Monthly Archives: April 2012

I have never driven a Ferrari

Bo Gaugua, a Harvard student, is having a bad year.  Highlights include:

  • Dad, prominent China Communist Party Leader Bo Xila, has been dismissed, triggering China’s biggest political crisis in decades.
  • Mentor, British businessman Neil Heywood, died last fall.
  • Mom, Gu Kailai, was arrested for Heywood’s murder earlier this month.

But what really hurts are the accusations leveled against Gaugua himself, namely acting like a spoiled rich kid, throwing lavish parties and driving a red Ferrari.  It’s those personal attacks that Guagua decided to tackle head on, in an email he sent to the Harvard Crimson.

Investment Banker’s Excel Spreadsheet of Dating Prospects

Creepy as hell, but excellent attention to detail and use of Excel’s Data Validation feature.

Here’s the spreadsheet (click to enlarge):

Read more at dealbreaker:

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“Efficient” markets: do we need them for valuation?

Anyone who has done valuation for very long, whether discounted cash flow models or comparables, realizes that there are a host of assumptions behind the mechanics of the analysis. Some of these are based on straightforward economic logic. For example, if the returns we expect on our investment exceed our opportunity cost of capital (i.e., what we could have earned doing the next best thing), then we have created economic value for ourselves (which can easily be expressed as a positive NPV). If not, we have misallocated our capital. Or, for example: the less uncertainty we bear with regard to receiving our returns (i.e., higher probability of receiving the cash flows), all else being equal, the more highly we will value them (i.e., we will discount them less); thus debt has a lower “cost” than equity for the same firm.

But economic logic only takes us so far. When it comes to many of the assumptions in our models (e.g., the DCF), we look to historical data, either from the capital markets or the economy as a whole. Common examples: Using the historical nominal GDP growth as a proxy for terminal growth rate. Calculating a firm’s current market capitalization/total capitalization as a proxy for its future capital structure for the purpose of estimating WACC. Finally, using market prices to estimate a firm’s “cost” of equity (i.e., the CAPM).

Naturally, these latter assumptions, all of which rely on empirical and historical data from the markets, prompt us to ask: how reliable are those data as benchmarks for valuation? The question of whether markets are “efficient” or not is not merely an academic discussion.

I recently had an interesting correspondence with Michael Rozeff, Professor Emeritus of Finance at the University at Buffalo, on some of these very issues. He shared with me a paper he published online critiquing the Efficient Market Hypothesis (EMH) and offering an alternative view, called the Market Pricing Maxim (MPM). I wanted to share it here with our readers:

Over the next several weeks, I plan to further discuss the concepts behind many of our assumptions (particularly with regard to the cost of capital), unpacking the logic behind them and asking how it lines up with economic reality, in the same spirit that Professor Rozeff does in his paper on efficient markets. In the meantime, enjoy the paper!

Investment Banking Interview Prep: Accounting Quick Lesson

You can’t avoid accounting questions in an investment banking interview.  Even if you’ve never taken an accounting class, chances are, you’ll be asked questions that require rudimentary accounting knowledge.

Wall Street Prep’s Accounting Refresher is designed to give people with about 10 hours of time to kill a serious crash course in Accounting.  But what if you only have 30 minutes?  That’s what this quick lesson is for.

Accounting Quick Lesson

There are three financial statements that you should use to evaluate a company:  Balance Sheet, Cash Flow Statement, Income Statement.   There is actually a 4th statement, the Statement of Shareholder’s Equity, but questions about this statement are rare.

The four statements are published in periodic and annual filings for companies and are often accompanied with financial footnotes and management discussion & analysis (MD&A) to help investors better understand the specifics of each line item.  It is critical that you take time to not only look at the four statements, but also read through the footnotes and MD&A carefully to better understand the composition of these numbers.

Balance Sheet
It is a snapshot of the company’s economic resources and funding for those economic resources at a given point in time.  It is governed by the fundamental accounting equation:

Assets  = Liabilities + Shareholders’ Equity 

Assets are the resources a company uses to operate its business and includes cash, accounts receivable, property, plant & equipment (PP&E).  Liabilities represent the company’s contractual obligations and include accounts payable, debt, accrued expenses, etc.  Shareholders’ Equity is the residual – the value of the business available to the owners (shareholders) after debts (liabilities) have been paid off.  So, equity is really assets less liabilities.  The easiest way to intuitively understand this is to think of a house worth $500,000, financed with a $400,000 mortgage and a $100,000 down-payment.  The asset in this case is the house, the liabilities are just the mortgage, and the residual is the value to the owners, the equity. One thing to note is that while both liabilities and equity represent sources of funding for the company’s assets, liabilities (like debt) are contractual obligations that have priority over equity. Equity holders, on the other hand, are not promised contractual payments.  That being said, if the company increases its overall value, the equity investors realize the gain while the debt investors only receive their constant payments.  The flip side is also true.  If the value of the business drastically falls then equity investors take the hit.  As you can see, equity investors’ investments are more risky than that of debt investors.

Income Statement
The income statement illustrates the profitability of the company over a specified period of time.  In a very broad sense, the income statement shows revenue less expenses equaling net income.

Net Income = Revenue – Expenses     

Revenue is referred to as the “top-line.”  It represents the sale of goods and services.  It is recorded when earned (even though cash may not have been received at the time of transaction).

Expenses are netted against revenue to arrive at net income.  There are several common expenses among companies including: cost of goods sold (COGS); selling, general, and administrative (SG&A); interest expense; and taxes.  COGS are costs directly associated with the production of the goods sold while SG&A are costs indirectly associated with the production of the goods sold.  Interest expense represents expense related to paying debt holders periodic payments while taxes is an expense related to paying the government.  Depreciation expense, a non-cash expense accounting for the use of plant, property and equipment, is often either imbedded within COGS and SG&A or shown separately.

Net Income is referred to as the “bottom-line.”  It is revenue – expenses.  It is the profitability available to common shareholder’s after debt payments have been made (interest expense).

Related to net income is earnings per share.  Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.

EPS = (net income – dividends on preferred stock) / weighted average shares outstanding)

Diluted EPS expands on basic EPS by including shares of convertibles or warrants outstanding in the outstanding shares number.

A very important part of accounting is understanding how these financial statements are inter-related.  The balance sheet is linked to the income statement through retained earnings in shareholder’s equity, specifically net income.  This makes sense because net income is the profitability available to shareholders during a specific period and retained earnings is essentially undistributed profits.  So, any profits not distributed to shareholders in the form of dividends should be accounted for in retained earnings. Getting back to the house example, if the house generates profits (via rental income), cash will go up and so will equity (via retained earnings).

Cash Flow Statement
The income statement discussed in the previous section is needed because it illustrates the company’s economic transactions.  While cash is not necessarily received when a sale occurs, the income statement still records the sale.  As a result, the income statement captures all the economic transactions of the business.  The cash flow statement is needed because the income statement uses what is called accrual accounting.  In accrual accounting, revenues are recorded when earned regardless of when cash is received.  In other words, revenues include sales using cash AND made on credit (accounts receivable).  As a result, net income reflects cash and non-cash sales.  Since we also want to have a clear understanding of the cash position of a company, we need the statement of cash flows to reconcile the income statement to cash inflows and outflows.

The cash flow statement is divided into three subsections: cash from operating activities, cash from investing activities, and cash from financing activities.

Cash from operating activities can be reported using the direct method (uncommon) and indirect method (the predominant method). The indirect method starts with net income and includes the cash effects of transactions involved in calculating net income.  Essentially, cash from operating activities is a reconciliation of net income (from the income statement) to the amount of cash the company actually generated during that period as a result of operations (think cash profits vs accounting profits). The adjustments to get from accounting profit (net income) to cash profits (cash from operations) are as follows:

Net income (from income statement)
+ non-cash expenses
– non-cash gains
- period-on-period increases in working capital assets (accounts receivable, inventory, prepaid expenses, etc.)
+ period-on-period increases in working capital liabilities (accounts payable, accrued expenses, etc.)
= Cash from operations

For a stable, mature, “plain vanilla” company, a positive cash flow from operating activities is desirable.

Cash from investment activities is cash related to investments in the business (i.e., additional capital expenditures) or divesting businesses (sale of assets).  For a stable, mature, “plain vanilla” company, a negative cash flow from investing activities is desirable as this indicates that the company is trying to grow by buying assets.

Cash from financing activities is cash related to capital raising and payments of dividends.  In other words, if the company issues more preferred stock, we will see such an increase in cash in this section.  Or, if the company pays dividends, we will see a cash outflow related to such a payment.  For a stable, mature, “plain vanilla” company, there is not a preference for positive or negative cash in this section.  It ultimately depends on the cost of such capital relative to the investment opportunity schedule.

Net Change in Cash Over the Period = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities

The cash flow statement is linked to the income statement in that net income is the top line of the cash flow from operations section when companies use indirect method (most companies use indirect).  The cash flow statement is linked to the balance sheet in that it represents the net change in cash over the period (magnification of the cash account on the balance sheet).  So, a previous period’s cash balance plus the net change in cash this period represents the latest cash balance on the balance sheet.

Statement of Shareholder’s Equity:
Bankers are rarely asked questions about this statement.  Essentially, it is a magnification of the retained earnings account.  It is governed by the formula below:

Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

The statement of shareholder’s equity (also called “statement of retained earnings”) is linked to the income statement in that it pulls net income from there and links to the balance sheet, specifically, the retained earnings account in equity.

Think you’re ready for the questions? Give them a try….

“Please walk me through the three financial statements”

Note: This question is part of our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge.

How to answer this question

Ultimately, your answer shouldn’t last more than 2-3 minutes.  Focus on the major parts of the three financial statements.  For example, if you forget to mention assets when discussing balance sheet but instead go off and discuss non-consolidated interests for 3 minutes, you clearly failed to separate essential from non-essential information and thus failed answering the question.

Poor answers to this question would be answers that don’t focus on the meaty parts of each financial statement.  If you find yourself discussing specific accounts in detail, you are straying from the general picture, which is what this question focuses on.

Great answers to this question are structured and presented strategically.  A great answer will be high level and will provide commentary on the general purpose of each statement while still highlighting key aspects.

Sample great answer

“The three financial statements are the income statement, balance sheet, and statement of cash flows. 

The income statement is a statement that illustrates the profitability of the company.  It begins with the revenue line and after subtracting various expenses arrives at net income.  The income statement covers a specified period like quarter or year. 

Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year.  The balance sheet shows the company’s resources (assets) and funding for those resources (liabilities and stockholder’s equity).  Assets must always equal the sum of liabilities and equity. 

Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance.  It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating.  Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year.”

For a deeper dive, check out this video.

“How are the financial statements linked together?”

Note: We continue our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge.  


To successfully answer this question, make sure you have the financial accounting fundamentals down pat.  Poor answers are ones that are too wordy or miss key linkages.

 Sample great answer

The bottom line of the income statement is net income.  Net income links to both the balance sheet and cash flow statement. 

In terms of the balance sheet, net income flows into stockholder’s equity via retained earnings.  Retained earnings is equal to the previous period’s retained earnings plus net income from this period less dividends from this period. 

In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations.  Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. 

Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash.  The net change in cash on the cash flow statement and cash from the previous period’s balance sheet comprise cash for this period.

For a deeper dive, watch this video.

“Company A has $100 of assets while company B has $200 of assets. Which company should have a higher value?”

Note: This question is part of our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge.

How to answer this question

On the face of it, we simply don’t have enough information to answer this question.   Statistics in a vacuum are meaningless.  It needs to be in comparison to something to have value.  We need certain efficiency and profitability ratios to understand how the companies are using assets to generate revenues.

But don’t blow off this type of question – it is a softball that you can turn to your advantage. This is an open-ended question; the interviewer wants you to ask follow up clarifying questions, solicit more information and to showcase your understanding of accounting and financial analysis to be able to say something meaningful about a company.

Sample great answer

You: Given that we only know the total amount of assets for both company A and B and nothing else, it is impossible to say whether A or B is more valuable. Would I be able to ask you some questions about both companies?

Interviewer: Sure

You: Would you be able to tell me what industry these two companies operate in?

Interviewer: They are both consumer products companies.

You: Can I assume that both companies have similar expected asset turnover (revenue/assets), leverage, return on asset, re-investment rates and profit margins?

Interviewer: Yes, let’s assume this is correct.

You: Okay, thank you.  Based on this information, it appears that we are comparing two companies with similar returns on capital, long term growth rates, and costs of capital.  Since these elements are the primary drivers of value for a business, as long as both companies generate returns above their cost of capital, the firm with the larger assets deserves a higher valuation because they are both effectively “converting” their assets into profitability with equal efficiency, given similar risks and expected growth.

Investment Banking Interview Question: “Walk me through the accounting for the following transaction”

Note: This question is part of our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge.

Question: If I issue $100mm of debt and use that to buy new machinery for $50mm, walk me through what happens in the financial statements when the company first buys the machinery and in year 1.  Assume 5% annual interest rate on debt, no principal pay down for the 1st year, straight-line depreciation, useful life of 5 years, and no residual value.

Sample Great Answer

If the company issues $100mm of debt, assets (cash) goes up by $100mm and liabilities (debt) goes up by $100mm.  Since the company is using some of the proceeds to buy machinery, there is actually a second transaction that will not affect the total amount of assets.  $50mm of cash will be used to buy $50mm of PPE; thus, we are using one asset to buy another one.  This is what happens when the company first buys the machinery.

Because we have issued $100mm of debt, which is a contractual obligation, and because we are not paying down any part of the principal, we must pay interest expense on the entire $100mm.  So, in year 1 we must record corresponding interest expense which is the interest rate times the principal balance.  Interest expense for the 1st year is $5mm ($100mm * 5%).  And, since we now have $50mm of new machinery, we must record depreciation expense (as required by matching principle) for use of the machinery.  Since the problem specifies straight-line depreciation, useful life of 5 years, and no residual value, depreciation expense is $10mm (50/5).  Both interest expense and depreciation expense provide tax shields of $5mm and $10mm, respectively, and will ultimately reduce the amount of taxable income.

“Why is the cash flow statement important and how does it compare to the income statement?”

Note: This question is part of our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge

How to answer this question

To successfully answer this question, you need to make sure that you clearly illustrate your understanding of cash vs. accrual accounting.  You need to recognize that both statements are important yet each has its own purpose (a related question revolves around the difference between EBITDA and free cash flows).

Poor answers to this question include ones that don’t discuss the purpose of each statement and specifically the differences (cash vs. accrual accounting).

Sample great answer

The income statement shows a company’s accounting-based profitability.  It illustrates a company’s revenues, expenses, and net income.  Income statement accounting uses what is called accrual accounting.  Accrual accounting requires that businesses record revenue when earned and expenses when incurred. 

Under accrual method, revenues are recognized when earned – not necessarily when cash is received – while expenses are matched to associated revenue – again not necessarily when cash goes out the door. The benefit of the accrual method is that it strives to show a more accurate picture of the companies profitability.  However, focusing on accrual based profitability without looking at cash inflows and outflows is very dangerous, not only because companies can more easily manipulate accounting profits than they can cash profits, but also because not having a handle on cash can potentially make even a healthy company go bankrupt.

Those shortcomings are addressed by focusing on the cash flow statement. The cash flow statement identifies all of the cash inflows and outflows of a business over a certain period of time.  The statement utilizes cash accounting.    Cash accounting is the system used to keep track of actual cash inflows and outflows.  What this really means is that since not all transactions are made with cash (i.e., accounts receivable), such transactions would be backed out of the cash flow statement.

Cash accounting literally tracks the cash coming into and out of the business.  One final point on cash vs. accrual accounting is that the differences between the two accounting systems are temporary timing differences that will eventually converge.      

The key to financial analysis is to use both statements together.  In other words, if you have incredibly high net income, such net income should be supported by strong cash flow from operations and vice versa.  If this is not the case then you need to investigate why such a discrepancy exists.