Morgan Stanley IB Interview Questions

A company trades at a higher P/E (price-to-earnings ratio: share price divided by earnings per share) in four cases: investors expect faster earnings growth, its cost of equity is lower (the return shareholders require, which is lower when the business is less risky), it pays out more of its earnings at the same growth rate, or its current earnings are temporarily depressed. The first three come straight out of a dividend discount model. The fourth is a denominator effect. The price reflects normal future earnings, but the ratio divides by a trough figure.

Answer in three slots, in this order. Business: name the company and its sector, and say what it does in one line. Financials: give its approximate market capitalization (the total value of its shares) and its valuation multiples, such as EV/EBITDA (enterprise value, the value of the whole business to all investors, divided by EBITDA, a proxy for operating cash profit) and P/E (share price divided by earnings per share). Then say how those compare with peers. Interest: give two reasons it is interesting, one tied to an M&A (mergers and acquisitions) deal and one tied to a macro trend. That way any follow-up leads into material you have prepared.

You subtract the increase in net working capital because NOPAT, the after-tax operating profit FCFF starts from, is an accrual number. It records revenue when earned and costs when incurred, regardless of when cash changes hands. Net working capital (NWC) is operating current assets, such as receivables and inventory, minus operating current liabilities, such as payables. When NWC rises, the business has cash tied up that earnings never showed. FCFF is the cash available to both debt and equity holders, so it takes that amount out. When NWC falls, the same line adds cash back.

Company A pays $6.00 per Company B share. At 7x EBITDA, Company B's enterprise value (what the whole business is worth to lenders and shareholders together) is 7 × 100 = 700. Debt is 4x EBITDA, or 400. That leaves 300 of equity value for B's 50 shares, which is $6.00 per share. Paying in stock changes how A pays. The price stays the same: A issues its own shares worth that amount.

The equity is worth $0. Enterprise value (the value of the whole business to all its lenders and owners) is $50mm of EBITDA (earnings before interest, taxes, depreciation and amortization, a rough proxy for operating cash flow) × 4 = $200mm. That is $100mm short of the $300mm of debt. Shareholders are paid last and have limited liability, so their stake stops at zero and cannot go negative. Walk the $200mm down the claims in order of priority. The $100mm of senior debt (paid first) is covered twice over and should trade at or near par, meaning 100 cents per dollar of face value. The $200mm of junior debt (paid after senior) gets the remaining $100mm and should trade near 50 cents on the dollar.

The two metrics are ARR growth and net dollar retention (NDR). ARR (annual recurring revenue) growth gives the size of the growth: how fast the base of contracted subscription revenue gets bigger. NDR gives its quality: what the same group of customers pays this year against last year, after upgrades, downgrades and cancellations.

Duration is the weighted average time until you receive a bond's cash flows, with each payment weighted by its present value (what that future payment is worth in today's money). In practice it measures interest-rate risk. Modified duration gives the approximate percentage change in a bond's price for a one percentage point change in its yield (the annual return you earn if you buy at today's price and hold the bond to maturity). A bond with a modified duration of 7 loses roughly 7% of its value if its yield rises by 1%.

Enterprise value (EV, the value of the business's operations to all its investors, lenders and shareholders together) stays the same in a simple world without taxes. Equity value goes up by $100 and debt goes down by $100, so the two changes cancel out. Add taxes and value falls slightly. The company loses part of its tax shield: the tax it saved by deducting interest on the $100 of debt it paid off.

All else equal, the semiconductor company will usually have the worse credit rating. A credit rating is an agency's grade (for example from S&P or Moody's) of how likely a borrower is to repay its debt on time. Chipmakers tend to have cyclical revenue, heavy capital expenditures, and weaker free cash flow conversion. Their cash available to service debt is less predictable than a typical software company's recurring, asset-light cash flow.

Equity value is 1,000 and the share price is $10.00. An 8x EV/EBITDA multiple on 200 of EBITDA gives enterprise value of 1,600. Enterprise value is the price of the whole operating business, the piece lenders and shareholders fund together, and EBITDA is earnings before interest, taxes, depreciation and amortization, a rough proxy for operating cash flow. A leverage ratio of 3x is normally read as debt sized at three times EBITDA, so debt is 600. Take 600 out of 1,600 and equity value is 1,000. Spread 1,000 over 100 shares and you get $10.00 a share.

A net asset value (NAV) model values a business piece by piece at what the pieces would fetch in the private market today, then nets out what is owed. For a real estate company or REIT, you capitalize stabilized net operating income (property rental revenue less property-level operating costs) at the market capitalization rate for that asset type. Add the assets NOI does not capture: development in progress, land, cash and joint venture stakes. Subtract debt, preferred and noncontrolling interests. Divide by fully diluted shares including operating partnership units. The output is NAV per share. Compare it to the traded share price and you see whether the stock sits at a premium or a discount to the value of its assets.

A pays with borrowed cash, so it issues no new shares, and the deal breaks even when the after-tax interest cost equals B's net income of 5. Solve r_d × Purchase Price × (1 − 20%) = 5, which gives r_d = 5 ÷ (Purchase Price × 0.80) = 6.25 / Purchase Price. Purchase Price = B's acquisition P/E × 5, so this is the same as r_d = 1.25 ÷ B's acquisition P/E.