Equity Research Interview Questions

If you are called for an equity research interviews, you can be asked any

question from anywhere. You should not take this lightly as this can change

your Finance career. Equity Research interview questions are a mix of

technical and tricky questions. So, you need to have thorough knowledge in

financial analysis, valuation, financial modeling, the stock market, current

events and stress interview questions.

Let’s find out below the top 20 Equity Research interview questions that are

repeatedly asked for the positions of equity research analysts.

Question #1 – Do you know the difference between equity value and

enterprise value? How are they different?

This is a simple conceptual equity research interview question and you need
to first mention the definition of enterprise value and equity value and then tell
the differences between them.

Enterprise value or Firm Value considers much more than just the value of a
company’s outstanding equity. It tells you how much a business is worth.
Enterprise value is the theoretical price an acquirer might pay for another firm,
and is useful in comparing firms with different capital structures since the
value of a firm is unaffected by its choice of capital structure.
- The simple formula for enterprise value is: EV = Market Capitalization +
Market Value of Debt – Cash and Equivalents. The extended formula is: EV =
Common Shares + Preferred Shares + Market Value of Debt + Minority Interest –
Cash and Equivalents.
 - Enterprise Value = Market Value of Common Stock + Market Value of
Preferred Stock + Market Value of Debt + Minority Interest – Cash &
Investments.
- Whereas, equity value formula can be expressed as follows 
- Equity Value = Market Capitalization + Stock Options + Value of equity
issued from convertible securities – Proceeds from the conversion of
convertible securities
- The basic difference between enterprise value and equity value is
enterprise value helps investors get a complete picture of a
company’s current financial affairs; whereas, equity value helps
them shape future decisions.

2. What are the most common ratios used to analyze a company?

1. Solvency Ratio Analysis

- Current Ratio
- Quick Ratio
- Cash Ratio
2. Turnover Ratios
- Receivable Turnover
- Days Receivable
- Inventory Turnover
- Days Inventory
- \Accounty Payable Turnover
- Days Pyable
- Cash Conversion Cycke
3. Operating Effiency Ratio Analysis
- Asset Turnover Ratio
- Equity Turnover
4. Operating Profitability Ratio Analysis
 5. Business Risk
6. Financial Risk
7. External Liquidity Risk

3. What is Financial Modeling and how it is useful in Equity Research?

- This is again one of the most common equity research interview questions􏰬 Financial
Modeling is nothing but projecting the financials of the company is a very organized
manner. As the companies that you evaluate onl􏰬 pro􏰬ide the historical 􏰬nancial
statements􏰬 this 􏰬nancial model helps equit􏰬 anal􏰬st understand the fundamentals of the
company - ratios􏰬 debt, earnings per share, and other important 􏰬aluation parameters.

- Forecast income statement, cash flow, and balance sheet for the future years

4. How do you do a DCF?

Financial modeling starts with populating the historical financial statements of the
company in a standard format.

Thereafter, we project these three statements using a step by step financial modeling
technique.

The three statements are supported by other schedules like the: Debt and Interest
Schecule, Plant and Machinery & DepreciationSchedule, Working Capital, Shareholder
Equity, Intangible and Amortization Scheules

Once the forecast ius done, you move to the vakuations fo the firm using thr DCF approach

Calcuate the “Free Cash Flo=w” to “Firm or Free Cash Flow to Equity” and find rhe present
valye of the cash flows rto the ifnd their valuation fo the stock

5. What is free cash flow to firm?  Free cash flow to firm is the escess cash that si generated
after taking into consideration the working capital requirements as the cost associated with
maintaining and revnewing the fixed assets. Free cash flow to firm goes to tehe holderts and the
equity holderts.

Equity and shareholders' equity are not the same thing. While equity typically
refers to the ownership of a public company, shareholders' equity is the net
amount of a company's total assets and total liabilities, which are listed on the
company's balance sheet. For example, investors might own shares of stock in a
publicly traded company.

A Company's Equity Defined

Equity could also refer to the extent of ownership of an asset. For example, an
owner of a house with a mortgage might have equity in the house but not own it
outright. The home owner's equity would be the difference between the market
price of the house and the current mortgage balance.

KEY TAKEAWAYS

 Equity typically refers to the ownership of a public company or an asset.

An individual might own equity in a house but not own the property
outright.
 Shareholders' equity is the net amount of a company's total assets and
total liabilities as listed on the company's balance sheet.
 Shareholders' equity is an important metric for investors. It forms part of
the ROE ratio, which shows how well a company's management is using
its equity from investors to generate profit.
KEY TAKEAWAYS

 Equity typically refers to the ownership of a public company or an asset.

An individual might own equity in a house but not own the property
outright.
 Shareholders' equity is the net amount of a company's total assets and
total liabilities as listed on the company's balance sheet.
 Shareholders' equity is an important metric for investors. It forms part of
the ROE ratio, which shows how well a company's management is using
its equity from investors to generate profit.

Shareholder's Equity as a Metric

Market analysts and investors prefer to see a stable balance between the
amount of retained earnings that a company pays out to investors in the form of
dividends and the amount retained to reinvest back into the company.

Shareholders' equity represents a company's net worth. It is the amount that

would be returned to shareholders if all the company's assets were liquidated
and all its debts repaid.
Shareholders' equity is an important metric for investors. The metric is used to
determine the ratio return on equity (ROE). ROE is the result of a company's net
income divided by shareholders' equity, and the ratio is used to measure how
well a company's management is using its equity from investors to generate
profit.

Return on Equity – ROE

What Is Return on Equity – ROE?
Return on equity (ROE) is a measure of financial performance calculated by
dividing net income by shareholders' equity. Because shareholders' equity is
equal to a company’s assets minus its debt, ROE could be thought of as
the return on net assets.

ROE is considered a measure of how effectively management is using a

company’s assets to create profits.

Formula and Calculation for ROE

ROE is expressed as a percentage and can be calculated for any company if net
income and equity are both positive numbers. Net income is calculated before
dividends paid to common shareholders and after dividends to preferred
shareholders and interest to lenders.

Net Income is the amount of income, net of expense, and taxes that a company
generates for a given period. Average Shareholders' Equity is calculated by
adding equity at the beginning of the period. The beginning and end of the period
should coincide with that which the net income is earned.
Net income over the last full fiscal year, or trailing 12 months, is found on
the income statement—a sum of financial activity over that period. Shareholders'
equity comes from the balance sheet—a running balance of a company’s entire
history of changes in assets and liabilities.

It is considered the best practice to calculate ROE based on average equity over
the period because of this mismatch between the two financial statements. Learn
more about how to calculate ROE.

What Does ROE Tell You?

Return on equity (ROE) deemed good or bad will depend on what’s normal for a
stock’s peers. For example, utilities will have a lot of assets and debt on the
balance sheet compared to a relatively small amount of net income. A normal
ROE in the utility sector could be 10% or less. A technology or retail firm with
smaller balance sheet accounts relative to net income may have normal ROE
levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the
average for the peer group. For example, assume a company, TechCo, has
maintained a steady ROE of 18% over the last few years compared to the
average of its peers, which was 15%. An investor could conclude that TechCo’s
management is above average at using the company’s assets to create profits.

Relatively high or low ROE ratios will vary significantly from one industry group or
sector to another. When used to evaluate one company to another similar
company the comparison will be more meaningful. A common shortcut for
investors to consider a return on equity near the long-term average of the S&P
500 (14%) as an acceptable ratio and anything less than 10% as poor.

KEY TAKEAWAYS

 Return on equity measures how effectively management is using a

company’s assets to create profits.
 A good or bad ROE will depend on what’s normal for the industry or
company peers.
 As a shortcut, investors can consider a return on equity near the long-term
average of the S

Using ROE to Estimate Growth Rates

Sustainable growth rates and dividend growth rates can be estimated using ROE
assuming that the ratio is roughly in line or just above its peer group average.
Although there may be some challenges, ROE can be a good starting place for
developing future estimates of a stock’s growth rate and the growth rate of
its dividends. These two calculations are functions of each other and can be used
to make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply ROE by the

company’s retention ratio. The retention ratio is the percentage of net income
that is “retained” or reinvested by the company to fund future growth.

ROE and Sustainable Growth Rate

Assume that there are two companies with an identical ROE and net income, but
different retention ratios. Company A has an ROE of 15% and returns 30% of its
net income to shareholders in a dividend, which means company A retains 70%
of its net income. Business B also has an ROE of 15% but returns only 10% of its
net income to shareholders for a retention ratio of 90%.

For company A, the growth rate is 10.5%, or ROE times the retention ratio, which
is 15% times 70%. business B's growth rate is 13.5%, or 15% times 90%.

This analysis is referred to as the sustainable growth rate model. Investors can
use this model to make estimates about the future and to identify stocks that may
be risky because they are running ahead of their sustainable growth ability. A
stock that is growing slower than its sustainable rate could be undervalued, or
the market may be discounting risky signs from the company. In either case, a
growth rate that is far above or below the sustainable rate warrants additional
investigation.

This comparison seems to make business B look more attractive than company
A, but it ignores the advantages of a higher dividend rate that may be favored by
some investors. We can modify the calculation to make an estimate of the stock’s
dividend growth rate which may be more important to income investors.

Estimating the Dividend Growth Rate

Continuing with our example from above, the dividend growth rate can be
estimated by multiplying ROE by the payout ratio. The payout ratio is the
percentage of net income that is returned to common shareholders through
dividends. This formula gives us a sustainable dividend growth rate, which favors
company A.

The company A dividend growth rate is 4.5%, or ROE times payout ratio, which
is 15% times 30%. Business B's dividend growth rate is 1.5%, or 15% times 10%.
A stock that is growing its dividend far above or below the sustainable dividend
growth rate may indicate risks that need to be investigated.

Using ROE to Identify Problems

It’s reasonable to wonder why an average or slightly above average ROE is good
rather than an ROE that is double, triple, or even higher the average of their peer
group. Aren’t stocks with a very high ROE a better value?
Sometimes an extremely high ROE is a good thing if net income is extremely
large compared to equity because a company’s performance is so strong.
However, more often an extremely high ROE is due to a small equity account
compared to net income, which indicates risk.

Inconsistent Profits
The first potential issue with a high ROE could be inconsistent profits. Imagine a
company, LossCo, that has been unprofitable for several years. Each year’s
losses are on the balance sheet in the equity portion as a “retained loss.” The
losses are a negative value and reduce shareholder equity. Assume that LossCo
has had a windfall in the most recent year and has returned to profitability. The
denominator in the ROE calculation is now very small after many years of losses
which makes its ROE misleadingly high.

Excess Debt
Second is excess debt. If a company has been borrowing aggressively, it can
increase ROE because equity is equal to assets minus debt. The more debt a
company borrows, the lower equity can fall. A common scenario that can cause
this issue occurs when a company borrows large amounts of debt to buy back its
own stock. This can inflate earnings per share (EPS), but it doesn’t affect actual
growth rates or performance.

Negative Net Income

Finally, there’s negative net income and negative shareholder equity that can
lead to an artificially high ROE. However, if a company has a net loss or negative
shareholders’ equity, ROE should not be calculated.

If shareholders’ equity is negative, the most common issue is excessive debt or

inconsistent profitability. However, there are exceptions to that rule for
companies that are profitable and have been using cash flow to buy back their
own shares. For many companies, this is an alternative to paying dividends and it
can eventually reduce equity (buybacks are subtracted from equity) enough to
turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a

warning sign worth investigating. In rare cases, a negative ROE ratio could be
due to a cash flow supported share buyback program and excellent
management, but this is the less likely outcome. In any case, a company with a
negative ROE cannot be evaluated against other stocks with positive ROE ratios.

ROE vs. Return on Invested Capital

While return on equity looks at how much in profit a company can generate
relative to shareholders’ equity, return on invested capital (ROIC) takes that
calculation a couple of steps further.
The purpose of ROIC is to figure out the amount of money after dividends a
company makes based on all its sources of capital, which includes shareholders
equity and debt. ROE looks at how well a company utilizes shareholder equity,
while ROIC is meant to determine how well a company uses all its available
capital to make money.

Limitations of Using ROE

A high return on equity might not always be positive. An outsized ROE can be
indicative of a number of issues—such as inconsistent profits or excessive debt.
As well, a negative ROE, due to the company having a net loss or negative
shareholders’ equity, cannot be used to analyze the company. Nor can it be used
to compare against companies with a positive ROE.

Example of How to Use ROE

For example, imagine a company with an annual income of $1,800,000 and
average shareholders' equity of $12,000,000. This company’s ROE would be as
follows: