Risk Latte - Interview Questions # 5: Job Interview of a trainee (Equity) Analyst

Interview Questions # 5: Job Interview of a trainee (Equity) Analyst

Team Latte
May 14, 2007


Here is a brief text (partial transcript) of an interview of a trainee equity analyst fresh out of campus.

Interviewer's Question :

What is the difference between the book value of equity and the market value of equity? Why is the market value of equity for some companies so much higher than the book value?

Candidate's Answer :

Book value of equity is what is recorded on the book whereas the market value is the stock market value of the company. The stock market, given its speculative nature, always values a company much more than what is reflected on its book.

Our Comment :

When shareholders (promoters of a company) put up money as equity to start a company that becomes the initial book value of the equity valued at par. Then as the company lives on, the new issue of shares to new investors by the Directors of the company gets added to this value; on top of that all the undistributed profits of the company, which shows up as the last item on the profit and loss account also goes into this value. Of course, if the company makes a loss then that loss is deducted from this value. In short, initial equity (shares) plus the new issued equity plus the profits (or minus the losses) are the components of the book value of the equity. In many cases, some items such as revaluation reserve (which are not technically free reserves) are also added to the book value of the equity.
Market value of the equity, on the other hand, is the investors' - he general public who buy and sell shares through the stock market - valuation of a particular company and theoretically speaking it should be related to the investors' (implicit) forecast of profits (in the form of dividends). Market value of a share is the book value plus the present value of the residual income.
Of course, candidate's quip about the "speculative nature of the stock market" is based on the belief that a lot of investors are more concerned about the short term capital gains from holding a stock rather than motivated by any long term stream of dividends. This is also a valid argument, but it can be shown, both mathematically as well as using economic rationale that even capital gains from holding a stock is derived from an appreciation of a long term divided stream.


Interviewer's Question :

What is alpha? Where does alpha figure in the capital asset pricing model?

Candidate's Answer :

Not available.

Our Comment :

Alpha is the excess return of a manager. Here the excess return means by how much the manager has been able to beat the market. In other words, alpha can be expressed as the excess stock returns of a manager (his portfolio return over the risk free return) over the excess market return (the difference between the market return and the risk free return. In a linear capital market line:

Alpha corresponds to the intercept of the of the slope of the line of regression of excess stock returns against excess market returns. In a Capital Asset Pricing framework alpha should be zero.


Interviewer's Question :

What do you understand by DCF value of a firm?

Candidate's Answer :

N/A

Our Comment :

DCF, or discounted cash flow valuation methodology, is based on the rationale that the value of an asset is the sum of the total cash that it generates over its life (some finite horizon) adjusted of the present value of that cash. DCF is a "bottom up" process as opposed to relative value measures such as P/E multiple. P/E multiple, which is a "op down" process, is popular amongst many sell side professionals because it is rather easy to understand and explain. DCF is a complex process simply because estimating the future cash flows from the assets of the company is not always an easy task and can be tedious.


Interviewer's Question :

A company business operations or asset mix does not change significantly continuously over a very short period of time, say from day to day or even hour to hour; yet the traded price of the stock changes continuously and sometimes quite substantially over the short period of time. What is the reason for this?

Candidate's Answer :

N/A

Our Comment :

This is due to the continuous flow of information that comes to the investors as a result of the analysis and research (formal and informal) of a large number of experts and analysts. The price of a company's stock is the subject of continuous analysis by the experts and this generates information which is complex, some times confusion and most of the time cannot be treated as white noise. This causes the stock price of a company to gyrate and move over the short period of time.
In 1970, Eugene Fama coined the term "Efficient Market" and Fama's theory essentially took into account the above dynamics of the stock price. We refer the reader to this field of study to get more insight on this subject.


Interviewer's Question :

What is meant by the term Value investing? Can you give any two characteristics of a value stock?

Candidate's Answer :

N/A

Our Comment :

If the stock price of a company is significantly lower than what it should be otherwise given by the intrinsic (market determined) value of its assets and an investor tries to exploit this relationship by buying that stock, then he is engaging in value investing. Normally, the debt to equity ratio of a value stock is less than one. Another characteristic of a value stock is that the P/E yield, which is the inverse of P/E ratio, is normally double the yield of triple A (highest grade) bonds.



Reference: There are numerous text books, articles and research papers on corporate finance available. Some of them are excellent and some very good. However, we would like to recommend a very good concise reference which is available on the internet. It is Dr. Mark B. Shackleton's notes on "Advanced Corporate Finance". Dr. Shackleton is a Senior Lecturer in Finance at the University of Lancaster Management School .The reader can also check out the book "Equities - An Introduction to the Core Concepts" by Mark Mobius


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