Equity Investment Interviews: Key Questions To Prepare For

Equity research interview questions are designed to assess a candidate's suitability for a role in equity research. These interviews typically cover technical knowledge, transaction experience, firm knowledge, and culture fit. Technical questions aim to evaluate the candidate's understanding of financial concepts, such as valuation methods, financial statements, and cost of debt or equity. Candidates may also be asked to pitch a stock or explain their approach to research and modelling. Transaction experience questions focus on the candidate's previous deals and their ability to handle challenging situations. Firm-specific questions explore the candidate's knowledge of the company and its portfolio, while culture fit questions assess their personality, work ethic, and motivation for joining the firm.

Pitch a stock

A stock pitch is a short write-up or presentation that analyses the potential of investing in a public company's stock. It can be used for networking, interviews, investment clubs, investment competitions, personal investing, and on the job as an investor. A good stock pitch will articulate the investment thesis to investors in a concise and convincing manner.

The classic structure of a stock pitch should include:

• Stock recommendation (long or short)
• Company overview (background, business model, market share, industry trends, stock price, trading volumes)
• Investment thesis (why the market is wrong about the current stock price)
• Catalysts (upcoming events that will affect the stock price and push the market to fulfil the asset's intrinsic value)
• Valuation (DCF, NAV, or relative valuation)
• Risk factors and how to mitigate them

Stock Recommendation

The first part of your stock pitch should be a brief summary of your investment idea. State whether you are recommending a long or short position on a specific company and give a strong reason why.

Company Overview

Provide an overview of the company's background, including market share and major industry trends. You can also include the stock price and trading volume data for the company's history or recent years. Give a brief description of the company's business model and its appeal, including its position in the industry, product portfolio, differentiation points, business segments, geographical exposure, competitors, customers, and suppliers.

Investment Thesis

The investment thesis should explain why the stock is a good investment by defining the value of the stock in a portfolio. The thesis should be motivated by the idea that the stock is currently mispriced, and the market has not yet factored in certain information. Point out something that others may be missing or misunderstanding about the company.

Catalysts

Back up your investment thesis by mentioning upcoming events or potential events that will affect the stock price in the suggested timeframe (usually 6-12 months). These could include product launches, acquisitions, earnings reports, cash flow fluctuations, and competitor tactics.

Valuation

For a long recommendation, show that the stock is undervalued (e.g. trading at $25 but worth $35-$40). For a short recommendation, demonstrate why the stock is overvalued. Use valuation metrics such as DCF (discounted cash flow), NAV (net asset value), or relative valuation to calculate the stock's fair value.

Risk Factors and How to Mitigate Them

Finally, describe the key risks associated with your suggested investment strategy and how to reduce them. Make sure to consider only company-specific risk factors. For example, a global recession would impact a wide range of companies, not just the one you are pitching.

Explain the difference between enterprise value and equity value

Enterprise value and equity value are two metrics used to value a business, often in the context of a merger or acquisition. While they both relate to the value of a company, there are some key differences between the two.

Enterprise Value

Enterprise value (EV) represents the total value of a business, encompassing both debt and equity. It takes into account the market value of equity, as well as the market value of net debt and other sources of funding, such as preferred shares and minority interests. Essentially, it reflects the value of the business to all investors, including lenders (debt holders) and shareholders (equity holders).

The formula for calculating enterprise value is:

> EV = (share price x number of shares) + total debt - cash

Enterprise value is often used in valuation techniques as it allows for a comparison between companies with different capital structures. It is commonly used in investment banking when advising clients on mergers and acquisitions.

Equity Value

Equity value, on the other hand, represents the portion of the company's value that belongs to the shareholders. It gives information about the shareholders' wealth in the firm, excluding debt obligations. Equity value is calculated by adding enterprise value to redundant or non-operating assets and then subtracting the net debt (total debt minus cash available).

The formula for calculating equity value is:

> Equity value = Enterprise Value - total debt + cash

Equity value is commonly used by owners and shareholders and is an important metric for them as it represents their stake in the company. It is also used in equity research, where analysts advise investors on buying individual shares.

Key Differences

The main difference between enterprise value and equity value lies in their scope. Enterprise value provides an overall picture of the company's worth, including all sources of funding, while equity value focuses specifically on the value attributable to shareholders. Enterprise value tends to be a faster and easier calculation, while equity value offers an indication of potential future value and growth potential.

To summarise, while enterprise value represents the total value of the business, equity value represents the value belonging to shareholders after any debts have been paid off. Both metrics are important in understanding the financial health and attractiveness of a company, especially in the context of mergers, acquisitions, and investment decisions.

Describe your ideal work environment

When asked to describe your ideal work environment, it is important to remember that employers ask this question to determine if you would be a good fit for the role and their company culture. Therefore, your answer should be well-researched and honest. Here are some tips to help you craft an effective response:

• Determine your ideal work environment: Reflect on the factors that contribute to your preferred atmosphere at work. This could include communication styles, work-life balance, training programs, access to amenities, physical workspace design, and management approach, among others.
• Consider what employers are looking for: Employers seek an answer that aligns with what their company can offer. They want an honest and confident response that showcases your understanding of their company culture.
• Research your prospective employer: Take time to research the company's policies, values, and work environment. Visit their website and social media accounts, reach out to current employees, and read company reviews and press releases to gain insights into their culture and work environment.
• Highlight overlaps during the interview: During the interview, discuss any overlaps between your ideal work environment and what the company offers. Refer to your research on the company and showcase your teamwork abilities and core values that align with theirs.
• Focus on important environmental elements: When answering the question, focus on one or two key environmental elements that are crucial for your success. Explain why you believe the company can provide this type of work environment and reference specific details such as company size or core values to demonstrate your understanding of their culture.
• Practice your response: Prepare in advance by identifying the most important factors for you and practicing your response out loud. This will help you connect the company's culture to your ideal work environment during the interview.

"I prefer to work both independently and as part of a team. During my research about your company, I noticed that employees collaborate and then branch off into their individual duties. This balance of teamwork and independence is how I thrive as an accountant. While I value collaborating with colleagues, I also appreciate having dedicated time to focus on my accounting responsibilities."

How do you calculate the cost of equity?

Calculating the cost of equity is a crucial skill for investment bankers and financial analysts. The cost of equity is the rate of return a company pays out to equity investors, and it is used to assess the relative attractiveness of investments. Companies usually use a combination of equity and debt financing, with equity capital being the more expensive option.

There are three main methods for calculating the cost of equity: the Capital Asset Pricing Model (CAPM), Dividend Capitalization, and the Weighted Average Cost of Equity (WACE).

Capital Asset Pricing Model (CAPM)

The CAPM takes into account the riskiness of an investment relative to the market. The formula for CAPM is:

> E(Ri) = Rf + βi * [E(Rm) – Rf]

Where:

• E(Ri) = Expected return on asset i
• Rf = Risk-free rate of return
• Βi = Beta of asset i
• E(Rm) = Expected market return

The risk-free rate of return is the expected return from a risk-free investment, such as government bonds or US Treasury bills. The beta of an asset measures its systematic risk or volatility relative to the market. The expected market return is typically the average return of the market over a specified period, usually between five to ten years.

Dividend Capitalization Model

The Dividend Capitalization Model only applies to companies that pay dividends and assumes that dividends will grow at a constant rate. The formula for this model is:

> D1 = Dividends/share next year

> P0 = Current share price

> g = Dividend growth rate

To calculate the dividends per share for the next year, companies usually announce dividends in advance. This information can be found in company filings or press releases. If not available, an assumption can be made based on historical data.

The current share price of a company can be found by searching the ticker or company name on the exchange the stock is traded on or by using a credible search engine.

The dividend growth rate can be obtained by calculating the growth of the company's past dividends and then taking the average. The growth rate for each year is calculated using the following equation:

> Dividend Growth = (Dt/Dt-1) – 1

Where:

• Dt = Dividend payment of year t
• Dt-1 = Dividend payment of the previous year (t-1)

Weighted Average Cost of Equity (WACE)

The WACE method is suitable for companies with multiple forms of equity and considers stock prices, retained earnings, and equity distribution. This approach is more complex, and professional advice may be warranted.

Example Calculation

As an example, let's calculate the cost of equity for XYZ Co., which is currently trading at $5 per share and has announced a dividend of $0.50 per share for the next year. The dividend growth rate is estimated to be 2%.

Using the CAPM formula:

> Re = ($0.50/$5) + 2%

The cost of equity for XYZ Co. is 12%.

In conclusion, calculating the cost of equity involves assessing the rate of return expected by equity investors. This calculation is essential for investment decisions and financial analysis, helping determine the attractiveness of investments and the potential return on equity investments.

How do you value a private company?

Valuing a private company is a complex process that requires a good understanding of different valuation methods and their application. Here are the key steps and considerations for valuing a private company:

• Understand the Nature of the Private Company: The first step is to categorise the private company into one of the three main types: Money Businesses, Meth Businesses, or Empire Businesses. Money Businesses are small companies heavily dependent on their owners, such as a local barber shop. Meth Businesses are typically venture-backed startups aiming for rapid growth, like tech startups. Empire Businesses are large private companies with diverse management teams and strong processes, like Ikea or Cargill. This categorisation is crucial as it determines the valuation approach and the extent of discounts applied.
• Obtain Standardised Financial Statements: Before beginning the valuation, ensure that the company's financial statements follow standard accounting principles (IFRS, U.S. GAAP, or local GAAP) and that revenue and expense items are properly classified. This step is especially important for Money Businesses, as they often have non-standard financial statements.
• Comparable Company Analysis: This method compares the valuation ratios of the private company to similar public companies. Find a comparable public company of similar size and business operations, and apply its valuation multiples, such as the price-to-earnings (P/E) ratio, to the private company. For example, if a public widget-making company has a P/E ratio of 15, investors value its earnings at $15 for every $1 of earnings per share (EPS). You can reasonably apply this ratio to your private widget-making company. If your company has earnings of $2 per share, the share price would be $30, and 10,000 shares would be worth approximately $300,000.
• Discounted Cash Flow (DCF) Analysis: This method is more complex and involves forecasting future free cash flows and discounting them to their present value using an appropriate discount rate. The DCF analysis is suitable for Empire and Meth Businesses. However, for Money Businesses, it is crucial to heavily discount the terminal value or skip it altogether due to their high dependence on key individuals.
• Precedent Transactions: This approach compares the private company's valuation to recent transactions of similar private companies. It is important to note that this method does not typically involve an illiquidity discount, as it reflects the acquisition of entire companies rather than individual share purchases.
• Asset-Based Valuation: This method involves examining the company's balance sheet and subtracting the total liabilities from the total net asset value. There are two approaches: the Going Concern Approach, suitable for companies planning to continue operations, and the Liquidation Value Approach, used when the company is winding down.
• Understand the Purpose of the Valuation: The purpose of the valuation can impact the chosen methodology and the extent of discounts applied. For example, if valuing a venture-backed tech startup before its Initial Public Offering (IPO), you might not apply a discount, whereas if estimating the price for a private buyer, a modest discount might be appropriate.
• Consider the Buyer's Perspective: The valuation should also take into account the profile of the potential buyer. A large, diversified public company as a buyer would warrant a lower discount rate, whereas a single, non-diversified private buyer would require a higher discount rate due to increased risk.
• Apply Private Company Discounts: When using comparable company analysis, it is common to apply a private company or "illiquidity" discount, typically ranging from 10% to 30%, to account for the lack of liquidity and differences in scale. The discount applied depends on the nature of the private company, with Money Businesses requiring larger discounts and Empire Businesses requiring smaller or no discounts.
• Calculate Terminal Value: The calculation of terminal value depends on the type of private company. For Money Businesses, heavily discount the terminal value or skip it altogether, assuming the business will decline once key individuals are no longer involved. For Meth and Empire Businesses, calculate the terminal value using standard methods, such as the Multiples Method or Perpetuity Growth Method.
• Consider Other Valuation Methods: Other methods can be used depending on the specific circumstances, such as the net tangible assets approach or the internal rate of return (IRR) method.
• Seek Professional Opinion: Valuing private companies can be complex, and there are firms specialising in equity valuations for private businesses. Engaging their services can provide a professional opinion to support your valuation.

In conclusion, valuing a private company requires a tailored approach that considers the company's nature, financial statements, comparable companies, and the purpose of the valuation. By applying appropriate valuation methods, discounts, and adjustments, you can arrive at a reasonable estimate of the private company's value.

Frequently asked questions