance. balance. In other words, if you have $580K in “resources,” you must have gotten that $580K from somewhere. Assets don’t just appear out of thin air.

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Here are the key Balance Sheet rules:

Balance Balanc e Shee t Ye ar 1

Year 2

Assets:

1. Assets must Assets must always equal always equal Liabilities + Equity – Equity – no exceptions. Asset is an item that will 2. An Asset is result in, directly or indirectly, additional cash in the future. future. Liability is an item that will 3. A Liability is result in, directly or indirectly, less cash in the future. future. Most Liabilities are related to external parties – parties – payments owed to suppliers, or borrowed money, for example. Liabilities are used fund a business. to fund a 4. Equity line Equity line items are similar to Liabilities (used to fund a business), but they refer to the company’s own internal operations rather than external parties. To the right, you’ll see a screenshot of what a company’s Balance Sheet might look like, with the most common items shown.

Current Assets: Cash & Cash-Equi val e nts: Short-Te rm Inve stme nts: Accounts Re ce i vabl e : Prepai d Ex pe nse s: Inve ntory: Total Curre nt Assets:

$

722 $ 1,391 99 95 95 97 102 99 103 101 101 1,121 1,783

Long-Term Assets: Pl an ants, Pr Prope rt rty & Eq Equi pm pme nt nt (P (PP&E): Othe r Intangi bl e Asse ts: Long- Term Inve stme nts: Goodwill: Total Long-Te rm Asse ts:

986 185 103 100 10 0 1,374

974 974 165 165 106 106 100 100 1,345

Total Asse ts:

$ 2,495

$ 3,128

Liabilities & Equity: Current Liabilities: Re vol ver (Short-Te rm Debt): Accounts Payabl e : Accrued Ex pe nses: Total Curre nt Liabi litie s:

$

101 $ 204 201 506

102 199 199 198 198 499 499

209 200 20 0 103 512

214 214 200 200 106 106 520 520

Total Li abi li tie s:

$ 1,018

$ 1,019

Shareholders' Equity: Common Stock & APIC: Tre asury Stock: Re tai ne d Earni ngs: Accumulated Other Compr. Income: Total Share holde rs' Equity:

616 (105) 866 100 10 0 1,477

637 637 (110) 1,482 100 100 2,109

Long-Term Liabilitie Liabilitie s: De fe rre d Re venue : Deferred Tax Liability: Long- Term De bt: Total Long-Te rm Li abi li ti es:

Total Li abi li tie s & Equity: $ 2,495 $ 3,128 You can see that it’s split into Current Assets (anything Assets (anything that lasts for under 1 year) and Long-Term Assets (anything Assets (anything that lasts for more than 1 year) and similar categories for Liabilities.

Definitions of key Assets: •

Cash: Just Cash: Just like cash in your bank account.

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•

•

•

•

•

•

•

•

Short-Term Investments: Less liquid than cash – Certificates of Deposit (CDs) and money-market accounts and such. Accounts Receivable: The company has recorded this as revenue on its Income Statement but hasn’t received it in cash yet. It’s like an “IOU” from a customer. And it will turn into cash when the customer pays. Prepaid Expense: The company has paid these expenses in cash but hasn’t recorded them as expenses on the Income Statement yet. Inventory: What they need to manufacture and sell products – for a company like Apple, all the parts that go into iPhones and iPads. PP&E: Factories, buildings, land, equipment, and anything else that will last for over a year and contribute to the company’s core business. Other Intangible Assets: Patents, trademarks, intellectual property… usually the result of acquisitions. Similar to Goodwill, but this balance amortizes (decreases) over time as these items “expire.” Long-Term Investments: Less liquid and longer-lasting investments than Cash or Short-Term Investments. Goodwill: The premium that the company has paid over other companies’ Shareholders’ Equity when acquiring them.

Now, the definitions of key Liabilities: •

•

•

•

•

Revolver: Similar to a “credit card” for a company; it borrows money as needed and must repay it quickly. Accounts Payable: The company has recorded these as expenses on the Income Statement, but hasn’t yet paid them out in cash yet – used for one-time items with specific invoices, such as payment for legal services. Accrued Expenses: The company has recorded these as expenses on the Income Statement, but hasn’t yet paid them out in cash yet – used for recurring monthly items without invoices, such as employee wages, utilities, and rent. Deferred Revenue: The company has collected cash in advance from customers for products/services yet to be delivered, and it will recognize this as real revenue over time. Deferred Tax Liability: The company has paid lower taxes than what it really owes, and needs to make it up by paying additional taxes to the government in the future.

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•

Long-Term Debt: Similar to a mortgage or a car loan: debt that is due and must be repaid in over a year’s time.

And finally, Equity line items: •

•

•

•

Common Stock & Additional Paid-In Capital (APIC): This represents the market value of shares at the time those shares were issued by the company. When a company goes public, the total dollar value of shares issued shows up here. This does not change even if the share price changes afterward. Treasury Stock: This represents the cumulative value of shares the company has repurchased from investors. This does not change even if the share price changes afterward. Retained Earnings: This represents the company’s saved up, after-tax profits (minus any dividends it has issued). This is like the $200K you saved up, aftertaxes, in our “personal Balance Sheet” example above. Accumulated Other Comprehensive Income (AOCI): This is a section for “miscellaneous saved-up income” – you see items like the effect of foreign currency exchange rate changes here, as well as unrealized gains and losses on certain types of securities (i.e. if their values go up or down but the company has not yet sold them).

Key Rule #3: The Cash Flow Statement Similar to the Income Statement, the Cash Flow Statement tracks changes over a period of time (one month, one quarter, or one year). It exists for 2 reasons: 1. You may have shown non-cash revenue or expenses on the Income Statement. These need to be adjusted on the Cash Flow Statement to determine how your cash balance actually changes. 2. There may be additional cash inflows and outflows that have not appeared on the Income Statement. For example, Capital Expenditures and Dividends are both real cash expenses. You need to factor these in to figure out how your cash balance really changes by.

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Cash Flow Statement Year 1

Year 2

Operating Activities: Net Income: $ Non-Cash Expenses & Other Adjustments: Depreciation: Stock-Based Compensation: Amortization of Intangibles: (Gain) / Loss on Sale of PP&E: Changes in Operating Assets & Liabilities: Accounts Receivable: Prepaid Expenses: Inventory: Accounts Payable: Accrued Expenses: Deferred Revenue: Cash Flow from Operations:

20 10 15 (1)

25 15 20 -

5 (2) (3) 4 1 9 634

(2) 3 2 (5) (3) 5 687

Investing Activities: Purchase Short-Term Investments: Sell Short-Term Investments: Purchase Long-Term Investments: Sell Long-Term Investments: Capital Expenditures: PP&E Sale Proceeds: Cash Flow from Investing:

(2) 3 (4) 1 (10) 5 (7)

(1) 5 (5) 2 (15) 2 (12)

(10) 4 (1) 2 (1) (5) 6 (5)

(11) 5 (2) 3 (2) (5) 6 (6)

Financing Activities: Dividends Issued: Issue Long-Term Debt: Repay Long-Term Debt: Issue Short-Term Debt: Repay Short-Term Debt: Repurchase Shares: Issue New Shares: Cash Flow from Financing:

576

$

The Cash Flow Statement is separated into 3 main sections (see diagram on the left).

627

Beginning Cash:

$

100

$

722

Increase / Decrease in Cash: Cash & Cash Equivalents:

$ $

622 722

$ 669 $ 1,391

1. Cash Flow from Operations (CFO) – Net Income from the Income Statement flows in at the top. Then, you adjust for non-cash expenses, and take into account how operational Balance Sheet items such as Accounts Receivable and Accounts Payable have changed. 2. Cash Flow from Investing (CFI) – Anything related to the company’s investments , acquisitions , and PP&E shows up here. Purchases are negative because they use up cash, and sales are positive because they result in more cash. 3. Cash Flow from Financing (CFF) – Items related to debt , dividends , and issuing or repurchasing shares show up here. Some accounting textbooks (and some guides…) claim that CFO is for Current Assets and Current Liabilities, CFI is for Long-Term Assets, and CFF is for Long-Term Liabilities and Equity.

That definition isn’t completely wrong , but it’s not 100% accurate because there are many exceptions: •

•

Deferred Revenue is often a Long-Term Liability, but never shows up in Cash Flow from Financing – because it’s related to customers paying the company for products/services. Short-Term Investments is a Current Asset, but it appears in Cash Flow from Investing, not Cash Flow from Operations – since it’s an investment and has nothing to do with accepting customer payments or paying for employees or other expenses.

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•

The Revolver is a Current Liability, but it appears in Cash Flow from Financing, not Cash Flow from Operations – because it’s related to how the company is financing its operations, not its actual operations.

So you need to be careful when using this commonly cited “rule” – it’s better to associate each section of the Cash Flow Statement with types of items rather than strict categories from the Balance Sheet. If an item was already recorded on the Income Statement and it is a true cash revenue or expense, it will not appear on the Cash Flow Statement… with one exception. Sometimes, you use the Cash Flow Statement to “re-classify” income or expenses. The most common example is Gains or Losses on Asset Sales – those are most certainly cash income or expenses … so why do you list them in Cash Flow from Operations? Because you’re re-classifying that cash flow – you’re subtracting it out of Cash Flow from Operations and instead including it as part of the full selling price of the assets in Cash Flow from Investing instead. This is an advanced point and it is unlikely to come up in interviews, but we’re pointing it out because you see it with a few other, more advanced accounting concepts as well.

Key Rule #4: How to Link the 3 Statements In real life, this process gets complicated because of many exceptions and unusual items on the statements. Luckily for you, interviews are not real life and those scenarios are unlikely to come up – so we can create a step-by-step process for linking the statements: 1. First , Net Income from the bottom of the Income Statement becomes the top line of the Cash Flow Statement. 2. Second , you add back non-cash expenses from the Income Statement (and flip the signs of

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3.

4. 5. 6. 7.

items such as Gains and Losses). Third , you reflect changes in operational Balance Sheet line items – if an Asset goes up , cash flow goes down and vice versa; if a Liability goes up , cash flow goes up and vice versa. Fourth , you reflect Purchases and Sales of Investments and PP&E in Cash Flow from Investing. Fifth , you reflect Dividends, Debt issued or repurchased, and Shares issued or repurchased in Cash Flow from Financing. Sixth , you calculate the net change in cash at the bottom of the CFS, and then link this into cash at the top of the next period’s Balance Sheet. Seventh , you update the Balance Sheet to reflect changes in Cash, Debt, Equity, Investments, PP&E, and anything else that came from the Cash Flow Statement.

A few more rules to keep in mind as you link the statements: 1. Reflect each Balance Sheet item once and only once on the Cash Flow Statement, and vice versa. 2. If an Asset goes up , cash flow goes down; if a Liability goes up , cash flow goes up , and vice versa. 3. The Balance Sheet must always balance (Assets must always equal Liabilities + Equity), no matter what else happens. Those 3 rules above are universal and there are no exceptions. If you remember them and what goes in each section of the Cash Flow Statement, you’ll be in better shape than 99% of interviewees.

Key Rule #5: Changes on the Statements At this stage, you are much better off looking at the free 3-statement model we provide (see the next section) so you can see how everything changes visually. To provide more structure, though, you can put most changes into 4 different categories: 1) Changes to True Cash Item on the Income Statement

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These are all straightforward – Pre-Tax Income and Net Income change, and so do Cash and Retained Earnings. • •

•

Examples: Revenue, COGS, Operating Expenses, Interest Income / (Expense) What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income, Cash, Retained Earnings How the Balance Sheet Balances: Cash and Retained Earnings both change

2) Changes to Non-Cash or Re-Classified Item on Income Statement These are relatively straightforward because they follow a set pattern: Pre-Tax Income and Net Income change, but you need to add back or subtract the charge on the Cash Flow Statement. So Cash and Retained Earnings change, but something else on the Balance Sheet will also change. The tricky part is what that “something else” is, but most of the time it is intuitive. The corresponding Balance Sheet items that change are shown in parentheses below: •

•

•

Examples: Depreciation (PP&E), Amortization (Other Intangible Assets), StockBased Compensation (Common Stock & APIC), Gains / (Losses) on PP&E (PP&E), Write-Downs (The Asset that you are writing down), Impairment Charges (The Asset that you are impairing) What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income, Cash, Retained Earnings, Something Else on Balance Sheet How the Balance Sheet Balances: Cash and Retained Earnings both change, and something else on the Balance Sheet makes up the difference

3) Changes to Operational Balance Sheet Item These consist of items like Inventory, Accounts Receivable, Accounts Payable, Accrued Expenses, Prepaid Expenses, and Deferred Revenue changing. Non-operational items such as Cash, Investments, and Debt are not counted because they are simpler to think through and are part of category #4 below.

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You need to understand the 2 following points with these questions: 1. Whether or not changes to these items will impact the Income Statement. 2. How an item increasing vs. that same item decreasing are different. There is no good “rule” you can apply for all of these items, but if you take a look at the 3-statement model we’ve included, a lot of this will become intuitive. Let’s go through the most common items in interviews: Accounts Receivable What It Means Going UP: If AR goes up, it means that you have recorded revenue but not collected it in cash from customers yet. You’ve delivered the product/service, but they haven’t paid you in cash yet… but you record it as revenue anyway. Changes on the Statements: Revenue, Pre-Tax Income, and Net Income change; Cash, Accounts Receivable, and Shareholders’ Equity (Retained Earnings) all change. See the diagram on the left for an AR increase of $100. What It Means Going DOWN: If AR goes down, that means you’ve collected the cash from customers that owe you. So nothing on the IS changes – it’s only a cash collection, and your cash goes up. Changes on the Statements: Cash (up) and Accounts Receivable (down). Prepaid Expenses What It Means Going UP: When Prepaid Expenses goes up, you pay in advance, in cash, for a future product or service but you do not record the expense on the Income Statement yet because it hasn’t been delivered yet. For example, prepaid insurance plans often fall under this category.

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Changes on the Statements: Cash (down) and Prepaid Expenses (up). What It Means Going DOWN: When Prepaid Expense goes down, you now record on the Income Statement the expense that you previously paid in cash. So the IS changes, and so do a number of BS items. Changes on the Statements: Pre-Tax Income, Net Income, Cash, Shareholders’ Equity (Retained Earnings), Prepaid Expenses. See the diagram for an example of a $100 decrease in Prepaid Expenses. Inventory What It Means Going UP: When Inventory goes up, that means that you’ve purchased products but have not manufactured or sold anything yet. Therefore, nothing on the IS changes and only Inventory and Cash on the BS change. Changes on the Statements: Cash (down) and Inventory (up). What It Means Going DOWN: When Inventory goes down, that means that you’ve now turned it into finished products and sold it to customers… so expenses on the IS increase to reflect the cost of these goods, and you (usually) have additional revenue as well from having sold them. Changes on the Statements: Revenue (Ask to confirm this), Additional COGS on the IS, Pre-Tax Income, Net Income, Cash, Shareholders’ Equity (Retained Earnings), Inventory. See diagram for a $100 decrease in Inventory (representing a $100 increase in COGS – no additional revenue here). Accrued Expenses

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the


What It Means Going UP: When Accrued Expenses goes up, it means that we’ve recorded an expense on the Income Statement but haven’t paid it out in cash yet. For example, we pay an employee in cash at the end of each month but record it as an expense over each week of the month before paying it out at the end. The expense would be recorded on the weekly Income Statements and Accrued Expenses would increase until the payout at the end of the month. It’s the opposite of Prepaid Expenses. Changes on the Statements: Pre-Tax Income, Net Income, Cash, Shareholders’ Equity (Retained Earnings), Accrued Expenses. See the diagram for what happens after a $100 increase in Accrued Expenses. What It Means Going DOWN: When Accrued Expenses goes down, it means we’ve now paid out in cash an expense that was previously recorded on the IS… so nothing on the Income Statement changes. Changes on the Statements: Cash (down) and Accrued Expenses (down). Accounts Payable What It Means Going UP: The same as Accrued Expenses: we’ve received a product/service, recorded it as an expense on the IS, but haven’t paid for it in cash yet. Changes on the Statements: Pre-Tax Income, Net Income, Cash, Shareholders’ Equity (Retained Earnings), Accounts Payable. What It Means Going DOWN: The same as Accrued Expenses: when it decreases, that signifies a cash payout of an expense that was previously recorded on the IS. Changes on the Statements: Cash and Accounts Payable.

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Deferred Revenue What It Means Going UP: When Deferred Revenue goes up, it means that we’ve collected cash from customers for a product/service, but haven’t recorded it as revenue yet – so there are no changes on the Income Statement. Changes on the Statements: Cash (up) and Deferred Revenue (up). What It Means Going DOWN: When Deferred Revenue goes down, it means that now we’re recognizing this previously collected cash in the form of revenue, so the Income Statement changes. Changes on the Statements: Revenue, PreTax Income, Net Income, Cash, Shareholders’ Equity (Retained Earnings), Deferred Revenue. See the diagram for a $100 decrease in Deferred Revenue. 4) Non-Operational Balance Sheet Item or Cash Flow Statement Item Changes These items are simple because there are no Income Statement changes. All that happens is that there’s a net inflow or outflow of cash on the Cash Flow Statement, and both Cash and the corresponding Balance Sheet item change. Below, we list a few common examples with the corresponding Balance Sheet item that changes in parentheses: •

•

Examples: Purchasing or Selling Securities (Short-Term or Long-Term Investments), Capital Expenditures (PP&E), Selling PP&E (PP&E), Raising Debt (Debt), Paying Off Debt (Debt), Issuing Stock (Common Stock & APIC), Repurchasing Stock (Common Stock & APIC), Issuing Dividends (Retained Earnings) What Changes as a RESULT of These Items Changing: Cash and the corresponding Balance Sheet item.

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•

How the Balance Sheet Balances: Cash and the corresponding Balance Sheet item both change.

Most of these changes are very straightforward – if you have any doubts at all, please see the 3-statement model we include and you’ll understand how everything works. Return to Top.

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Equity & Enterprise Value Overview and Key Rules of Thumb If you want to value companies and model transactions, you need to understand Equity Value and Enterprise Value first. This is the shortest technical section of the interview guide because there aren’t that many questions they could ask you on this topic – at least, not compared to the number of possible questions on accounting, valuation, DCFs, merger models, and LBO models. But the concepts here and the key rules of thumb are very important to understand. If you get them right, you’ll understand the later technical sections in this guide more effectively as well. Just as with the other technical sections, we’re going to start with the concepts and key rules of thumb and then move onto the 3 main categories of questions you could get: 1. Basic Conceptual Questions (“What’s the difference between Equity Value and Enterprise Value?”) 2. More Advanced Conceptual Questions (“Why would you subtract the value of Net Operating Losses when calculating Enterprise Value?”) 3. Calculation Questions (“A company has 100 basic shares outstanding. Calculate its diluted shares outstanding if it has…”) Let’s get started with the key rules first:

Key Rule #1: Equity Value and What It Means Equity Value, otherwise known as Market Capitalization or Market Cap, just means: Share Price of Company * Total Number of Shares. At a basic level it answers a simple question: “How much is this company worth?”

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If you have 1,000 shares outstanding and each one is worth $10.00, for example, you’re worth $10.00 * 1,000, or $10,000. Most public companies are worth hundreds of millions or billions of US Dollars. When you read about “a $10 billion company” in the news, usually the “$10 billion” refers to the Equity Value of the company. There is nothing complicated about determining a company’s share price; calculating the total number of shares can require more work, because there’s Basic Equity Value and Diluted Equity Value , which we’ll get into in Key Rule #3 below.

Key Rule #2: Enterprise Value and What It Means If you compare buying a company to buying a house, Equity Value is like the “sticker price.” You’re driving by and you see a nice house… or a nice company… how much does it cost to buy it? Well, according to the sign on the front lawn, it’s on sale for $500,000. And in the same way, maybe the company’s Equity Value is $500 million (50 million shares * $10.00 per share). But is that the true price to buy the house – or the company? Nope! There are additional items that might push up the effective price afterward, or possibly push down the effective price. For a house, these might be: • • •

The previous owner left lots of furniture – we can save some money! We need to make significant repairs or improve the landscaping. There are unpaid bills or other obligations that we need to pay off.

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So the actual cost of buying that house may be much different from the sticker price. In the same way, the actual cost of buying a company may also be much different from its “sticker price” – its Equity Value: • • •

The company might have Debt that needs to be repaid upon acquisition. The company might have Excess Cash that we can claim for ourselves. The company might have Unfunded Pension Obligations and other Liabilities that we’ll have to repay at some point.

To take into account all of those, we calculate Enterprise Value. Think of it like this: Enterprise Value = Equity Value + Debt, Debt-Like Items and Other Obligations – Cash, Cash-Like Items, and Anything That Saves Us Money. Essentially we add anything that we’re going to have to set aside funds to pay off in the future, and subtract anything that can save us money in the future. A more precise definition would be: Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests – Cash & CashEquivalents. We’ll discuss each of those items and why they get added or subtracted, as well as a few more advanced items, in Key Rule #4 below.

Key Rule #3: Diluted Shares Outstanding Calculating the exact number of shares a company has can be tricky due to dilutive securities. A security is “dilutive” if it could potentially create more shares. The best example is a call option , which gives someone (usually an employee) the ability to pay the company money and get a newly created share in return.

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Let’s say that a company’s stock is worth $10.00 per share right now. It has also issued call options to employees that have exercise prices of $5.00 per share. In other words, employees can pay the company $5.00, and in exchange, receive one (1) share that’s worth $10.00 each time it pays the company $5.00. Of course, these options might also be out-of-the-money – for example, if the exercise price is $15.00 rather than $5.00, the options can’t be exercised until the stock price hits $15.00 per share. If employees have in-the-money options, why would they wait to exercise them? One reason is the expectations of future value. If they think that the share price will rise to $20.00 next week, they’ll most likely hold onto their options. Also, employees may be restricted from exercising their options depending on how long they’ve worked at the company in question. But the potential for additional shares is always there… and that is what we care about when calculating the diluted shares for a company. To calculate the impact of diluted shares , you use the Treasury Stock Method: you assume that the new shares get created when options are exercised, and that the company then buys back some of those new shares with the funds it receives. Simple Example: Let’s say that the company’s share price is $10.00 and that 100 options were issued at $5.00 exercise prices. The option holders exercise those options and get 100 shares – and the company receives $500 in cash as a result. Since its share price is $10.00, it can therefore buy back 50 shares with the proceeds. So as a result, there are 50 additional shares outstanding and the diluted share count goes up by 50.

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With the Treasury Stock Method (TSM), you assume that all in-the-money options contribute to dilution. Options are the most common dilutive securities, but there are others: •

•

• •

•

Warrants: The treatment is similar to options; use the Treasury Stock Method. Convertible Bonds: Treatment is “either or” – they count as debt, or count 100% as additional shares, with no Treasury Stock Method involved – see the Calculations questions below for an example. Convertible Preferred Stock: The same as the treatment above for Convertibles. Restricted Stock Units: These are a straight addition – there are no exercise prices or conversion prices to worry about. Performance Shares: If the stock price is above a certain level, they count as additional shares; otherwise, they count as nothing.

Why bother with this extra math to calculate the Diluted Equity Value of a company? For the same reason we calculate Enterprise Value: to see what it would really cost to acquire a company. When you buy another company, the purchase agreement normally states that any inthe-money dilutive securities get cashed out or get converted into an equivalent number of the buyer’s securities. Either of those scenarios would cost the buyer something when it acquires the company in question. So it’s more accurate to calculate the Diluted Equity Value when you’re determining the Enterprise Value – otherwise you’re underestimating how much the company would truly cost to acquire.

Key Rule #4: Items That Go Into Enterprise Value

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In this section, we’re going to cover the more common items that are added and subtracted when calculating Enterprise Value (i.e. when you start with Equity Value, and then add and subtract items to better approximate a company’s true value). •

•

When Do You Subtract an Item? Normally when it saves you money or potentially gives you extra cash, either immediately or in the long-term. When Do You Add an Item? Normally 1) When it represents something that must be paid immediately upon acquiring the company (e.g. Debt), or 2) When it’s something that must be repaid in the future, but wouldn’t come from the company’s normal cash flows (e.g. Unfunded Pension Obligations); or 3) When you’re adding it back for comparability purposes (e.g. Noncontrolling Interests).

Here are a few examples of items that you would subtract: •

•

•

Cash: This saves you cash right away because it’s yours once you buy the company; technically you should only subtract excess cash (i.e. the amount over the minimum they need to operate) but normally you subtract the entire amount. (Potentially) Short-Term, Long-Term, and Equity Investments: You could sell these investments in the future and get extra cash, so sometimes they’re also subtracted – depending on how liquid they are. Net Operating Losses: These could potentially save you cash as future tax deductions, so sometimes they are factored in (standards vary widely).

Now let’s go through a few examples of items that you add because they normally require immediate repayment in an acquisition scenario: •

•

Debt: It’s added because the acquirer normally has to repay it upon completing the acquisition. Preferred Stock: It’s similar to Debt because of the required dividends, which act as interest expense; also, normally it must also be repaid upon acquisition.

Then there are items that get added because they must be repaid in the future, but wouldn’t

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necessarily come from the company’s normal cash flows: •

•

•

Unfunded Pension Obligations: This is a big one for certain types of companies (e.g. auto manufacturers). If they have nowhere near enough cash flow from normal business operations to pay for these, they’ll need to get the money from somewhere… which means that the buyer is paying, or that they’re raising debt to pay for them. Capital Leases: These are “Debt-like items” and sometimes you have to repay these leases in an acquisition; similar to Unfunded Pension Obligations, often you add them because the funds from ordinary business operations are insufficient to repay these. Restructuring / Environmental Liabilities: The logic is similar to the points above – these must be paid in the future to cover obligations that the company owes, and if they’re significant the company probably won’t be able to cover them with its normal cash flow.

There’s only one common item in the final category – items that you add back for comparability purposes: •

Noncontrolling Interests (AKA Minority Interests): You add these because when you own over 50% of another company, you consolidate 100% of its financial statements with your own. But Equity Value only reflects the value of the percentage that you own , not 100%. So you need to reflect 100% of that other company in Enterprise Value – if you did not add Noncontrolling Interests, you would only be reflecting 60%, or 70%, or however much you own.

Let’s say that your revenue is $100, and you own 70% of another company that has $50 in revenue. On your statements, you show $150 in revenue because you consolidate 100% of the statements (see the Accounting section of the guide). But Equity Value, by itself, only reflects the 70% of the other company that you own. An Enterprise Value / Revenue multiple would be wrong because we would have 100% of the other company’s revenue , but only 70% of its value.

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As a result, we need to add the Noncontrolling Interests line item that reflects the 30% we do not own – that way, we’re including 100% of the other company’s value in Enterprise Value. Do you need to know all the explanations above in an interview? No, not really – these more advanced items are unlikely to come up in entry-level interviews. But it’s good to have some intuition behind why items get added or subtracted when calculating Enterprise Value.

Key Rule #5: Which One to Use? With this last rule, we move into Valuation territory – which is technically the next section of the guide. You will almost always calculate both Equity Value and Enterprise Value for a company. In fact, you need to calculate Equity Value before you can even calculate Enterprise Value. The only exception is that in some industries, such as commercial banking and insurance, only Equity Value is meaningful – see the industry-specific guides for more on those. So it’s not a question of “Which one is more useful?” since you’ll almost always look at both. The real questions: What do they mean and when do you use each one? We’ve already covered what they mean: Equity Value is like the “sticker price” and Enterprise Value is how much the Available to All Investors company would actually cost to acquire. Before Net Interest Expense (Equity and Debt) – (and possibly Debt Payments) Interest (and possibly Debt Payments)

Enterprise Value Paid to Debt Investors – They’re out of the equation now.

Their usage depends on what’s in the denominator when calculating valuation multiples.

Only Available to Equity

If the denominator includes interest income and expense , you use Equity

After Net

Interest (and possibly Debt Payments)

Investors – Equity Value

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Value; if it is does not include interest income and expense , you use Enterprise Value. Think of a company’s cash flow like a funnel: at the top, before any interest (or debt principal) is paid, that cash flow is available to both Equity and Debt investors, and so it therefore corresponds to Enterprise Value. Whereas after interest (and possibly debt principal) is paid, now the Debt investors are entitled to nothing and everything remaining only goes to the Equity Investors. Here’s a list of the key metrics you could use in the denominator of valuation multiples, along with what you should use in the numerator: • •

• •

•

•

Revenue: Enterprise Value EBIT or Operating Income: Enterprise Value EBITDA: Enterprise Value Net Income (EPS): Equity Value (Per Share Price) Unlevered Free Cash Flow (Free Cash Flow to Firm): Enterprise Value Levered Free Cash Flow (Free Cash Flow to Equity): Equity Value

There are more valuation multiples, but the ones above are the more common ones. When in doubt, think: “Does this include interest income and expense, i.e. do we subtract interest expense and add interest income to get to this metric?” If it does, use Equity Value; if it does not , use Enterprise Value. Return to Top.

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Valuation Overview and Key Rules of Thumb There is a 99.9% chance that you will get questions about Valuation in any finance interview – whether you’re interviewing at an investment bank, private equity firm, hedge fund, in equity research, or even in private wealth management. That’s because Valuation is core to everything you do in finance and investing: Is a company undervalued? Overvalued? Should we buy it or sell it right now? Or hold off and wait? Bankers expect you to know 3 main points when it comes to Valuation: 1. How do you value a company, i.e. what are the key methodologies, metrics, and multiples to use? 2. What does a valuation tell you, and how can you interpret the results? 3. Why do valuations matter, and what do they mean in the real world? A long time ago, questions were more focused on the very basics of valuing companies. You could still get those questions in interviews, but expectations tend to be higher now and the trend is toward explaining and analyzing different methodologies and the trade-offs between them – plus, how valuation works with real companies. Just as in the previous technical sections of this guide, we’re going to divide this into 5 Key Rules first and cover the most important points in the beginning. After that, you can test your knowledge and play around with the numbers with the Valuation Model we have provided, as well as the Interactive Quiz that covers all categories of questions. Then, we’ll go into several different question categories for both the Basic and Advanced questions and walk through dozens of questions and answers in each category.

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One final note: we do not cover the Discounted Cash Flow (DCF) analysis in detail here, because that is addressed in a completely separate section of the guide. There are so many possible DCF-specific questions and answers that we wanted to separate it from the rest and provide more specific rules and steps.

Key Rule #1: How Do You Value a Company? Fundamentally, there are only 2 ways to value a company: relative valuation – comparing it to what similar companies are worth – and intrinsic valuation – estimating the net present value of its future cash flows, or estimating how much its Assets are worth, net of Liabilities. All valuation methodologies are just variants of these two. With relative valuation , you mostly look at other public companies (Comparable Public Companies, AKA Public Comps) and recent M&A deals (Precedent Transactions) to estimate what your company might be worth. Simple Example: Three companies similar to yours in revenue growth, profit margins, and industry focus have recently sold for 3x annual profits, 5x annual profits, and 4x annual profits in the past year. From that, you might conclude that your own company is worth around 4x annual profits, since that’s the median profit multiple of the set. In real life you use more formal metrics than just “annual profits” – that’s why you see items like EBIT, EBITDA, and Unlevered FCF that have very specific line items on the financial statements added back, subtracted, and excluded. On the intrinsic valuation side, most methodologies come down to 1) Estimating future cash flows and discounting them back to their present value – because money today is worth more than money tomorrow – or 2) Valuing the firm’s Assets and assuming that the firm’s total value is linked to its adjusted Asset value minus its Liabilities in some way.

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We go into the Discounted Cash Flow Analysis (DCF) in the section of this guide dedicated to that; the basic idea is that a firm’s value is the sum of its discounted future cash flows and its discounted terminal value – whatever it’s worth at the end of the 510 year period you analyze. Simple Example: A firm’s future free cash flows are $100, $120, $140, $160, and $180 over a 5-year period. You assume a Discount Rate of 10%, so the Net Present Value of those is approximately $516. You estimate that the company can be sold for $1,000 at the end of year 5 in your analysis. The present value of that $1,000 is $621 ($1,000 / (1 + 10%)^5). Therefore, the company’s total value is $1,137 ($516 + $621). As an alternative to the DCF, you can also value a firm’s Assets and Liabilities , subtract the modified Total Liability Value from the modified Total Asset Value, and assume that this number reflects its value. That methodology is called a “Net Asset Value” or “Liquidation” model, and it is more common in Balance Sheet-centric industries such as insurance. So, When Do You Use Which Methodology? You will almost always use Public Comps and Precedent Transactions to value companies in any industry, because they are universally applicable. If you were buying a house or car, for example, you would always look at what similar houses or cars have sold for in the market. The only difference is that you will use different metrics and valuation multiples depending on the industry (see the next section). For example, if you were valuing a commercial bank vs. a healthcare company, you would always look at comparable public companies and comparable M&A deals, but you would use different metrics and multiples in your analysis (see the next section).

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In most “standard” industries (e.g. consumer/retail, technology, healthcare, industrials) you almost always use a Discounted Cash Flow analysis to value the company based on its cash flows. In some industries, the DCF analysis is not relevant because: 1) “Free Cash Flow” is not a meaningful metric; or 2) The industry is asset-centric and so you’re better off valuing the company’s Assets and Liabilities. Industries Where the DCF is Not Relevant: Commercial Banks, Insurance Firms, (Some) Oil & Gas Companies, Real Estate Investment Trusts (REITs). Public Comps and Precedent Transactions work best when there’s a lot of good market data and there are truly similar companies; they don’t work as well when the data is spotty and/or when the company you’re analyzing is unique and can’t be easily compared to others. The DCF analysis works well for stable, mature companies with predictable growth rates and profit margins; it doesn’t work as well for high-growth start-ups, companies on the brink of bankruptcy, and other situations where growth and margins are artificially high, low, or unpredictable. One of the most common, incorrect , lines of reasoning is that a DCF will always produce higher values because it’s dependent on future assumptions. The DCF can produce higher numbers, but it won’t necessarily do that: the DCF is simply more dependent on assumptions than the relative valuation analyses. You could make extremely conservative assumptions in a DCF that result in lower valuations as well. Generally , Precedent Transactions will produce higher numbers than Public Comps because a buyer must pay a premium to acquire 100% of another company. If a company’s share price is $20.00, it wouldn’t sell for only $20.00 per share – a buyer might have to offer $25.00 per share, or $30.00 per share, to entice it to sell.

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So if you calculate EV / Revenue or EV / EBITDA multiples for a set of public companies in an industry and recent transactions for that same industry, the multiples are often higher for the set of transactions. There is no “best” methodology and there is no “correct” number that tells you what a company is worth – it’s very subjective. You use all these methodologies not to determine a precise number (e.g. “The company is worth $1.04 billion!”) but rather to estimate a valuation range (e.g. “Based on these methodologies, the company might be worth between $900 million and $1.1 billion”). How Do You Pick Companies and Transactions? For the assumptions to use in a DCF please refer to that section of the interview guide; we don’t want to repeat it here because the proper assumptions are covered in-depth there. To pick comparable public companies , you use the following criteria: 1. Geography (US? China? Europe? South America?). 2. Industry (Diversified Consumer? Food and Beverages specifically?). 3. Financial (Revenue or EBITDA above, below, or between certain numbers). Here’s an example from the Valuation model that accompanies this guide:

You can see how we’ve applied those criteria here: •

Geography: US-Based

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• •

Industry: Diversified Industry: Diversified Food and Beverage Companies Financial: Between Financial: Between $1 Billion and $10 Billion in Revenue

You may tweak these assumptions and cut or add companies as you continue with the analysis; senior bankers often have their own idea of what should be in there and you’ll have to change your assumptions to support their ideas. transactions is similar, but there’s one additional criterion: Picking precedent transactions is 1. 2. 3. 4.

Geography (US? Geography (US? China? Europe? South America?). Industry (Diversified Industry (Diversified Consumer? Food and Beverages specifically?). Financial (Revenue Financial (Revenue or EBITDA above, below, or between certain numbers). Time (Transactions Time (Transactions Since… or Transactions Between Year X and Year Y).

Here’s what that might look like for a valuation done in the same industry as shown in the Public Comps selection above:

And yes, we are cheating by listing the timeframe as “Since January 1, 20XX” – that is because I am paranoid about this guide looking “out of date” so I’ve left out the dates date s here. In real life you would list the timeframe as “Since January 1, 2001” or “Since January 1, 2011” or “Since January 1, 2051” depending what year you’re in and how far you want to go back.

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Time is Time is very important for M&A deals because markets change over time – imagine if you looked at Internet company valuations during the late 90’s and then compared them to valuations 5 years later. Multiples are only meaningful when you limit the transactions to a specific time period. period. What About Other Methodologies? There are a few other valuation methodologies to be aware of, even in entry-level interviews. Let’s start with Asset-Based Valuations (alternatives Valuations (alternatives to the DCF Analysis): •

Liquidation Valuation – Valuation – You value a company’s Assets, assume they are sold to repay its Liabilities, and that whatever remains goes to Equity Investors and is the company’s Equity Value. This one also goes by a few other names, including the “Net Asset Value” model.

There are some industry-specific variations here as well – for example, there are “Net Asset Value” models in real estate, oil & gas, and insurance, and they’re all slightly different. Please see the industry-specific sections of the guide for details on those. Comps and Precedent Transactions: Then there are variants on Public Comps and •

•

M&A Premiums Analysis – Analysis – You still select Precedent Transactions but instead of calculating valuation multiples you calculate the premium that premium that the buyer paid for the seller in each case (e.g. if the buyer paid $30.00 per share and the seller’s share price was $20.00, that was a 50% premium). Future Share Price Analysis – Analysis – You project a company’s future share price based on the P / E (or other) multiple of comparable companies, and then discount it back to its present value.

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•

Sum of the Parts – Parts – You split a company into different segments (e.g. Chemicals, Manufacturing, and Consulting Services), pick different sets of Public Comps and Precedent Transactions for each, assign multiples, value each division separately, and then add up all the values at the end to determine the company’s total value.

One final methodology is the Leveraged Buyout (LBO) Analysis – Analysis – there, you assume that a private equity firm acquires a company and needs to achieve a certain Internal Rate of Return (IRR), such as 15% or 20%... and work backwards to calculate how much they could potentially pay to achieve that return. It’s a variation on the DCF analysis because you still value a firm via its future cash flows – only those cash flows are used to repay debt.

Key Rule #2: Which Metrics and Multiples Do You Use? This is very dependent on the industry you’re analyzing and what stage of growth the company is in. You will generally use a Revenue Multiple (Enterprise Value / Revenue), which measures how valuable a firm is relative to its Net Sales, as well as a Profitability Multiple to assess how valuable it is relative to its Profits (P / E, EV / EBITDA, EV / EBIT, EV / Unlevered FCF, or Equity Value / Levered FCF, all of which measure different things). Often, you will use two or more Profitability Multiples to gain a better perspective on what the company might be worth. Before going into what these multiples mean, let’s take a step back for a second and explain how to calculate each calculate each metric that you use here: • •

P / E: Price E: Price Per Share / Earnings Per Share, or Equity Value / Net Income. EBIT (Earnings Before Interest & Taxes): This Taxes): This is the company’s Operating Income from Income from its Income Statement, or Revenue – COGS – Operating Expenses. includes the impact of Depreciation, Amortization, and perhaps other nonThis includes the cash charges.

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•

•

•

EBITDA: EBIT + Depreciation + Amortization. The idea here is to remove most of the non-cash charges and make it more accurately reflect cash flow potential. You may add back other non-cash charges, such as Stock-Based Compensation, as well. Unlevered Free Cash Flow (Free Cash Flow to Firm): There are a few ways to calculate this (see the DCF section); one method is EBIT * (1 – Tax Rate) + NonCash Charges – Change in Operating Assets and Liabilities – CapEx. Levered Free Cash Flow (Free Cash Flow to Equity): Again, there are a few methods to calculate this (see the DCF section); one method is Net Income + NonCash Charges – Change in Operating Assets and Liabilities – CapEx – Mandatory Debt Repayments.

These Profitability Multiples all measure different things: Multiple Name: Enterprise Value / EBIT

Enterprise Value / EBITDA

P/E

Equity Value / Levered FCF

•

•

•

•

Used For: Used for many types of companies; most useful for those where CapEx is more important to factor in (Since D&A follows CapEx closely) Used for many types of companies; most useful for those where CapEx and D&A are not as important since it excludes both Used for many types of companies; most relevant for banks and financial institutions; distorted by non-cash charges, capital structure, and tax rates Not very common because it requires more work to calculate and may produce wildly different numbers depending on capital

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•

•

•

•

What Does It Mean? Rough approximation of how valuable a company is relative to its income from business operations Rough approximation of how valuable a company is relative to its operational cash flow Rough measure of how valuable a company is in proportion to its aftertax earnings Most accurate measure of a company’s true “cash flow” and how valuable it is relative


Enterprise Value / Unlevered FCF

•

structure Used when CapEx or changes in Operational Assets and Liabilities such as Deferred Revenue have a big impact; also critical in DCFs

•

to that Similar to Levered FCF, but it’s capital structure-neutral – so better for comparing different companies

Of these multiples, EV / EBITDA and EV / EBIT are by far the most common in finance. P / E is probably the “worst” (or at least, “least accurate”) multiple for the reasons stated above – it includes non-cash charges and is impacted by tax rates and capital structures – and is more common among the general public than finance professionals. The Free Cash Flow multiples are “more accurate” than the EBIT and EBITDA multiples, but there are two problems with using them: 1. They take more time to calculate and you have to go through the company’s financial statements in detail. 2. They may not be standardized because companies include very different items in the Cash Flow from Operations section of their Cash Flow Statements. So that is why EBIT and EBITDA multiples tend to be more common: convenience and comparability. Book Value Multiples (Equity Value / Book Value, or Price per Share / Book Value per Share) are also common; they tell you how valuable a company is relative to its Balance Sheet. Book Value is just another word for “Shareholders’ Equity” (with slight adjustments sometimes). But the problem is that P / BV multiples have become less relevant over time for most industries because most companies’ Equity Values are vastly different from the Shareholders’ Equity on their Balance Sheets.

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That happened because companies have become more and more service-oriented and intellectual property-oriented over time – whereas when Benjamin Graham wrote The Intelligent Investor , Balance Sheet Assets were much more important for most companies. Depending on the industry you’re in, there may be specific multiples you need to use as well (see the industry-specific sections for more detail). A few examples: •

•

•

•

Retail, Restaurant, and Airlines: EV / EBITDAR (R stands for “Rent” – you add back the rental expense) is often used for comparability purposes because some companies own buildings and others rent them. Oil & Gas Companies: EV / EBITDAX (X stands for “Exploration” – you add back the exploration expense) is often used for comparability purposes because some companies capitalize (portions of) this expense whereas others expense it on their Income Statements. EV / Proved Reserves and EV / Daily Production multiples are also common because those are very important in energy. Real Estate: P / FFO (Funds from Operations) per Share and P / AFFO (Adjusted Funds from Operations) per Share multiples are widely used because they are more accurate than P / E for REITs since they add back Depreciation (massive non-cash charge) and Gains / (Losses). Internet Companies: Here, it’s common to see multiples like EV / Unique Visitors or EV / Registered Users if the company has not yet reached profitability or isn’t even generating revenue.

And the list goes on. You can make a valuation multiple out of almost any metric you want, and you’ll see variants like EV / # of Beds in Healthcare, EV / Subscribers in Telecom, and EV / Passenger Miles for Aerospace & Defense. You don’t need to memorize all these metrics and multiples: just be aware that they exist and that they depend on the industry you’re working in. Once you’ve calculated all the relevant multiples, you normally find the minimum, maximum, median, 25 th percentile, and 75 th percentile each year and then apply them to the company’s own financial figures.

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If the company’s EBITDA is $100 million and the median EV / EBITDA multiple of the set is 10x, then the company’s implied valuation based on the median multiple of the set is $1 billion. You don’t necessarily just use the medians; you normally create a graph based on the full range of values (see below), and you may weight certain multiples more heavily or less heavily than others. You can see this concept in action in the diagram below:

This is a bit different from what’s described above because we’re calculating the Implied Share Price for Ralcorp (the company we’re valuing) rather than just multiplying 9.0x by their EBITDA of $672 million, for example. But the strategy is the same: we’ve calculated EV / Revenue and EV / EBITDA multiples for a set of comparable public companies, and now we’re applying all of them to Ralcorp’s own figures.

Key Rule #3: What Does a Valuation Mean? The most common incorrect interpretation of a valuation is that it tells you how much a company is worth. It does not – it only gives you a range of possible values for a company. When you value a company, the worst way to interpret the results would be to say, “Aha! Based on all 8 methodologies here, this company is worth exactly $1,423,987,176.00, or $23.41 per share.”

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Valuation is all about the potential range for a company’s value. A much better interpretation would be, “Based on all the methodologies here, the company is worth between $1.3 billion and $1.5 billion, or $21.37 to $24.66 per share.” Take a look at the “Football Field” graph below to understand how you would present the results: Public Company Comparables Year 1 EV / Revenue: Forward Year 1 EV / Revenue: Forward Year 2 EV / Revenue: Year 1 EV / EBITDA: Forward Year 1 EV / EBITDA:

Min to 25th 25th to Median

Forward Year 2 EV / EBITDA:

Median to 75th

Precedent Transactions

75th to Max

Trailing EV / Revenue: Trailing EV / EBITDA:

Discounted Cash Flow Analysis 6.5-8.5% Discount Rate, 7-11x Terminal Multiple: $0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

$180.00

You can see the enormous range implied by this particular valuation – it goes from close to $0.00 per share all the way up to over $160.00 per share. However, it is also incorrect to say, “Aha! The company might be worth anywhere from $0.00 per share to $160.00 per share based on this!” Normally, you would interpret this data using the following reasoning: “The 25 th percentile to 75 th percentile is between $60.00 and $80.00 for the transactions, and between $100.00 and $120.00 for the rest; so the company might be worth anywhere from $80.00 per share to $120.00 per share.” The graph above is extremely unusual because Precedent Transactions result in lower multiples than everything else… which means that we may not have picked the right set, or that this market is quite strange.

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And some companies have revenue multiples so low that the implied per share value is close to $0.00 based on those. We could make a good argument for excluding the EV / Revenue multiples altogether and just focusing on EV / EBITDA, and perhaps adding in P / E as well. Nevertheless, the graph above is also how you normally present the data to investors, potential buyers, and the company itself: you show a wide range of values to make sure no one takes it personally when they see a number they don’t like. A valuation like this might be used to give the company an idea of what it’s worth, or to see whether or not an acquisition offer is reasonable.

Key Rule #4: Trade-Offs and Correlations Advantages and Disadvantages of Different Methodologies: Methodology Public Comps Precedent Discounted Cash Name: Transactions Flow Analysis Based on real Based on what Not as subject Advantages: data as opposed real companies to market to future have actually fluctuations assumptions paid for other Theoretically companies sound since it’s based on ability to generate cash flow Disadvantages: There may not Data can be Subject to far be true spotty (especially in-the-future comparables for private co. assumptions Less accurate for acquisitions) Less useful thinly traded There may not be for faststocks or truly comparable growing, volatile transactions unpredictable companies companies •

•

•

•

•

•

•

•

•

•

And then for the more “exotic” methodologies:

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•

•

•

•

•

Liquidation Valuation: Good because it ignores “noise” in the market and determines value based on Assets and Liabilities; but it’s not useful for most healthy companies because it tends to produce extremely low values. M&A Premiums Analysis: Same issues as with Precedent Transactions. Also, you can’t use acquisitions of private companies for this because premiums only apply to public companies with stock prices. Future Share Price Analysis: Good because it tells you how much a company might be worth, theoretically, 1-2 years into the future; but bad because of its dependence on assumptions. Sum of the Parts: Good because it more accurately values diversified, conglomerate-type companies; but bad because often you lack the appropriate data for each division. Leveraged Buyout (LBO) Analysis: Good because it sets a “floor” on valuation by determining the minimum amount a PE firm could pay to achieve its returns; bad because it gives a relatively low / “floor” number rather than a wide range of values.

Remember that interviews have shifted more and more to understanding the concepts as opposed to reciting facts and formulas – so these trade-offs are likely to come up in interview questions. Comparing Expected Values from Different Methodologies There are few rules here because so much depends on assumptions and it’s very difficult to directly compare methodologies. Here’s what we can say: •

•

Precedent Transactions vs. Public Comps: Transactions tend to be higher due to the control premium, i.e. the premium the buyer pays to acquire the seller. But not always, as you saw from the valuation graph above for a real company. Discounted Cash Flow: It’s hard to draw conclusions about its value, but tends to be the most variable of the methodologies because of its dependence on future assumptions.

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•

•

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Liquidation Valuation: 99% of the time, this will produce the lowest numbers because most companies are worth significantly more than what their Balance Sheets suggest. Sum of the Parts: A bit obvious, but if a company truly is worth more in “parts” then this one will tend to produce higher values than relative valuation methodologies. LBO Analysis: Tends to produce lower values, usually lower than a DCF or relative valuation, but once again it’s dependent on assumptions.

There are very few hard-and-fast rules, and almost all of these guidelines have exceptions or do not hold up in many cases. So don’t get caught in a trap in interviews when they start asking you about how these different methodologies stack up in terms of numbers… in this world, only death and taxes are certain. The Link Between Metrics and Multiples Generally, there’s a correlation between growth rates and relevant multiples , and sometimes also between margins and multiples: •

•

All else being equal, a company with higher revenue growth will also have higher revenue multiples than companies not growing as quickly. Similarly, a company with higher EBITDA growth tends to have higher EBITDA multiples than companies not growing as quickly.

And you see the same behavior with the other profitability multiples as well. To account for this, you will sometimes calculate PEG (P / E Divided by EPS Growth) multiples to get a better view of a company’s real value. But keep in mind two other very important points as well: 1. These are just general , “all else being equal”-type rules. Plenty of other factors besides revenue/EBITDA/EPS growth rates impact the multiples… and there are many exceptions.

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2. Basic math can also impact the multiples, especially when companies have very different margins. On point #1, valuations are impacted by everything from lawsuit rulings to recent earnings announcements to (perceived) market leadership to competitive advantages not reflected in the financials (intellectual property, talented employees, etc.). On point #2, here’s a quick example of what we mean:

On paper, Company A’s Forward Year 1 EBITDA multiple is 15x and Company B’s Forward Year 1 EBITDA multiple is 10x… but is Company A really “more valuable?” It’s hard to say because both companies’ margins are very different. Multiples are most meaningful when growth rates and margins are in similar ranges. Advantages and Disadvantages of Multiples To recap briefly, EV / Revenue and P / E multiples, while easy to calculate, are taken the least seriously because 1) A company should be valued based on its profits , not its sales… earning revenue is easy, keeping it is hard; and 2) P / E is subject to non-cash and non-recurring charges, significantly different tax rates, the company’s capital structure, and a host of other problems. The other common multiples – EV / EBIT, EV / EBITDA, EV / Unlevered FCF, and Equity Value / Levered FCF – all have their strengths and weaknesses and you can review them above.

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P / BV multiples used to be common in 1930 or so, but nowadays they are mostly relevant for banks and insurance firms and not much else – companies’ Balance Sheets are far different from their true market values.

Key Rule #5: Valuation in the Real World We’ve touched on many of these points in the other sections above, but to recap: The entire purpose of a valuation is to give a client an idea of what it’s worth, to justify (or argue against) an acquisition offer or a price at which you invest, and also to approximate a company’s value for internal purposes. You always present a valuation via the “Football Field” graph shown above and you focus on ranges rather than specific numbers. A company may be valued at a premium or discount for many reasons, including its market position, competitive advantages that are not reflected in the financial statements (employees, IP, legal rulings, product benefits), and recent news and announcements. You can pick certain multiples and ranges or focus on them for many reasons – for example, if a company is truly outperforming its peers, maybe you’ll focus on the 75 th percentile in a set of comps when displaying the multiples and the “Football Field” graph. Accounting choices and oddities can also greatly affect valuation – for example, owning vs. leasing buildings makes a big impact on EBITDA. If you own a building, there’s Depreciation and Interest Expense (from the mortgage), neither of which are reflected in EBITDA. If you lease it, the rental expense does show up in EBITDA and reduces it. And then there are non-recurring charges related to Restructuring, Lawsuits, Asset Impairments, and all sorts of other things (see the Accounting section of the guide) – all of those can potentially affect valuation multiples, so you need to adjust for them and be aware of what the numbers truly tell you.

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One final point: what should you do if a company has no profit and/or no revenue? If it’s unprofitable (negative Net Income), you can still use revenue multiples or possibly cash flow-based multiples… but a DCF is relatively useless unless you project it far into the future. If it doesn’t even have revenue yet (e.g. Internet start-ups), then you can take one of two approaches: 1) In industries like Consumer Internet you can alternate metrics and multiples , such as Enterprise Value / Unique Visitors or Enterprise Value / Registered Users, or even more creative ones. 2) Sometimes for Biotech and Pharmaceutical companies, you will actually create a far-in-the-future, multi-stage DCF – it’s more acceptable there since potential profits from a drug with a known market size are easier to estimate than what a pie-in-the-sky Internet startup might be worth. Return to Top.

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DCF Overview and Key Rules of Thumb It would be shocking if you went through an interview and you did not get questions on the DCF analysis and related concepts like discount rates and WACC. Valuation is one of the core skill sets you use in investment banking, private equity, at hedge funds, in equity research, and anything else in finance, and the Discounted Cash Flow analysis is one of the key methods you use to value a company. Yes, there are plenty of downsides… and in some industries and for some companies it is not taken seriously. But it is still an extremely common topic in interviews, so you need to know it like the back of your hand – even if you’re interviewing for a group like FIG where it’s not as applicable. Here are the 5 main topics you need to understand with a DCF: 1. What it is , how you use it, and how to walk through a DCF analysis. 2. How to calculate and project Free Cash Flow (FCF) and how Levered Free Cash Flow (Free Cash Flow to Equity) differs from Unlevered Free Cash Flow (Free Cash Flow to Firm). 3. How to calculate the discount rate in a DCF and how to apply concepts like WACC and the Cost of Equity. 4. How to calculate the Terminal Value , what it means, and how it contributes to a DCF. 5. How different factors impact the output of a DCF and what changes have the biggest effect. We’re going to tackle those 5 topics in each of the sections below, bringing in the Excel DCF model included with this guide as necessary.

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Then, we’ll go through a comprehensive set of Basic and Advanced interview questions on the DCF that covers all topics – including a few questions that most working bankers would not even be able to explain (e.g. how to derive the Gordon Growth formula for Terminal Value).

Key Rule #1: DCF Concept and Walking Through It The basic concept behind a Discounted Cash Flow analysis is that a company is worth the present value of its future cash flows. What the “market” thinks the company is worth is irrelevant – all that matters is how much in real cash flow it generates in the future. Money today is worth more than money tomorrow, because you could always invest money today, earn interest on it, and end up with more in the future. So you have to discount all these future cash flows back to their present value to account for that “cost” – the time value of money. Example: Let’s say you estimate that a company’s future cash flows are $100 in Year 1, $120 in Year 2, and $140 in Year 3. You’re going to discount the cash flows at 10% per year because you believe you could earn 10% per year by investing your money elsewhere. So the discounted value in Year is $100 / (1 + 10%), or about $91, in Year 2 it’s $120 / ((1 + 10%)^2), or about $99, and in Year 3 it’s $140 / ((1+ 10%)^3), or about $105. Adding these up, the net present value is $295. This is the basic concept, but it gets more complicated for a simple reason: companies don’t just “stop” operating after a few years. They continue to generate cash flow far into the future, perhaps for decades or hundreds of years – and we need a way to estimate all those cash flows and discount them appropriately.

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You normally tackle this problem by dividing a DCF into 2 parts: the projection period (the near future) and the Terminal Value (the distant future). We assume that we can project a company’s cash flows more precisely over the next 510 years, so we project them, discount them, and add up everything for that period. Beyond that we say, “We can’t estimate cash flows as precisely, so let’s not even bother… but we can come up with an approximation (the Terminal Value) of how much the company might be worth into the distant future.”

So that is the basic concept: divide a company’s cash flows into a “near future” period and then a “distant future” period, determine the values for each period, and then discount them back to their present values since money today is worth more than money tomorrow. This concept is not rocket science, but the execution gets tricky: 1. How do you project cash flows for a company? 2. What’s the appropriate discount rate to use? 3. How do you estimate the Terminal Value , AKA what the company might be worth in that “distant future” period?

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We’ll go into detail on each of these points below. When you walk through a DCF in interviews, you should divide it into steps and say something like this: “In a DCF analysis, you value a company with the Present Value of its Free Cash Flows plus the Present Value of its Terminal Value. You can divide the process into 6 steps: 1. Project a company’s Free Cash Flows over a 5-10 year period. 2. Calculate the company’s Discount Rate, usually using WACC (Weighted Average Cost of Capital). 3. Discount and sum up the company’s Free Cash Flows. 4. Calculate the company’s Terminal Value. 5. Discount the Terminal Value to its Present Value. 6. Add the discounted Free Cash Flows to the discounted Terminal Value.” Now that we’ve been through the concept and the main steps in the analysis, we’ll go through each step in more detail.

Key Rule #2: Calculating and Projecting Free Cash Flow (FCF) If you’ve been through the Accounting and Valuation sections of this guide, you already know what “Free Cash Flow” means: how much after-tax cash flow the company generates on a recurring basis, after you’ve taken into account non-cash charges, changes in Operating Assets and Liabilities, and required Capital Expenditures. You calculate and use Free Cash Flow in a DCF because that closely corresponds to the actual cash flow that you, as the investor, would receive each year if you bought the entire company. It is far more accurate than metrics like Net Income and EBITDA, because those leave out big uses of cash like CapEx, and because those don’t take into account changes in cash due to items like Accounts Receivable, Accounts Payable, Inventory, and more. How do you project Free Cash Flow? The first step is to decide which kind of Free Cash Flow you need: Unlevered FCF (Free Cash Flow to Firm), which excludes net interest expense and mandatory debt repayments, or Levered FCF (Free Cash Flow to Equity), which includes net interest expense and mandatory debt repayments.

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99% of the time you care about Unlevered FCF, which is good news because it’s much easier to calculate. If you already have a 3-statement model for the company you’re valuing, this entire process is easy: you can pull all the numbers directly from there. But in interviews you won’t have that and so you’ll have to understand the Free Cash Flow calculation. If you’re calculating Unlevered FCF (we’ll go through Levered FCF after this), here’s what you do: 1) First, you project the company’s revenue growth , i.e. the percentage it grows revenue by each year over that 5-10 year “near future” period. From that, you can determine the company’s projected annual revenue based on the most recent historical numbers.

2) Next, you need to assume an operating margin for the company so that you can calculate its EBIT, or Operating Income, each year. Usually you base this on historical margins. So if they have $1 billion in revenue and a 30% EBIT Margin, that’s $300 million in EBIT.

3) Now, you apply the company’s effective tax rate to calculate its Net Operating Profit After Tax, or NOPAT. Continuing with this example, if the tax rate is 40% then the NOPAT is $300 million * (1 – 40%), or $180 million.

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4) Once you have this, you move to the Cash Flow Statement and project the 3 key items there that impact Free Cash Flow: Non-Cash Charges, Changes in Operating Assets and Liabilities, and Capital Expenditures.

5) The main Non-Cash Charges are Depreciation & Amortization; you may also project others, such as Stock-Based Compensation. You add them back here because you want to reflect how the company saves on taxes, but does not actually pay any cash for them. You can make these percentages of revenue. If we assumed they were equal to 5% of revenue here, we’d add back $50 million here.

6) Next, you estimate the change in Operating Assets and Liabilities. What this really means is, “If the company’s Operating Assets increase more than its Operating Liabilities, it needs extra cash to fund that… so it reduces cash flow. If its Liabilities increase more, that adds to cash flow.” You can make this a percentage of revenue as well – so if it’s 3% of revenue and Assets increase more than Liabilities, then we subtract $30 million here.

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7) Finally, you estimate Capital Expenditures each year, which always reduces cash flow. You might average previous years’ numbers, assume a constant change, or make it a percentage of revenue. In this case if CapEx is $50 million, that reduces cash flow by $50 million.

So what’s the Free Cash Flow in this case? You take NOPAT, $180 million, add back the $50 million of non-cash charges, subtract the $30 million change in Operating Assets and Liabilities, and subtract the $50 million of CapEx, so that FCF equals $150 million. Most of this is straightforward because we’re replicating the Cash Flow Statement, but excluding interest, debt repayments, and everything in Cash Flow from Financing.

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We’re also eliminating everything under Cash Flow from Investing except for CapEx because that’s generally the only recurring item there from year to year. We eliminate the entire Cash Flow from Financing section as well, because items there are either related to Debt (not applicable since this is Unlevered FCF) or to one-time events such as Equity Issuances and Share Repurchases. Operating Assets and Liabilities… Say What? You may be confused about the Change in Operating Assets and Liabilities , otherwise known as the Change in Working Capital or Change in Operating Working Capital. This section comes directly from a company’s Cash Flow from Operations section, and all you are doing here is the following: • • • •

If an Asset goes up , cash flow goes down… If an Asset goes down , cash flow goes up… If a Liability goes up , cash flow goes up… If a Liability goes down , cash flow goes down.

These are the exact rules we went over in the Accounting section of the guide. What makes this concept of “Changes in Operating Assets and Liabilities” confusing is that you’re combining many items into one single line. Let’s look at a few examples to make this clearer: Example #1: Let’s say that Accounts Receivable goes up by $10 and Inventory goes up by $10 and on the other side, Deferred Revenue goes up by $10. How does cash change here? The Operating Assets have increased by $20, which reduces cash flow, and Operating Liabilities have increased by $10, which increases cash flow. So overall cash flow is down by $10, and we would record this as a

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negative $10 in the “Changes in Operating Assets and Liabilities” line. Example #2: Now let’s say that AR goes down by $10, Inventory goes up by $10, Prepaid Expenses goes down by $10, and on the other side Accounts Payable goes up by $10 and Deferred Revenue goes up by $10. Here, cash flow is up by $30 because the Operating Assets have decreased by a net amount of $10, which boosts cash flow by $10, and the Liabilities have increased by $20 total, which also boosts cash flow by $20. All you’re doing in this section of the DCF is estimating the net cash flow impact from changes in these items. If the Operating Assets increase more than the Operating Liabilities, it’s a cash flow reduction, and vice versa. And if Operating Assets decrease more than the Operating Liabilities, it’s an addition, and vice versa. You exclude Cash because you’re calculating the Change in Cash at the bottom of the Cash Flow Statement; you also exclude Short-Term and Marketable Securities because those count as Investing Activities and are normally one-time purchases or sales. You exclude all changes in Debt here as well because issuing / repaying Debt is a Financing Activity. Do NOT fall into the trap of stating that this section has “only” Current Assets and Current Liabilities because that is not true at all… “Operating Assets and Liabilities” is the best way to state it. Unlevered vs. Levered Free Cash Flow One final point: how does this calculation change if we’re using Levered Free Cash Flow (Free Cash Flow to Equity) rather than Unlevered Free Cash Flow (Free Cash Flow to Firm)?

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The main difference is that you need to subtract interest expense and add interest income right after you calculate EBIT. So effectively, you use something closer to Net Income rather than NOPAT. And then you also need to subtract mandatory debt repayments after you subtract CapEx – so if the company must repay, at the minimum, $20 million in debt per year, that would be subtracted in the Levered FCF calculation. Projecting Levered FCF can be considerably more time-consuming because you need to know how the company’s Debt and Cash balances change from year to year – so you need to track those as well. And then you need to hunt through its filings to find the required debt repayments each year. To make things even more confusing, sometimes you’ll see alternate definitions for Levered FCF: some people will add additional borrowings (debt issuances) and subtract even optional debt repayments, for example. We don’t view those definitions as correct because neither one is required for the company to continue operating and paying off its Debt and Interest each year. In an interview, you are best off avoiding this issue altogether by sticking with Unlevered FCF unless they ask you about Levered FCF specifically – and if they do, stick to the definition we outlined here, where the differences lie in interest and mandatory debt principal repayments.

Key Rule #3: Discount Rates and WACC After the calculation of Free Cash Flow, the Discount Rate probably causes the greatest amount of confusion in DCF models. You need to discount both the company’s future Free Cash Flows and its Terminal Value because of the time value of money. Yes, it’s great to earn $100 in cash flow each year from an asset… but if you invested that money in something else today , what could you earn on it?

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There’s also another way to interpret it: what return are investors expecting to earn, at the minimum, when they invest in this company? The Discount Rate therefore reflects not just the time value of money, but also the return that investors require before they can invest. It also represents the “ risk” of a company, because higher potential returns correspond to higher risk. All else being equal, smaller companies tend to have higher Discount Rates than larger, more mature companies because investors expect that they will grow more and deliver higher growth, profits, and returns in the future. And they’re also “riskier” than large companies. Companies in emerging markets also have higher Discount Rates than companies in developed markets, because the potential growth, returns, and risk (the government could collapse, mercenaries could take over, etc.) are all higher. You estimate a company’s Discount Rate by separating its capital structure into components – normally Equity, Debt, and Preferred Stock – and calculating the “cost” of each one. The “costs” of Debt and Preferred Stock are simple and intuitive: you use the Interest Rate on Debt or the Effective Yield on Preferred Stock (e.g. if it’s a $100 million issuance and pays $7 million in Preferred Dividends each year, it’s 7%). Sometimes in real life you will see variations and adjustments, particularly when the market value of Debt drifts significantly from the book value. But for interview purposes, Interest Rate on Debt = Cost of Debt. Calculating the Cost of Equity “But wait,” you say, “issuing Debt or Preferred Stock costs the company something in the future, but how does issuing Equity ‘cost’ it anything?” Equity costs the company something in two ways:

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1. If the company issues Dividends to common shareholders, that is an actual cash expense. 2. By issuing Equity to other parties, the company is giving up future stock price appreciation to someone else rather than keeping it for itself. These “expenses” are tricky to estimate because the company’s share price changes over time. So for #1, you can’t just assume a simple Dividend Yield and base everything on that. In practice, here’s the method you normally use to estimate Cost of Equity: Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta The “Risk-Free Rate” means, “What interest rate could we earn by investing in a ‘risk-less’ security, such as 30-Year US Treasury notes?” If you’re in another country you would use the going rates on government bonds in that country. The Equity Risk Premium is the extra yield you could earn by investing in an index that tracks the stock market in your country of choosing. The theory behind this number: “Well, yes, we could get 2% or 3% or 4% interest by investing in boring government securities, but that’s… boring. We could make more by putting our money into the stock market instead, since historically the stock market has generated higher returns than these government bonds!” What number do you use for this Equity Risk Premium? No one knows. You will see a wide range of values there, from 3% to 10% to everything in between, because finance professors, textbook authors, bankers, and analysts all have different views about what this “Equity Risk Premium” should really be. Generally you use a number in the middle of this range; some banks also use a publication called Ibbotson’s that provides estimates each year.

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The last part of the equation, Beta , refers to the “riskiness” of this company relative to all other companies in the stock market. If Beta = 1, that means that the company is just as risky as the overall index. If the market goes up by 10%, this company’s stock will go up by 10%. If Beta = 2, the company is twice as risky as the market; if the market goes up by 10%, this company’s stock will increase by 20%; and if the market goes down by 10%, this company’s stock will go down by 20%. You could just use the company’s historical Beta (e.g. how its own stock has moved up or down in relation to the market as a whole) for this. The more popular method, though, is to make your own estimate for Beta by using the Public Company Comparables for the company you’re valuing and assuming that the company’s “true” Beta is different from what the historical data suggests. Un-levering and Re-levering Beta The reason you go through this exercise is because of the assumption that the company’s “true” riskiness is more in-line with how risky similar companies in the market are than to its own historical track record. In a Valuation you might say, “Well, right now the company’s Enterprise Value based on its current share price is $1 billion. But based on the median multiples that similar companies are trading at , it appears that it should be valued at $1.2 billion instead.” You’re doing the same thing with Beta: it’s about figuring out what a company’s “riskiness” should be rather than what it is currently. The first step: you look up Beta for each company in the set of Public Company Comparables you’re using to value the company. Then, you un-lever Beta for each

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company using the following formula: Unlevered Beta = Levered Beta / (1 + (1 – Tax Rate) * (Debt / Equity Value)) What this formula means: We’ve been saying that Beta represents “risk.” If you think about it, there are two types of risk with a company: the inherent, business risk, and then the risk that comes from Debt – e.g. defaulting on the debt, not being able to pay interest, and so on. We’re removing the additional risk from Debt with this formula. The bottom part is saying, “Let’s assume that this risk from Debt is directly proportional to the company’s Debt / Equity ratio. But remember that interest paid on Debt is also tax-deductible, and as a result that helps reduce the risk from Debt slightly, since we save on taxes.” Example: The company’s “Levered Beta” (i.e. the number you find when you look it up) is 1.0. Its tax rate is 40% and it has $200 million in Debt and an Equity Value (Market Cap) of $1.0 billion. Here, Unlevered Beta = 1.0 / (1 + (1 – 40%) * ($200 / $1000)) = 1.0 / (1 + 60% * 20%) = 0.89. If you ignore this company’s Debt, it’s less risky than the market as a whole. The next step is to calculate this Unlevered Beta for all the Public Comps, take the median, and then re-lever it to calculate the approximate Levered Beta for the company we’re valuing. You do this because you want to determine the company’s true, inherent business risk , based on the comps. But if the company has Debt, it’s not fair to ignore that altogether in the calculation. Debt does create additional risk and we need to account for it. We can re-lever Beta for the

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company by multiplying by that term above instead: Levered Beta = Unlevered Beta * (1 + (1 – Tax Rate) * (Debt / Equity Value)) Here we’re saying, “Now let’s increase Unlevered Beta by however much additional risk the Debt adds, also taking into account that the tax-deductible interest reduces risk as well.” You can then use either the company’s Historical Beta or its Calculated Beta (that you found by un-levering and re-levering Beta): Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta.

To recap: We estimate Cost of Equity by approximating what a stock’s potential return in the future might be via the formula above. We un-lever Beta to isolate inherent business risk, and then we assume that the company we’re analyzing has that same inherent business risk; then we re-lever it to capture the total risk, including inherent business risk + risk from Debt. One final note: there is an alternate formula for Cost of Equity: •

Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends

We generally don’t use that because not all companies issue Dividends. But it can be useful for companies in industries such as Utilities that issue and grow Dividends at stable, predictable rates. Calculating the Weighted Average Cost of Capital (WACC)

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Now we get to the easy part: calculating the Weighted Average Cost of Capital (WACC). WACC = Cost of Equity * % Equity + Cost of Debt * % Debt * (1 – Tax Rate) + Cost of Preferred Stock * % Preferred Stock.

You’re determining the “cost” of each part of a company’s capital structure, and then calculating a weighted average based on how much Equity, Debt, and Preferred Stock it has. You multiply by (1 – Tax Rate) for Debt because interest payments are tax-deductible and so Debt will (almost) always cost a company less than Equity or Preferred Stock (Preferred Dividends are not tax-deductible). If you’re using Unlevered FCF (Free Cash Flow to Firm), you use WACC as the Discount Rate because you care about all parts of the company’s capital structure – Debt, Equity and Preferred – because you’re calculating Enterprise Value, which includes all investors. If you’re using Levered FCF (Free Cash Flow to Equity) instead, you use Cost of Equity as the Discount Rate instead because you only care about Equity investors there, and you’re calculating Equity Value rather than Enterprise Value. Think: “Free Cash Flow to Equity  Cost of Equity  Equity Value.”

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We’ll get into this in more detail in Key Rule #5 below, but you can already see some implications of this formula for WACC: •

•

•

Debt will almost always push down WACC because the Cost of Debt is almost always lower than the Cost of Equity – interest rates on Debt are lower and the interest is tax-deductible. Preferred Stock is generally cheaper than Equity, but not as cheap as Debt because Preferred Dividends are not tax-deductible. Equity tends to “cost” the most, which makes sense intuitively: would you expect to earn more investing in the stock market over the long-term, or by investing in bonds?

And for Cost of Equity: • •

Higher Risk-Free Rates and Equity Risk Premiums always increase it. Yes, Debt increases the Cost of Equity – how is that possible?! Well, if a company has Debt, investing in its Equity also becomes riskier – because Debt increases the chances of it defaulting and leaving you, the common shareholder, with nothing.

One final note before we move on: Unlevered vs. Levered Beta has nothing to do with Unlevered vs. Levered Free Cash Flow (yes, it’s confusing). Regardless of which type of Free Cash Flow you use, you always use Levered Beta when calculating Cost of Equity. Remember that if a company has Debt, it makes both the Equity of the company and the entire company itself riskier. Targeted vs. Existing Capital Structures This one always seems to come up: what if the company’s capital structure changes in the future? In other words, what if it raises additional Debt or issues more Equity or Preferred Stock or does something else?

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If you know for sure that the company’s capital structure will change in the (near) future, sure, you can use the new Debt and Equity values in all these calculations. In real life this almost never comes up because no one “knows” how a company’s capital structure will change far in advance. advance. So if this comes up in interview, say, “Yes, ideally we would use the company’s targeted or planned capital structure rather than the one they currently have… if we we have access to that information.”

Key Rule #4: Calculating Terminal Value Once you’ve calculated the Discount Rate following the steps in the last section, you discount the company’s cash flows over the projection period and add them all up. Then, in the next step you estimate the company’s “far in the future” value, AKA its Terminal Value. You can do that with one of two methods: Method #1: Assume That the Company Gets Sold for a Certain Multiple For example, maybe the company has EBITDA of $500 million in Year 5 and based on the Public Comps, you think it might be worth 10x EBITDA if they sell to an acquirer at that stage. That means their approximate “far future value” is $5 billion ($500 million * 10x). This method (the Multiples Method) is simple and is commonly used in banking. The downside is that the exact multiple is hard to estimate years in advance, so you always use a range of multiples in multiples in the analysis and show the results in a sensitivity table – see the diagram below for an example:

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This table does more than just estimate the Terminal Value – it actually gives us the entire company’s value – but you can understand the fundamental idea from looking at the table. Method #2: Assume That the Company Keeps Operating Indefinitely and Sum Its Future Cash Flows Warning: there Warning: there will be some math here. With this method (the “Gordon Growth” or “Perpetual Growth” method), you assume that the company’s Free Cash Flow keeps growing far into the future and that it keeps operating forever… value of the Free Cash Flow each year keeps shrinking because the But the present value of Discount Rate is higher than the growth rate of rate of these Free Cash Flows. Here’s an example:

See how the Present Value of FCF decreases each year and how the Cumulative Sum amount each year? Those two together mean that the keeps growing… but by a smaller amount each sum of these future cash flows will eventually converge on a single number. number . You can estimate that single number with this formula:

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•

Terminal Value = Value = Final Year Free Cash Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal FCF Growth Rate).

You must use the correct Terminal Growth Rate. It should always be very low – less than or equal to the country’s GDP growth rate, the rate of inflation, or something else like that. Otherwise, eventually the company’s FCF will exceed the GDP of the entire country, which wouldn’t make sense. Which Method to Use? There is no “best” method when calculating Terminal Value. You almost always use both in a DCF and compare the results: results:

The main disadvantage in both cases is that the key variables – the Terminal Multiple and the Terminal Growth Rate – are difficult to determine precisely. precisely. Neither one will necessarily produce a higher or lower value because you can’t directly compare them – it depends on the company’s financial profile, the Discount Rate, and so on. cyclical or multiples are hard to predict , , the Gordon Growth If the industry is cyclical or Gro wth method may be better; if multiples are easier to estimate, the Multiples Method may be better.

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Once you have the Terminal Value, you discount it using the same Discount Rate, and then add it to the discounted value of the company’s Free Cash Flows (see the diagram on the left). That gets you Enterprise Value (with Unlevered FCF) or Equity Value (with Levered FCF). And then you can work out what the company’s implied per share price is. You can see a sample calculation for all this on the left. Remember that this is just the “baseline” calculation – we always show a range of values for the analysis using a sensitivity table.

Key Rule #5: Factors That Impact a DCF and WACC Ah, now for the fun part. This section is important because many interview questions involve these concepts. They’ll ask things like: • •

Will Cost of Equity be higher for a $500 million or $5 billion company? Will a 1% change in revenue or 1% change in the Discount Rate have a greater impact on the DCF?

Luckily, you have a secret weapon at your disposal: the DCF model we’ve included with this guide (see the section below). You should use that model as much as possible, play around with and tweak all the variables there, and see what really makes an impact. We explain quite a few questions on this topic in the Q&A sections below, but here are some rules of thumb to keep in mind.

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Overall Impact: The Discount Rate and Terminal Value tend to have the biggest impact here. Yes, if a company’s revenue growth rate or margins change dramatically , those could change the DCF significantly. But even a 1% increase or decrease in the Discount Rate makes far more of an impact than a 1% increase or decrease in revenue or revenue growth or EBIT margins because that Discount Rate affects everything in the analysis. A Discount Rate difference of 1% will impact the analysis far more than a 1% increase or decrease in Terminal Value because Terminal Value is a large number and 1% is tiny. It gets trickier with questions like, “Well, what about a 10% change in revenue vs. a 1% difference in the Discount Rate?” You’re better off “hedging” your answer here and saying that at a certain level, the revenue increase or decrease will make more of a difference than the new Discount Rate, but it varies greatly by company and by the specific assumptions you’ve made. Rules of Thumb for Cost of Equity: •

•

•

•

•

Smaller companies generally have a higher Cost of Equity than larger companies because expected returns are higher. Companies in emerging and fast-growing geographies and markets also tend to have a higher Cost of Equity for the same reason. Additional Debt raises the Cost of Equity because it makes the company riskier for all investors. Additional Equity lowers the Cost of Equity because the percentage of Debt in a company’s capital structure decreases. Using Historical vs. Calculated Beta doesn’t have a predictable impact – it could go either way depending on the set of comps.

Rules of Thumb for WACC: •

Assuming that the companies all have identical capital structures, the first two points above about Cost of Equity also apply to WACC – it’s higher for smaller companies and those in emerging markets.

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•

•

•

Additional Debt reduces WACC because Debt is less expensive than Equity. Yes, Levered Beta will go up, but the additional Debt in the WACC formula more than makes up for the increase. Additional Preferred Stock also generally reduces WACC because Preferred Stock tends to be less expensive than Equity (Common Stock). Higher Debt Interest Rates will increase WACC because they increase the Cost of Debt.

When in doubt, think about the individual components of these items and reason your way through how each one changes. And if it’s something truly ambiguous, they will care far more about your thought process than whether you got it “right or wrong.” Return to Top.

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Merger Model Overview and Key Rules of Thumb The merger model (also known as an accretion / dilution model or M&A model, among others) is another topic that’s almost 100% guaranteed to come up in interviews. The merger model is very common in investment banking since bankers spend so much time advising clients on M&A activity, but it also pops up even in roles like equity research and private equity, because the companies you follow could always acquire other companies, or be acquired – and you need to understand how to analyze those scenarios. The great part about a merger model is that the analysis itself is not terribly complex – if you already know accounting, you could learn the fundamentals in about an hour. But at the same time, it’s also very insightful and tells you a lot about the deal in question. But many interviewees only memorize selected facts about M&A and merger models rather than aiming to understand the full picture – which causes problems in interviews, since interviewers could always come up with new variations on standard questions. Here are the 5 most important concepts you need to understand: 1. Why would you buy (or merge with) another company? Merger models are pointless if you don’t understand this. 2. How does a merger model work? How do you set it up, make assumptions, combine two companies’ financial statements, and analyze the result at the end? 3. How do you finance the purchase? There are 3 main methods, and they all have different trade-offs and effects on the model. 4. What happens immediately after you buy the other company? 5. What happens in the long-term , and what causes mergers and acquisitions to be successful or unsuccessful?

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Once again, the Excel model that we provide will be huge for understanding these questions because you’ll see the effects of everything firsthand. The interactive quiz will also be helpful, but we focus more on concepts there rather than specific numbers – since conceptual questions are more likely in interviews. We’ll start by going through each of these key rules below, and then delve into the Basic and Advanced questions and answers.

Key Rule #1: Why Buy Another Company? Everything in finance (and arguably life itself) comes down to the return on investment. A company would buy another company if it believes that it will earn more from the acquisition than it spends to complete the acquisition. For example, maybe the buyer is considering acquiring the seller for $500 million. The buyer has run the numbers, analyzed the seller’s business and its own business, and concluded that it might earn between $1 billion and $1.2 billion over the next 10 years by acquiring the seller. If you do the math in Excel, you’ll see that this is roughly a 15% Internal Rate of Return (IRR) if you assume $100 million in “additional earnings” each year afterwards – a good result for most deals. If the buyer only projected, say, a 5% return from the acquisition, it would be far less likely to do the deal. This explains the buyer’s rationale for pursuing or not pursuing an acquisition – but investors and analysts tend to focus on Earnings Per Share (EPS) and how that changes as a result of the acquisition in the near-term (the next 1-2 years).

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EPS is simply Net Income / Shares Outstanding, and depending on the price the buyer pays, the seller’s pre-tax profits, and the purchase method, it may go up, go down, or be about the same afterward. In a merger model, you usually focus on EPS accretion / dilution (accretion = the buyer’s EPS goes up, dilution = the buyer’s EPS goes down) and figure out whether the deal will increase or decrease EPS, or have no impact. Before you start thinking about that, though, you need to understand more about why a buyer might want to acquire a seller. In other words, what could cause the buyer to earn a good return on investment, or (perhaps) boost its Earnings Per Share? We can divide the rationale for buying a company into “financial reasons” and “fuzzy reasons.” Financial Reasons for Acquisitions In mature markets, consolidation often motivates M&A activity. For example, there might be 4 major players in the market and the 3 rd largest company wants to acquire the 4th largest company to take on the #1 and #2 companies more effectively. With these types of deals, it’s usually obvious that the acquisition will yield a good return on investment or otherwise boost EPS because both businesses are mature and predictable. Sometimes geography plays a role in deals as well – the buyer is based in North America, but the seller’s customer base is in Europe and so they could expand by growing geographically. Besides gaining market share, a buyer might also be motivated to acquire a seller because it needs to grow more quickly and sees a faster-growing, smaller company

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as


a solid way to achieve that goal. All else being equal, investors value higher-growth companies more highly. Sometimes the company in question might be undervalued – or at least be viewed as undervalued – in which case the buyer might also be interested. At the right price almost any deal would yield a good return, so a specific company’s valuation can motivate M&A activity as well. The buyer might also be motivated to gain the seller’s customers – maybe it estimates that it could up-sell higher-priced products or services to 20% of the seller’s customers, or cross-sell some of its own products, which results in significantly more revenue and profit for them. There’s a lot of guesswork involved with this type of reasoning, which takes us into our next category for acquisitions: fuzzy reasons. Fuzzy Reasons for Acquisitions Bankers would like to claim otherwise, but plenty of acquisitions happen for completely irrational reasons. In fact, massive acquisitions (anything worth over $50 billion USD) are often driven almost entirely by ego, politicking, and sometimes a sense of “destiny” (Of course we should buy them! It’s our destiny to be the biggest company ever!). The cross-selling and up-selling motivation above usually qualifies for this category, because there’s no way to know in advance what the uptake will be or how much these efforts will add to the bottom-line. Other reasons include: •

The seller has a particularly important technology, patent, or other intellectual property that the buyer views as essential.

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•

•

•

The seller poses a threat , whether real or imagined, to the buyer’s business and the buyer wants to make a defensive acquisition. The seller has amazing employees and the buyer is willing to pay a premium just to get these employees (an “acqui-hire,” common with tech start-ups). Although the seller is not projected to yield a good ROI or boost EPS in the nearterm, the buyer thinks that there are intangible benefits that will materialize in the very long-term.

These reasons are much more common in research & development-driven industries such as technology and biotech, and much less common in old-school, asset-based industries like manufacturing. Here’s the key takeaway: a buyer will only acquire a seller if it believes that it will gain something from the deal – it will earn more from the acquisition than what it’s spending on the acquisition. Mergers vs. Acquisitions The only difference between a “merger” and an “acquisition” is that in a merger, the buyer and seller are about the same size, whereas in an acquisition the buyer is significantly bigger (usually at least 2-3x bigger by revenue or market cap). Mechanically, they work exactly the same way and there is no difference in a merger model regardless of whether the deal is classified as a merger or an acquisition. There are certain transaction structures and purchase methods that may differ depending on whether it’s a merger or acquisition, which we’ll get into in the questions and answers below, but the mechanics are the same. There are also differences between acquiring over 50% of a company and less than 50% of a company, but we’ll address that in the Advanced Questions and Answers below.

Key Rule #2: How Does a Merger Model Work? You can divide a merger model into an 8-step process – we’ll briefly go through the steps here, and then look at a few of the steps in more detail below.

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Step 1: Determine the Purchase Price You do this the same way you value any other company: you would use a combination of Public Comps, Precedent Transactions, and the DCF (and possibly other methodologies) to come up with a reasonable price. If it’s a public company you come up with a per-share purchase price; if it’s a private company you might assume an Implied Equity Value based on the valuation. The example below is for a public company, where we’ve assumed a premium to the seller’s share price:

Step 2: Determine the Purchase Method Once you’ve determined the price for the seller, you need to figure out how to pay for it: cash, stock, or debt. •

•

•

Cash: Just like normal cash in your bank account. Cold, hard money that you can immediately withdraw and use to pay for something. The downside is that you give up interest that you could have earned on that cash, which is known as the foregone interest on cash. Debt: Similar to a mortgage, student loan debt, or auto debt in real life: you take out a loan and pay interest on that loan, also repaying the principal to the lenders over time. Stock: Sort of like “trading in” your existing car or house when you go to buy a new one. You’re using the value of an existing asset – your company – to buy something else. The downside is that you’ll get additional shares outstanding , which will reduce your Earnings Per Share and may upset investors.

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Some deals will involve just one of these, but many deals use 2 or 3 of these methods (e.g. 20% cash, 40% debt, 40% stock). The method you use depends on how much cash you can afford to use, how much debt or stock you can afford to issue, the structure of recent deals in the market, and what the company’s upcoming plans are (Expanding? Buying a new factor? Raising debt?). You would determine the interest rates for cash and debt based on what’s happening in the market and prevailing interest rates at the time of the deal. Buyers generally prefer to pay with 100% cash, if possible – it’s the cheapest option since the interest rate on cash is lower than the interest rate on debt. The “cost” of issuing equity depends on the P / E multiples of the buyer and seller (more on this below), but it is almost always more expensive than cash or debt. Step 3: Project the Financial Profiles and Statements of the Buyer and Seller This one comes straight from the 3-statement models that you’ve created for the buyer and seller. Here’s what you need at the bare minimum: •

•

• •

• • •

Valuation – Share Price, Shares Outstanding, and Equity Value and Enterprise Value. Tax Rates – You’ll need the buyer’s tax rate when combining the Income Statements in the next step. Revenue – Kind of a big deal on the Income Statement… Operating Income – You don’t need all the items in between revenue and operating income on the Income Statement. If you have them, great, but revenue and operating income are the most important ones. Interest Income / (Expense) – You need these to calculate Pre-Tax Income. Pre-Tax Income and Net Income – Self-explanatory. Shares Outstanding and EPS – You need these to calculate EPS and accretion / dilution at the end.

Here’s a simple example of Income Statement projections:

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You don’t truly “need” projections for the Balance Sheet and Cash Flow Statement, but you should at least have the Balance Sheets for the buyer and seller from just before the acquisition closes. Step 4: Combine the Buyer and Sellers’ Income Statements This is straightforward: you just add together everything on the Income Statements down to the Pre-Tax Income line. Then, you multiply the Combined Pre-Tax Income by (1 – Buyer’s Tax Rate) to get to the Combined Net Income – this is a very important point because many people do this incorrectly and multiply by the Seller’s Tax Rate or some type of “combined” Tax Rate, both of which are wrong. Finally, you add new shares issued to the buyer’s shares outstanding, and divide Net

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Income by that new share count to determine EPS. Note that you do not add in the seller’s shares outstanding – they are all wiped out in the acquisition, and go away completely. Step 5: Calculate Goodwill and Allocate the Purchase Price When a buyer acquires a seller, the seller’s shares outstanding disappear completely and its Shareholders’ Equity is also wiped out and goes to $0 – because it no longer exists as an independent entity. However, that creates a problem when we combine the Balance Sheets of the buyer and seller – consider the following scenario: •

•

•

The buyer has $10,000 in Assets, $8,000 in Liabilities, and $2,000 in Shareholders’ Equity. The seller has $1,000 in Assets, $800 in Liabilities, and $200 in Shareholders’ Equity. The buyer pays $500 for the seller, using 100% cash.

We add the Liabilities, so the combined total is $8,800, and we wipe out the sellers’ Shareholders’ Equity so the total is still $2,000. Liabilities & Equity = $10,800. Now, on the other side, we add Assets from both companies, which gets us to $11,000… except the buyer has used $500 in cash to purchase the seller, so its Assets side is only $10,500. The Balance Sheet is out of balance!

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When this happens, we need to create an Asset called Goodwill (and a related Asset called Other Intangible Assets) to account for the premium that a buyer has paid above the seller’s Shareholders’ Equity. In this case, the purchase price is $500 but the seller’s Shareholders’ Equity is only $200 – so we would create $300 in Goodwill (and/or Other Intangible Assets) to account for that premium, and we’d add that new $300 Asset to the combined Balance Sheet on the Assets side. Now the Balance Sheet would balance properly since the Assets side is $10,800, which matches the Liabilities & Equity side. There are other effects in an acquisition as well – for example: • • •

We often adjust the value of the seller’s PP&E and possibly other Assets. We usually “reset” the seller’s existing Goodwill and write it down to $0. We create Deferred Tax Liabilities due to the adjustments to PP&E and other Assets, and we may write off the seller’s existing Deferred Tax Liabilities.

And the list goes on – we cover this in more detail in the Advanced Questions and Answers section below.

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Here’s the key takeaway: you adjust a bunch of items on the Balance Sheet in a merger model, and you need to create Goodwill (and Other Intangible Assets) to plug the holes and represent the premium that a buyer pays over a seller’s Shareholders’ Equity. The difference between Goodwill and Other Intangible Assets is that Goodwill is not amortized and therefore doesn’t change unless there’s an Impairment charge, whereas Other Intangible Assets amortize over time, reflecting how they “expire.” Step 6: Combine the Balance Sheets and Adjust for Acquisition Effects This is fairly straightforward because you are mostly just adding together all the relevant line items. Here’s what you do in each section: •

•

•

•

Current Assets: You add most of these items, and subtract any Cash the buyer uses to acquire the seller. Long-Term Assets: You adjust the PP&E value up or down, and also adjust the values of Goodwill and Other Intangible Assets depending on the previous step. Current Liabilities: You add everything here, perhaps adding or subtracting Debt if the buyer uses Debt to acquire the seller or pays off the seller’s Debt. Long-Term Liabilities: You add most items here, but you add or subtract Debt if the buyer uses Debt to acquire the seller or pays off the seller’s Debt; you may also adjust the Deferred Tax Liability.

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•

Shareholders’ Equity: You wipe out the seller’s Shareholders’ Equity, but add the dollar value of new shares issued by the buyer.

Step 7: Adjust the Combined Income Statement for Acquisition Effects Here are the key items that you adjust for on the Income Statement: •

•

•

•

•

Synergies: If you’ve assumed revenue or expense synergies , you need to reflect them here. Depreciation & Amortization: If you’ve assumed changes to PP&E or you’ve created Other Intangible Assets, you need to reflect the new D&A expense on the combined Income Statement. Foregone Interest on Cash: If the buyer uses cash to acquire the seller, this equals Cash Used * Interest Rate. Interest Paid on New Debt: If the buyer uses debt to acquire the seller, this equals Debt Used * Interest Rate. Shares Outstanding: If the buyer issues shares to raise the funds to acquire the seller, the new number here equals Old Buyer Shares Outstanding + Number of Shares Issued in Deal.

See the diagram above for a visual example of what all these items would look like, and how they impact the EPS at the bottom. Step 8: Calculate Accretion / Dilution and Create Sensitivity Tables To calculate Accretion / Dilution, you compare the new, Combined Earnings Per Share (EPS) number to the buyer’s old, projected EPS number from before the acquisition.

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If the buyer was projected to have an EPS of $1.00 prior to the acquisition, but the combined company, post-acquisition, is projected to have $1.10 EPS, that’s 10% accretion. If they only have $0.90 EPS post-acquisition, that’s 10% dilution. You don’t stop with this number – normally you create sensitivity tables that allow you to analyze the change in EPS at different purchase prices, transaction structures, and purchase methods. For example, you might see how the EPS changes when you buy a company with 30% cash, 40% cash, 50% cash, and 60% cash, at purchase prices ranging from $500 million to $600 million. There’s an example below for the deal we’ve been referencing in this guide:

This type of table lets you better assess whether or not the deal still “works” under different assumptions.

Key Rule #3: How Does the Payment Method Affect the Deal? The two sections above give you the high-level overview of why a company might buy another company, and how to model an acquisition. It’s important to understand those, but you also need to understand the trade-offs behind different methods of financing an acquisition. Let’s start with the obvious: if a buyer pays more for a seller, the deal will be more dilutive (or less accretive), assuming that the mix of cash/stock/debt stays the same.

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A deal will generally be dilutive if the amount of extra Pre-Tax Income the seller contributes is not enough to offset the foregone interest on cash, the cash paid on Debt, and the effects of issuing shares. Here’s an example: • • • • •

It’s a 50 / 50 cash / debt deal. The seller contributes $100 in Pre-Tax Income. The buyer pays $80 in Interest on Debt. The buyer gives up $25 in Foregone Interest on Cash. This will be dilutive because the buyer gains $100 in Pre-Tax Income, but loses $105.

When you add a stock issuance to the mix t’s more difficult to assess, but there is a rule of thumb even for that (keep reading). The buyer almost always prefers to use 100% cash when acquiring a seller because cash is cheaper than debt – and unlike issuing stock, it doesn’t require the buyer to give up any ownership to the seller. Sellers also tend to prefer cash because it’s less risky than equity (the buyer’s share price might plummet immediately after the deal is announced, reducing the purchase price). However, the buyer is constrained because it may not have enough cash available to complete the purchase; it might have also earmarked the cash for other purposes, such as hiring more employees. So if it needs to use debt and/or stock, it has to assess how much it can reasonably use. On the debt side, it will look at the percentages of debt used in recent, similar deals, as well as what its Leverage Ratio (Total Debt / EBITDA) will be, and whether or not it can reasonably meet its interest payments. For stock issuances, it will look at how much ownership it’s giving up and how much it’s diluting existing shareholders.

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For example, if it currently has 90 million shares outstanding but it’s issuing 30 million shares to acquire another company, that’s bound to make investors question whether they want to give up 25% of the company to the seller. Share price is also a factor when issuing stock. A buyer will always prefer to issue stock when its shares are trading at high levels. If its share price were $100, for example, it only has to issue half as many shares as it would if its share price were $50 – and issuing half as many shares results in less dilution. Rules of Thumb for Merger Models Now we’re about to make your life – and your interviews – easier by providing 2 rules of thumb that you can use to estimate accretion / dilution for all scenarios. Rule #1: 100% Stock Deals and P / E Multiples This one is simple: in an all-stock deal, if the buyer has a higher P / E than the seller, the deal will be accretive; if the buyer has a lower P / E, it will be dilutive. Think of it like this: P / E = Equity Value / Net Income. If the buyer’s Equity Value is $100 and its Net Income is $10, its P / E is 10x. If you bought it, you’d be getting $0.10 in earnings for each dollar you pay for it (flip the P / E, so 1 / 10 = 10%). If the seller’s Equity Value is $80 and its Net Income is $10, its P / E is 8x. There, you’d be getting $0.125 in earnings for each dollar you pay for the seller (flip the P / E, so 1 / 8 = 12.5%). You get “more for your money” with the seller because its P / E multiple is lower. Since the buyer would get more for each dollar invested in the seller than what it’s currently earning for each dollar invested in itself , this acquisition is accretive. This is a simplification. This rule assumes that the buyer and seller have the same tax rates, that there’s no premium paid for the seller over its current share price, and that

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there are no other acquisition effects such as Depreciation & Amortization from Asset Write-Ups. So this rule rarely holds up in the real world. However, if the seller’s P / E is higher than the buyer’s P / E, you can be almost 100% certain that the deal will be dilutive. Rule #2: How to Determine Accretion / Dilution for All Deals Now we’ll show you a cool trick for determining accretion / dilution in all scenarios. First, let’s define a few key variables: • • •

•

Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer Tax Rate) Cost of Debt = Interest Rate on Debt * (1 – Buyer Tax Rate) Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. E / P or Net Income / Equity Value Yield of Seller = Reciprocal of the Seller’s P / E multiple (ideally, the P /E multiple at the purchase price for the deal)

To determine whether a deal is accretive or dilutive, simply calculate the weighted “cost” for the buyer and compare it to the Yield of the Seller. If the Buyer’s Cost exceeds the Seller’s Yield, it’s dilutive. Otherwise, it’s accretive.

Let’s look at a few examples of this rule in action: •

• • •

The buyer has a P / E multiple of 12x and the seller’s P / E multiple is 10x. The foregone interest rate on cash is 4% and the interest rate on new debt is 8%. The buyer’s tax rate is 40%. Cost of Cash = 4% * (1 – 40%) = 2.4% Cost of Debt = 8% * (1 – 40%) = 4.8% Cost of Stock = 1 / 12 = 8.3%

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•

Yield of Seller = 1 / 10 = 10.0%

In this case, this rule tells us that the acquisition will be accretive regardless of the cash / stock / debt mix used – because none of the buyer’s costs exceed the Yield of the Seller. But look what happens if we have slightly different numbers: •

• • • •

The buyer’s P / E multiple is 8x and the seller’s P / E multiple is 12x now. Everything else is the same. Cost of Cash = 4% * (1 – 40%) = 2.4% Cost of Debt = 8% * (1 – 40%) = 4.8% Cost of Stock = 1 / 8 = 12.5% Yield of Seller = 1 / 12 = 8.3%

In this case, the after-tax costs of debt and cash are less than the Seller’s Yield of 8.3%, so a 100% debt acquisition or a 100% cash acquisition would both be accretive. However, the buyer’s Cost of Stock is greater than the Yield of the Seller now, so a 100% stock acquisition would be dilutive. You can combine these rules to estimate what would happen in other scenarios, such as a 50/50 cash/stock deal, or a 33/33/33 cash/stock/debt deal – just calculate the weighted average cost. One interesting implication of this rule: cash is not necessarily the cheapest way to acquire a company. For example, if the buyer has an extremely high P / E multiple of 100x, the reciprocal would be 1%. And that 1% might very well be lower than the after-tax cost of cash for them (ex: 4% * (1 – 40%) = 2.4%. The only problem with this shortcut is that it doesn’t account for other acquisition effects – synergies, new D&A, and so on. Use it to quickly estimate what a deal will look like on a non-synergy, cash-only basis, rather than as a universal law.

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Another big problem (we cover this in the Excel file and tutorial) is that this doesn’t account for the premium paid for the seller, unless you use the purchase price for the Seller’s Yield rather than its current share price. Example: The seller’s Net Income is $100 million and its market cap is $1 billion, so its P / E is 10x and its current Yield is 1 / 10, or 10%. However, if the buyer pays $1.5 billion for the seller, its Effective Yield would only be $100 million / $1.5 billion, or 6.7%. This is really important to factor in for “real deal” scenarios, and you can review the Excel file and tutorial there for more details there.

Key Rule #4: Acquisition Effects and Synergies What happens after an acquisition is equally as important as important as how you acquire a company in the first place. Questions on this topic are much more likely if you’ve had full-time work experience already or you have more advanced knowledge from other sources. But just to be complete, we’ll discuss a few of the key points here (there’s more coverage in the Advanced Questions and Answers toward the end). Basic Acquisition Effects Here are the 5 key acquisition effects that you need to know – these are fair game even for entry-level interviews: 1. Foregone Interest on Cash – The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition – so that reduces its Pre-Tax Income, Net Income, and EPS. 2. Additional Interest on Debt – The buyer pays additional Interest Expense if it uses debt, which reduces its Pre-Tax Income, Net Income, and EPS. 3. Additional Shares Outstanding – If the buyer pays with stock, it must issue additional shares, which will reduce its EPS. 4. Combined Financial Statements – After the acquisition, the seller’s financial statements are added to the buyer’s, with a few adjustments.

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5. Creation of Goodwill & Other Intangibles – These Balance Sheet items represent the premium that the buyer paid over the seller’s Shareholder’s Equity, and are required to ensure that the Balance Sheet balances. You can calculate the impact of the first 3 effects using the rule outlined above: for the first two, multiply the interest rate by (1 – Buyer’s Tax Rate), and for the impact of issuing stock, flip the P / E multiple of the buyer. More Advanced Acquisition Effects Then there are a few additional effects that you see in more advanced merger models. These are unlikely to come up in entry-level interviews, but there’s no such thing as being overly prepared: •

•

•

•

•

•

PP&E and Fixed Asset Write-Ups – You may write up the values of these Assets in an acquisition, under the assumption that the market values exceed the book values. Deferred Tax Liabilities – Normally you write off the seller’s existing DTLs, and then create new ones based on Buyer’s Tax Rate * (PP&E and Fixed Asset WriteUp and Newly Created Intangibles). See the Advanced Questions for more. Deferred Tax Assets – In most deals, you write these off completely, depending on the seller’s tax situation; see the Advanced section. Transaction and Financing Fees – You expense legal and advisory fees and deduct them from Cash and Retained Earnings at the time of the transaction, but you capitalize financing fees and then amortize them 5-10 years, or as long as newly issued Debt remains on the Balance Sheet. Inter-Company Accounts Receivable and Accounts Payable – You may eliminate some of the combined AR and AP balances because the buyer might owe the seller money and vice versa. Once they’re the same company, this no longer makes sense. Deferred Revenue Write-Down – Accounting rules state that you can only recognize the profit portion of the seller’s Deferred Revenue post-acquisition. So you often write down the expense portion of the seller’s Deferred Revenue over several years in a merger model.

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Another important feature in more advanced merger models is the treatment Net Operating Losses (NOLs) and book vs. cash taxes; see the Advanced section for more on those. Revenue and Expense Synergies By combining forces, two companies may earn more revenue than if they simply added together their separate revenues, or they may pay fewer expenses as a result of consolidation. You could model revenue synergies by assuming a price increase or by assuming additional volume sold. For example, maybe as a result of acquiring Company B, Company A can add new features to its products that result in customers paying $105 rather than $100 for each unit – you could then multiply that difference by the units sold each year to estimate the annual revenue synergies. Revenue synergies are rarely taken seriously in practice because it’s impossible to predict how successful these types of up-sell / cross-sell efforts will be. Expense synergies are much more grounded in reality, and are easier to estimate. The two most common expense synergies: •

•

Reduction in Force: This is a nice way of saying, “Lay off employees.” Often, two companies will have redundant employees in administrative functions – accounting, bookkeeping, marketing, and so on, and they can reduce expenses by eliminating redundant positions. Building Consolidation: If the buyer and seller both lease buildings in the same city, it makes sense to consolidate into one larger space and save on rent –

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or in the case of owned buildings, save on loan payments and property taxes. You might estimate expense synergies by finding, for example, that each employee costs $100,000 per year, including salary, benefits, and other compensation, and then assuming that 5% of the workforce can be cut. 5% represents 30 employees, so that is a savings of $3 million per year.

Key Rule #5: M&A in the Real World Understanding merger models is great, but you also need to grasp how they work in real life and how bankers and other financiers actually use them. First off, realize that no deal ever happens because of the output of an Excel model. Financial modeling gives you an idea of whether a deal might be viable, or whether a company might be undervalued or overvalued, for example, but no one would ever say, “Aha! This deal is 12% accretive according to my Excel model! Let’s do it!” Merger models are used more for supporting evidence in negotiations and M&A discussions – not as a way to make decisions in the first place. Acquisitions Gone Bad Another harsh fact of life is that most M&A deals fail. It’s tough to merge two completely different organizations, and there are many factors that could lead to failure: •

•

Integration Difficulties – On paper it might have seemed like a great move, but in practice integrating two separate employee bases, supply chains, retail networks, and so on can prove incredibly difficult. And if companies can’t integrate properly, the deal will fail. Cultural Differences – While bankers like to think otherwise, a company is more than just revenue and profit in Excel. If

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•

•

two companies have radically different cultures (e.g. one is very relaxed and casual and one is stuffy and uptight), it will be challenging, if not impossible, for employees to work together successfully. Poor Rationale – Perhaps the original reason that the buyer gave to justify the acquisition made no sense in the first place. It sounds crazy, but huge deals really do happen for poor-to-nonexistent reasons. And when it becomes clear that the original reasoning made no sense, the deal works out poorly for everyone. Synergy Failures – Maybe the buyer acquired the seller to access its wonderfully lucrative customer base… only to find that the customer base does not, in fact, want any of its products. Whoops.

Overpaying for Companies Another common “failure” scenario happens when the buyer overpays for the seller. To see examples of this, just look up hyped tech start-up M&A deals and you’ll see examples of absurd multiples or companies with 0 revenue and profit being acquired for tens or hundreds of millions (or billions) of dollars. In these cases, enormous Goodwill & Other Intangible Asset balances get created… and afterward, there are often Impairment Charges and Write-Downs as the buyer reassesses what the seller was really worth. Maybe they record $500 million of Goodwill initially, but then they re-assess it in 1-2 years and record a $100 million Impairment Charge, which reduces (book) Pre-Tax Income, Net Income, and Goodwill. Sometimes the impact is more immediate as well – for example, if a public company is acquiring another company using a significant amount of stock, the market almost always has a strong reaction to news of any deal. If the buyer pays $100 million worth of stock for the seller but the market believes the seller is only worth $80 million, the buyer’s stock price will inevitably fall once the deal is announced.

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Its share price would not fall by 20% necessarily, but rather by the per-share amount that corresponds to this $20 million difference in value. Example: The buyer is worth $1 billion, has 100 million shares outstanding, and its current share price is $10.00. It wants to issue 10 million shares to acquire the seller for $100 million. But if the market believes that the seller is only worth $80 million rather than $100 million, the buyer’s share price might fall to $9.81 (implying a total value of $1.08 billion) to reflect this lower value. Moral of the Story: There are many ways for M&A deals to fail and to have disastrous consequences after the fact. This is why it’s so important to use sensitivities to analyze deal scenarios such as different purchase prices, synergy levels, cash/stock/debt combinations, and more. You want to ensure that even in the worst case scenario , the deal won’t be a complete disaster. Hardly anyone ever thinks about these dangers in real life because they’re incentivized to get deals done at any cost.

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LBO Model Overview and Key Rules of Thumb The leveraged buyout model (LBO model) is a more advanced topic, and you may not necessarily get many questions about it in entry-level investment banking interviews. But it is still important to understand at least the concept and how a simple model works, because anything is fair game for interviews – even if you don’t have an accounting or finance background. If you’re interviewing for private equity roles, LBO-related questions will comprise the majority of technical questions, so you should know everything in this section like the back of your hand. And if you’re interviewing for more a more technical group in banking, such as Leveraged Finance, LBO-related questions are also likely. Since the LBO model is a more advanced topic, you may be tempted to memorize the most common questions and answers… but we would strongly recommend against that. Just like with accounting, valuation, DCF, and merger model questions, interviewers can easily put a twist on the traditional questions and ask something that throws you off – but if you understand the concepts , you’ll be in good shape anyway. Here are the key topics you need to know: 1. 2. 3. 4. 5.

What is an LBO, and why does it work? How do you make basic model assumptions in an LBO? How do you project the financial statements in an LBO and pay off debt? How do you calculate returns and determine what influences returns? What are more advanced LBO features that you might see?

If you’re interviewing for equity research, asset management, or hedge fund roles, the LBO model is less important because you don’t work with transactions (i.e. buying and selling entire companies) as much there.

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But it’s still good to know the basics so that you can understand what happens when a company you’re following gets sold to a private equity firm.

Key Rule #1: What Is an LBO and Why Does It Work? Most people compare a leveraged buyout to buying a house with a down payment and a mortgage, living in that house for years, and then selling it at the end of the period. We think there is a better analogy to use: rather than buying a house and living in it yourself, think about it in terms of buying a house to rent out to other people. Let’s say that you want to buy your first property, a single-family home, for $500,000. You want to operate it for a few years, and then sell it for a higher value in the future. You’ve saved up a lot of money and you have a high-paying job, so there are two ways you could purchase the house: 1. Pay for it with 100% cash , i.e. $500,000 in cash, upfront. 2. Pay for it with 30% cash ($150,000) as the down payment and take out a mortgage for the rest ($350,000). The mortgage has an interest rate of 5%, and you’ll need to repay the principal evenly over 40 years (normally this is 20-30 years but we’re using cleaner numbers here). It may seem like option #1 is clearly better – after all, you don’t have to pay off interest or pay off the debt itself! …But it’s not that simple, because you will also earn income from this property, and you can use that income to pay the interest on the debt and to repay the debt itself. So here’s the real question you need to ask: Are you better off paying less in cash upfront and using the property’s income to pay off interest and debt principal, or are you better off paying more in cash up-front and keeping all that income for yourself? Let’s see how the numbers compare, using these assumptions: •

House value of $500,000, with rental income of $35,000 per year (7% yield).

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• •

•

•

Scenario 1: Buy it with 100% cash. Scenario 2: Buy it with 30% cash and 70% debt, and 5% interest on the debt with 2.5% principal repayment each year (paid off over 40 years). We can sell the house for $550,000 at the end of the 5-year period, and we must use the proceeds to repay the remaining mortgage. We’ll ignore fees and taxes in the interest of simplicity.

Here’s what Scenario #1 looks like:

Not bad. We get 1.5x our money back over 5 years, and we end up with a 9% internal rate of return (IRR) – in other words, we would have had to have invested the $500K and earned 9% interest, compounded annually, to achieve this same result otherwise. Maybe we could do better in the stock market, but a 9% return is decent and is much better than getting 1% or 2% in a savings account at a bank. But now consider what this looks like with only 30% cash used:

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Our returns have improved significantly , because we’ve only paid $150K in cash in the beginning rather than $500K. While we have to pay for interest and debt principal and then pay off the remaining debt principal at the end, overall we still perform much better. We earn close to 2x our initial investment back, and the IRR is 15% rather than 9% – and for the average person, it would be extremely difficult to earn 15% year after year with an investment of that size in the stock market. The returns go up because reducing the amount of cash you pay up-front for an asset has a disproportionate effect on your returns… since money today is worth more than money tomorrow. Private equity firms do the same exact thing, but with entire companies rather than properties or houses: they buy the company using a combination of debt and equity (cash), and then they sell it 3-5 years into the future to realize a return. And just like how we used the home’s rental income to pay off interest and debt principal, the PE firm uses the company’s cash flows to pay off interest and debt principal. So why does an LBO work? There are three key reasons:

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1. By using debt, you reduce the up-front cash payment for the company, which boosts your returns. 2. Using the company’s cash flows to repay debt principal and pay interest also produces a better return than keeping the cash flow. 3. You sell the company in the future, which allows you to gain back the majority of the funds you spent to acquire it in the first place. Unlike a merger model, you are not assuming that the PE firm keeps the company it acquires for the long-term. If it did that, realizing solid returns (above 15%) would be impossible.

It pays to use as much debt as the company’s cash flow can possibly support, and to maximize the price when you go to sell the company in the future. The Mechanics of an LBO Here’s how it works: 1. The private equity firm calculates how much it will cost to acquire all the shares outstanding of the company (if it’s public) or to simply acquire the company (if it’s private). 2. To raise the funds , the PE firm will use a small amount of its cash on-hand (almost always less than 50% of the company’s total value) and then raise debt from investors to pay for the rest… 3. …And it can raise debt from investors because it says to them, “We’re using the debt to buy an income-generating asset – this company. And we’ll repay everything because we’ll sell this company in the future and use the proceeds to pay you back.” 4. The PE firm raises the debt from investors, and then it combines that cash with its own cash to acquire the company. 5. The PE firm operates the company for years into the future, and uses its cash flow to pay the interest and repay the principal on the debt that it borrowed to buy the company.

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6. Then at the end of 3-5 years, the PE firm sells the company or takes it public via an IPO and realizes a return like that. It is very similar to the process of buying a house using a down payment and a mortgage, with the key difference being the magnitude: (most) companies are much more valuable than (most) houses. What Makes for a Good LBO Candidate? There are a few characteristics that private equity firms look for when buying companies – ideal candidates should: •

•

• • • • •

Have stable and predictable cash flows (so they can repay debt); Be undervalued relative to peers in the industry (lower purchase price); Be low-risk businesses (debt repayments); Not have much need for ongoing investments such as CapEx; Have an opportunity to cut costs and increase margins; Have a strong management team; Have a solid base of assets to use as collateral for debt.

The first point about stable cash flows is the most important one. This is why leveraged buyouts rarely happen in industries like oil, gas, and mining, where commodity prices can change dramatically and push cash flows up or down by 50-100% in a year. The rest of the points are all related to boosting cash flow, optimizing debt repayment, and getting as a high price as possible when the PE firm sells the company.

Key Rule #2: How to Make Basic Model Assumptions You need to do 3 major things here: 1. Assume a purchase price and the amount of debt and equity you’ll be using. 2. Figure out the debt terms , including interest rates and annual repayment.

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3. Create a Sources & Uses schedule that tracks where your funds are coming from, and where they’re going to. For the purchase price, you would use all the standard methodologies and also look at the premium if it’s a public company; you focus on Equity Value because you need to acquire all the outstanding shares of a public company. The percentages of debt and equity would be based on recent, similar deals as well as what lenders will go for – if you propose 90% debt, for example, that might be too aggressive and risky for them. Here’s what these basic assumptions might look like for a leveraged buyout:

Interest rates and annual repayments depend on the type of debt you want to use and what’s going on in the market. Bank debt generally has lower interest rates as well as 10-20% annual principal repayment – it’s “less risky” since it’s secured by collateral; high-yield debt , by contrast, tends to have higher interest rates and no annual repayment because it’s unsecured and therefore riskier, and investors will demand higher returns as a result. There are other differences as well. For example, bank debt has maintenance covenants (e.g. Total Debt / EBITDA must always be below 4x, or EBITDA / Interest Expense must always be above 2x), whereas high-yield debt has incurrence covenants (e.g. the company cannot acquire another company and cannot sell off assets). Normally in an LBO, you’ll look at several different combinations of debt and assess what makes the most sense for the company you’re acquiring:

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•

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•

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What’s the Leverage Ratio (Debt / EBITDA)? Is it too high or too low relative to other companies? What’s the Interest Coverage Ratio (EBITDA / Interest)? Is that too high or too low relative to other companies? Is the company planning a major expansion or acquisition that would limit the types of debt it can take on? What are lenders comfortable with? Will it be more / less difficult to get investors on board with certain debt structures?

There’s a lot that goes into it, and there’s no simple rule you can apply to determine the “best” structure. Here’s what the debt assumptions might look like for the same LBO example we used above:

Notice how the bank debt has a lower interest rate and higher principal repayments (though the 1% is still very low there), and how the high-yield debt has no principal repayments. Sources & Uses Once you’ve determined everything above, you create a Sources & Uses schedule that shows where the transaction funding is coming from, and where it’s going to. Common Sources of Funding: • •

•

Common Uses of Funding:

Debt (all types) Investor Equity (cash from the PE firm) Debt Assumed

• •

• •

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Equity Value of Company Advisory, Legal, Financing, and Other Fees Debt Assumed Refinanced Debt


It probably makes intuitive sense to include Debt and Cash from the PE firm in the “Sources” column – after all, that’s how the firm pays for the deal. The Uses column consists of anything that you use those funds for – the vast majority of the funds goes to pay for the company itself, but there are also lots of fees there… …and the possibility of having to refinance existing debt – in other words, pay off the company’s debt when the PE firm acquires it. Most of the time , the PE firm must pay off any existing debt when it buys a company because the terms of the debt state that it must be repaid when the company is acquired. But it is not a hard-and-fast requirement.

If the PE firm assumes the debt instead, it records it in both the Sources and Uses columns and the existing debt remains on the company’s Balance Sheet afterward. If the PE firm assumes the debt, it has no impact on the total funds it must raise; if it pays off the debt, it increases the funds required. You can see the impact for yourself in the Sources & Uses table below:

Since the PE firm is refinancing this company’s existing debt, that increases the funds required to complete the deal by $1.1 billion. Do You Pay the Equity Value or Enterprise Value to Acquire a Company in a Leveraged Buyout? Neither one! At least, not exactly either one – it depends on what you do with the company’s existing Debt:

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•

•

Assume Existing Debt: In this case, the effective purchase price will be closer to the company’s Equity Value (but not the same due to cash). Repay Existing Debt: Here, the effective purchase price will be closer to the company’s Enterprise Value (but not the same due to cash).

This is a little confusing, but that’s how it works. And if you understand these concepts, you’ll be well-ahead of other interviewees who have no idea how to explain this.

Key Rule #3: How to Project the Statements and Pay Off Debt Ideally, you can re-use the existing financial statements that you’ve already built for the company rather than re-inventing the wheel here. Projecting the full financial statements goes beyond the scope of this interview guide and gets into the concepts covered in our financial modeling courses – but here are a few quick guidelines, starting with the Income Statement: •

• •

•

•

Revenue Growth: You generally want this to decline over time (e.g. 10% initially down to 5% in Year 5). EBIT / EBITDA Margins: These should stay in the same range each year. Balance Sheet Items: Many of these can be percentages of revenue, COGS, or Operating Expenses; you can use historical averages. Depreciation & Amortization and Other Non-Cash Charges: Historical averages and percentages of revenue. Capital Expenditures: Make it a percentage of revenue, use a historical average, or assume a fixed dollar amount growth each year.

Here’s what these assumptions look like in our sample LBO model:

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Once you have the key financial statement line items for the period you’re projecting, you can use the numbers to calculate how much debt the company pays off each year. Calculating Free Cash Flow In the context of an LBO model, “Free Cash Flow” means Cash Flow from Operations minus CapEx. That is slightly different from the definitions used for Levered FCF and Unlevered FCF in the DCF section of the guide. Here it really means: “How much cash do we have available to repay debt principal each year , after we’ve already paid for our normal expenses and for the interest expense on that debt?” IF there are other recurring items in the Cash Flow from Investing and Cash Flow from Financing sections (e.g. investment purchases or sales each year), you may include those here as well – but it’s not particularly common to see them in an LBO model. Here’s what the calculations and projections look like in our model:

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Remember from the Accounting section that since interest on debt is tax-deductible , it shows up on the Income Statement, NOT the Cash Flow Statement. So we’ve already factored in interest by the time we calculate Free Cash Flow here, and it’s unnecessary to include it anywhere on the Cash Flow Statement. Once you’ve calculated FCF, the logic to repay Debt is straightforward: •

•

Make any mandatory repayments first. For example, if you are required to pay off $100 million each year on one tranche of debt, that always has to come first, before anything else. Then, with the remaining cash flow available, make optional repayments. So if you’re left with $50 million after making all the mandatory repayments, you can repay additional debt principal with that $50 million.

There’s a bit more to it than this because of the following factors: •

•

•

Most companies have a minimum cash balance that needs to be maintained at all times – they always need cash to pay employees and cover general operating expenses. So you can’t assume that 100% of its cash flow goes into repaying debt. Not all types of debt can be repaid early – it’s allowed with bank debt, but not with high-yield debt. The company may not have enough cash flow for its minimum mandatory debt repayments, in which case it would need to borrow more via a Revolver (sort of like a credit card for a company) to make the mandatory repayments.

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Interest Payments and Circular References One final note before we move on: the interest expense on the Income Statement in an LBO model depends on how much Debt is paid off over the course of a year – because the company pays interest each quarter or each month. So normally in models you average the beginning and ending Debt balances to determine the annual interest expense – but that also creates a circular reference because the ending Debt balance depends on how much cash flow you had, after paying for interest… but the interest itself depends on the ending Debt balance! You can leave that in, but to simplify models you can base the interest expense on only the beginning Debt balance each year to get around this problem. That’s the purpose of the “Allow Circular References?” field at the very top of our model:

If that is set to “Yes,” we average the beginning and ending Debt balances each year to calculate interest; otherwise, if it’s set to “No,” we use the beginning balances instead.

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Key Rule #4: How to Calculate Returns Calculating returns is very similar to what we did in the example at the top for buying, renting out, and selling a house: • •

•

The equity (cash) that the PE firm puts down at the beginning is a negative… Any cash or dividends issued to the PE firm throughout the period are positive (most of the time this is $0 because the PE firm uses all available cash flow to repay debt)… And the sale proceeds minus the debt outstanding at the end are also positive and represent what the PE firm “gets” when it sells the company.

You set all that up in Excel, as shown below, and use the IRR function to calculate the internal rate of return:

What does this number – the “IRR” – actually mean? It’s telling us, “If we invested this initially amount of money and got this specific interest rate, compounded each year , we’d end up with the total amount of money shown in the final year at the end of the period.” So the internal rate of return (IRR) is just the effective interest rate on this investment. If the PE firm receives cash or dividends from the company, those would increase the IRR because they’d boost the total amount of funds received by the firm. Determining the Exit Assumptions

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The “down payment” in the beginning is straightforward because it comes directly from the Sources & Uses schedule; cash and dividends received also come straight from the company’s financial statements, so there is nothing complicated there. But how do you determine how much the company can be sold for? We glossed over this part in the rental house example above and just assumed that its value increased 10% over 5 years. In an LBO model, you assume an exit EBITDA multiple for the company, usually close to or below the purchase EBITDA multiple. For example, if the PE firm acquired the company for 10x EV / EBITDA, maybe you’ll assume that they can sell it for 8 – 10x EV / EBITDA and show a range of different outcomes based on those numbers. Once you calculate the Enterprise Value, you work backwards to calculate the Equity Value based on the company’s Cash, Debt, Preferred Stock, and other Balance Sheet items that factor into the calculation. Mental Math and Rules of Thumb Especially in private equity interviews, they may ask you to calculate an approximate IRR in your head based on various assumptions. Here are a few rules of thumb you can apply to calculate IRR quickly: • • • •

If a PE firm doubles its money in 5 years, that’s a 15% IRR. If a PE firm triples its money in 5 years, that’s a 25% IRR. If a PE firm doubles its money in 3 years, that’s a 26% IRR. If a PE firm triples its money in 3 years, that’s a 44% IRR.

Time plays a huge factor here and if a PE firm can get a good price for a company early on, it will almost always sell the company earlier rather than later. Here’s an example of how you can use these rules to approximate IRR: •

•

A PE firm buys a company with no existing cash or debt for $1 billion, at an EV / EBITDA multiple of 10x. They use 50% debt and 50% equity.

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•

•

At the end of a 5-year period, they sell the company for the same 10x EBITDA multiple, but its EBITDA has grown to $150 million. It has also paid off $100 million worth of debt.

Here, you can say that Enterprise Value roughly equals Equity Value equals $1 billion in the beginning. The PE firm therefore puts down $500 million in cash in the beginning and uses $500 million of debt. At the end, they sell it for $1.5 billion, and they must repay $400 million worth of debt, so their net proceeds are $1.1 billion. They’ve more than doubled their money over a 5-year period ($1 billion in net proceeds would be doubling it), so you can estimate this IRR as “just over 15%” or guesstimate it as 16-18%. The actual IRR is 17.1%. What Affects the IRR in an LBO? These variables make the greatest impact on IRR in a leveraged buyout: 1. Purchase Price 2. % Debt and % Equity Used 3. Exit Price Other factors include the revenue growth rate, EBITDA margins, interest rates, and anything else that affects cash flow on the financial statements. •

•

Changes That Increase IRR: Lower Purchase Price, Less Equity, Higher Revenue Growth, Higher EBITDA Margins, Lower Interest Rates, Lower CapEx Changes That Reduce IRR: Higher Purchase Price, More Equity, Lower Revenue Growth, Lower EBITDA Margins, Higher Interest Rates, Higher CapEx

Know these rules and you’ll be able to answer all related questions effectively. When in doubt, ask yourself: will this change boost cash flow? If the answer is “yes,” then it will increase returns. Otherwise, it will decrease returns. Here’s what a few sensitivity tables based on these variables might look like:

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Investment Banking Interview Action Plan

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