Mastering the Technical Interview

You're set on breaking into investment banking, and have high (false) hopes of day drinking and purchasing a Bugatti with part of your bonus. Wonderful. Before you get there, a pesky hurdle remains: Your technical interviews.

Recognizing the importance of the matter, our contributor BowTiedFeline decided to share his wisdom with you. We'll hand it over to Feline now to show us how a pro prepares for, masters, and obliterates technical questions.

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Hello all. Feline here. I'll start with a personal anecdote. I was studying for months for an interview to get into my University’s “elite” hedge fund club. Resume, good. Behavioral Interview, good. Technical Interview...

“Describe to me what a Price to Depreciation-per-share ratio is supposed to say.” What! This wasn’t in the Vault Guides! I never even heard of this! But the interviewers know better than me, so this ratio is probably something I overlooked. “Yea sure. It’s used to determine a company’s capital intensity in relation to its market value. A higher ratio is likely common among less capital-intensive industries such as technology…”

My answer was great, I knew I could BS my way through that one! I later found out that the correct answer to this was something along the lines of “I don’t know.” Why? Because that metric is non-existent. It doesn’t even make sense.

So familiarizing yourself with guides like the Wall Street Vault and being confident in your knowledge and hard work is essential to getting through these interviews. Don’t try to BS it.

Accounting

Know what purpose each statement serves.

Income Statement: how much a company earns from its normal course of operations

Balance Sheet: what the company owns, owes, and is worth

Cash Flow: determines how much and from where cash is flowing in and out of the company

  • The most important statement, why? negative cash flows = road to bankruptcy

  • A company generating negative net income for years on end can STILL be standing as a result of debt or equity issuances (see: hydrogen companies)

Know how these 3 are all connected so you can describe a change in one line item and how/if it permeates throughout all 3 financial statements.

A question you are 100% going to receive (line-item may differ):

How does a $10 increase in depreciation impact the 3 financial statements?

Answer:

  • IS: $10 in expenses, at 30% tax rate net income will be -$7

  • BS: Assets: PP&E -$10, cash +$3, Equity: retained earnings -$7

  • CF: Cash from Ops: +$3

Answer (with thought process):

  • Start with income. OK Depreciation is an expense. So that needs to get subtracted. And we can’t forget about taxes. So we have -$10 in expenses, but at a 30% tax rate we get a +$3 benefit. So -$10 + $3 we get net income = -$7

  • Balance Sheet. Depreciation is the use of an asset. Property plant and equipment is a measure of total assets that get depreciated, so that must fall by $10. We also got that $3 tax benefit, so cash goes up by $3. And since Net Income fell by $7, that impacts our equity by -$7. Assets = -$7 and Equity = -$7

  • Cash Flow. Nothing happened to your cash except that you got that $3 tax benefit lol! Since Cash From Operations starts with Net Income, we start at -$7. But since depreciation has no effect on cash, yet we subtracted it anyways (in order to get net income), we will add back this non-cash expense of $10. Cash from operations is +$3

It could take a bit to make these connections, so try various scenarios and see what kind of though process works best for you. I think the best way is to start with the Income statement, then get Balance Sheet out of the way, then finish with the Cash Flow statement.

Valuation

This is where the money is. Literally. A good understanding of valuation will net your firm additional millions (USTT). How? Justify an 11x vs. 10x multiple on your company.

There are many ways to value a company – choosing the best one all depends on the company and situation. Lets go through the most common valuation types, when you should use them, and what kind of value they’ll likely spit out. Note: The current market cap of a public company is actually ONE way to value the company, which is price times shares outstanding – but because markets are NOT efficient, there are always opportunities to generate ALPHA, so you want to use other valuation methods using your own assumptions to determine any mis-pricing in the current market cap

You could value a company based on its Relative or Intrinsic value

Relative valuation types:

Precedent Transactions:

Analyzing a company based on another transaction that was completed with a similar company. Say you want to know how much your lemonade stand is worth, and you remember last year a lemonade conglomerate bought a lemonade stand right down the road from you. You can use that information to help piece together a valuation for your own business!

But sometimes it can be difficult to dig out specifics from a prior deal that:

  • is in a similar market

  • has similar financial metrics

  • is similar in size

  • and synergies that you may or may not want to include in your analysis

It’s difficult to find a true precedent to compare, but it’s possible and very useful when you find good comparable precedent transactions, especially if your company is private.

Example:

You want to know how much your lemonade stand is worth. You remember a similar stand across the street was bought out last year, and you decide to use Precedent Transaction to see how much your biz could be worth.

  • That lemonade stand was generating $20,000 of net income per year, and was bought for $200,000. That means it was bought at a 10x multiple! Your lemonade stand generates about $5,000 per year. So you do some math and see that it’s not too far-fetched to assume your business could be worth $50,000.

  • There are other considerations to take into account. Perhaps the neighborhood duck (troll) unexpectedly left. Now you can stop wasting your time and money buying it grapes and focus more on your biz. You now expect to generate more income this year and possibly DOUBLE. We are talking about a high-caliber troll here (LINK). So maybe your business should be worth more than $50,000 (> 10x multiple) now!

    power duck - YouTube
    Source: come on you know the source
  • OR. Maybe your neighborhood was throwing block parties every weekend last year which resulted in elevated sales, but has dramatically slowed down this year. In this case, a $50,000 purchase price (10x multiple) for your stand may be a bit optimistic.

  • Regardless the circumstance, at least you have a starting point to begin determining an accurate valuation for your biz.

  • Other note: for public companies, you can see that the buyer usually pays a premium to what the company currently trades at on the open market. This is because it includes a control premium they pay to acquire a controlling stake in the company (few will sell their company and give up their control at face value, need incentive to let it go). Synergies also play a role in acquiring other companies at a premium.

Public Company Comparables:

Actually very similar to precedent transactions, except uses multiple public companies’ current valuation (multiple) to determine:

  • where your company stands on the valuation ladder (public company) or

  • where your company could trade if it went down the IPO route (private company)

The key here again is to do your best to find companies in a similar market, geography, customer-base, capital structure, etc. as your company. Again you may not find perfect comparables, but it will give you a good sense of where your company stands/should stand in terms of valuation.

This is where the term “spreading comps” comes from - you’re creating a list of comparable companies with various multiples to see where a certain company stacks up against the rest of them.

Comparative Company Analysis Tutorial | Street Of Walls
Source: Street of Walls

Intrinsic valuation type:

Discounted Cash Flow Model:

Oh yea, the big enchilada. This method is based on the theory that a company’s current valuation is equal to the sum of all its future cash flows, which we discount to the present. This method works very well with established companies that have predictable cash flows. It does not work so well with growing tech companies, as forecasts could be anybody’s guess. Things such as Total Addressable Market penetration etc. could help venture a guess. BUT. Here’s the real *secret* I will share with you for getting this far:

Anybody that runs a DCF model on a company, any company, simply reverse-engineers it to return a value consistent with what it is trading at today. Then they simply nudge growth and cost numbers up or down depending on how they want to sell the stock to investors. Smart analysts (rare) would actually look at the numbers, see if they’re entirely off-base and adjust them accordingly, but this is usually too hard to predict. The final output is the price target they want it to be. Seriously. Wall Street estimates don’t actually mean anything.

Some of these valuation types (precedents, comparables, DCF) would be more appropriate than others in determining a company’s valuation. Often all of them are used to get a sense of a how much a company is worth based on every method. Another *secret*:

The one that spits out the highest valuation is usually given more weight than others, as long as it can be justified. The justification process is easy. Let’s say the DCF model spits out the highest valuation. The stock pitch to investors would go something like: “We think the DCF method is the best method to value the company. Peers in the space trade at lower comps (multiples) because their growth potential is nowhere near that of our company. The intrinsic valuation method is therefore best to use to capture the enormous anticipated market penetration of our company, justifying our (absurdly high) valuation.”

 

highest valuation methodology
Source: Wall Street Oasis

 

Discounted Cash Flow Analysis

Yes this is a section of its own, in fact I will probably make a whole substack on it with a real-world example. You have to know how to run a DCF model. I’ll go through this fairly quickly quickly and at a high level.

Some notes on assumptions seen in model screenshot:

  • Depreciation: kept flat for illustrative purposes – there are many ways to forecast this “more accurately” - you could build out a depreciation schedule based on the assets in the portfolio, make depreciation expense a percentage of Property Plant and Equipment etc.

  • CapEx: kept flat for illustrative purposes – it’s really just the growth in Gross PPE per year - you could have CapEx grow as a % of revenues since a company must spend money to make money, though this might not make much sense for a growing tech company as capital intensity declines, so you could factor in declining capital intensity depending on the biz

 

NOTE: For the turbo autists wondering why I used an 11.0x EV/EBITDA multiple under the Exit Multiple method. Because it got me close to the “price per share” seen in the Gordon Growth Method.

If I used a 15.0x multiple the price target would be $8.35, which is 32% (!!) above the current projected $6.57. You now see how analyst price targets could easily be manipulated. @BowTiedBull has discussed some reasons as to why an analyst might purposely do this. We’ll go through those reasons in detail in the future (Spoiler alert: Banks are Zeros).

In defense of the analysts: it really is impossible to know what terminal value multiple a company should have. Some do have the best intentions of honest research and analysis in mind, there are just too many unpredictable variables to accurately forecast. And as you saw above, the difference between an 11x and 15x exit terminal multiple (just one of many assumptions) is an enormous 32% price difference.

The question you’ll get in a technical interview: Walk me through a DCF

  • You can start from Revenue and take the interviewer down to EBIT

  • Forecast 5-10 years of EBIT

  • Multiply EBIT by 1 x tax rate to get NOPAT (Net Operating Profit After Tax)

  • Add back depreciation, subtract changes in NWC (Net Working Capital), subtract capex to get FCF

  • Discount them all to the present using WACC as the discount rate

  • Find the terminal value using the Gordon growth method

  • Take the last years’ cash flow, multiply by 1 * terminal growth rate, divide that by the WACC – growth rate

  • Discount that boy back to the present

  • Add up the present value of the terminal value and future cash flows to get enterprise value

  • Subtract debt and minority interest, add back cash to get Equity value

  • Divide equity value by number of shares outstanding to get Equity Value per share

Other questions you could be asked are related to individual aspects of the DCF model, like:

  • How do you calculate WACC?

    • wtd. avg. cost of equity plus wtd. avg cost of debt times 1 – the tax rate plus wtd. avg cost of preferreds

  • Why do you multiply the cost of debt by 1 minus tax rate?

    • tax shield on interest expense

  • How do you calculate cost of equity?

    • Capital Asset Pricing Model (CAPM)

  • What’s the formula for CAPM?

    Capital Asset Pricing Model (CAPM) - Quant investing
    Source: Robeco
  • How do you calculate Terminal Growth value using Gordon Growth Method?

    • Take the last year FCF times 1 + the terminal growth rate, and divide by the discount rate minus the growth rate

  • Why can’t the growth rate be higher than the discount rate?

    • because the number is the growth rate of the company in perpetuity. If it’s growing faster than the required rate of return forever, then the company would then become the entire world economy as every last drop of capital naturally flows into the business. That’s why the terminal growth rate is usually the rate of GDP growth, as a company matures it’ll likely grow in-line with GDP.

These are nowhere near all the possible questions you’ll receive, and we didn’t go over the more technical parts of some concepts (believe it or not). Such as explaining how to unlever Beta, minority interest, walk through an LBO model, etc. These can be found and studied in the guides. This substack goes through these concepts in laymens terms to grasp the conceptual aspect of the higher-level, most important topics.

But I will go through one last one since it’s kind of fun - the Brain Teaser

Brain Teasers

It’s exactly as it sounds. you’re asked a question impossible to answer without googling some facts to help you out. The point is to see how your mind works, how you attempt to problem solve, whether you use inductive or deductive reasoning to get to the answer, etc.

Example: how many quarters would I need to stack from the floor for it to reach the ceiling?

Don’t get flustered, you’re not expected to get a right answer. However, you should come within a 20-30% margin of error through your reasoning. Let’s walk through one of many ways you can go about it

OK. so 1 inch of quarters is probably around 8 or so. We’ll round up to 10 quarters per inch.

I’m about 6 feet tall, so my arm must be 3 feet, if I stand and reach to the ceiling, there’s probably another human length to go before the ceiling is reached. Let’s call it 15 feet in total.

15 feet times 12 inches to get total inches. Well 15 times 10 is 150, add 15 times 2 which is 30, and we get a total of 180 inches. We said 1 inch of quarters is about 10 quarters, so 10 times 180 equals 1,800 quarters to get from the floor to the ceiling.

That’s a great answer. And likely somewhat close to the real answer depending how good your 15 feet and 10 quarters = 1 inch assumptions are. Just think it through, what information could you use that you are aware of in order to deduct or induct a decent response?

As you can see, your technical interviews are a no-BS zone. Either you know your material or you don't. Prepare diligently, and perhaps one day, we'll be both able to dream about fancy cars and 24/7 bottle service on the roof of a skyscraper. Good luck.

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