Interview Test # 2:Job Interview of an Equity Analyst
Team Latte March 23, 2007
This is a rough and a partial transcript of a job interview of an equity analyst. The interviewer was the Head of Research in the investment banking division of a bank in Hong Kong and the interviewee had three years of experience after completing his CPA. He is also a CFA charter holder.
Interviewer's Question :
A property deal is about to take place. An investment bank is preparing a bid to acquire an important landmark building in Hong Kong for US$100 million. The building is around 7 years old and the expected operating income from the building in the next year is US$3 million. The rental yield in central Hong Kong is around 5%. The free cash flows that will be generated from the building will be $1 million for the next year and it is expected to grow at the rate of 10%.
Is this a good deal for the bank?
Candidate's Answer :
No, it is not a good deal. The sale price  the amount that the bank is bidding is too high. The capitalization rate is 3% as opposed to the rental yield of 5%.
Our Comment :
The candidate is spot on. One of the first things that you look for in any property deal is the capitalization rate  operating income divided by the sale price  and compare that to the return. It is somewhat like comparing the cost of cost of capital with the internal rate of return of a project. However, in the problem the rental yield is given, which may or may not be exactly equal to the return calculation. Of course, a detailed analysis of valuation can be done using free cash flow valuation method but in an interview that is not possible.
Interviewer's Question :
You are analyzing a listed company and a lot of information is given, including the projected (forward) next year's P/E ratio, which is say 15. Also given are the figures for EBITDA, which is $20 million, long term debt of $200 million, equity capital of $350 million, and free reserves of $10 million.
How would you calculate the cost of equity very roughly from the above?
Candidate's Answer :
It is difficult to explicitly compute the cost of equity from the above. If it is a listed company then one way to compute the cost of equity is to use a CAPM model with the value of beta, market return and the risk free rate.
Our Comment :
If you take the inverse of P/E ratio you can get a sense for the value of cost of equity. This is a quick and dirty method. If the P/E is 15 then a rough value for the cost of equity of the firm is 6.67%. On way to look at this is that the higher the price earning ratio the lower will be the cost of equity as it gets easier for the company to pay less and raise more from the market.
Interviewer's Question :
A company is planning to revalue some of its assets by 20% due to inflation in the property prices. How will it affect the balance sheet of the company? Does this mean that the valuation of the company will increase?
Candidate's Answer :
Since the assets are revalued the balance sheet will become bigger. But unless the company sells the assets right away this does not bring in any cash to the shareholders. The revaluation of the assets will show up as revaluation reserve on the liabilities side, so even if the balance sheet gets bigger there is no available reserve to the shareholders. If you are valuing the company based solely on its assets value then surely the valuation of the company will go up. However, what matters is how much of an added cash flow will be generated due to this revaluation (other things being equal) which will then change the discounted cash flow value of the company.
Our Comment :
In our opinion this answer is truly as good as it gets.
Interviewer's Question :
(With a broad smile......) What is broken with DCF analysis? How do you fix it? .
Candidate's Answer :
I am not sure what you are talking about. Are you talking about the flaws in DCF valuation models? There are a couple that I can point out, such as the choice of discount factor and the treatment of free cash flows, etc. Is that what you are asking?
Our Comment :
This is actually a cryptic question. "What is broken with DCF analysis?" Not sure we can answer this question either. Perhaps everything. Company valuation process using CAPM and DCF methods are static and deterministic. But we believe that a company survives, does well, defaults or decays according to a random phenomenon, which is at best approximated by analyzing the randomness surrounding a company's earnings and cash flows, plus many other things, such as stock price, debt level. In other words, volatility of earnings, cash flows, equity prices and asset prices is the key. Randomness is modeled in a stochastic framework by using volatility. But then that is far, far away from any conventional equity analysis
Interviewer's Question :
Suppose an analyst makes a forecast of 10 cents as the EPS of a company for the next year. This year's EPS was 8 cents and the next years actual EPS turns out to be 18 cents. How would you rate the analyst's forecasts?
Candidate's Answer :
The interviewee did not give us his answers
Our Comment :
This relates to Thiel's inequality coefficient (TIC) and the mean squared forecast error. Both these concepts are popular and widely used by analysts and institutional investors
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