Banking Careers Articles

Cheat Sheet / Updated 02-18-2022

Investment banking has a big impact on the world you live in, whether you have investments or not, and understanding what investment bankers do is important. Part of investment banking has to do with mergers and acquisitions, like why companies buy other companies and what’s in it for them. Even people who aren’t big on investing sometimes get the urge to be part of an initial public offering, more commonly known as an IPO. If visions of yachts and Bentleys are dancing in your head, we’ll disabuse you of those dreams, while letting you know what it really means to get in on an IPO.

Article / Updated 05-19-2020

The IPO (Initial Public Offering) still remains one of the pinnacles of what a company can achieve in its early life. When a company sells stock to the general public for the first time, it’s a sign that the company has a compelling enough story that it can attract outside investors to buy a piece of the company. IPOs are a financial transaction that requires the heavy involvement of investment banks. In this article, you find out the basics of IPOs. In a traditional IPO, the investment banking operation gets involved very early. The investment bankers are critical partners in allowing a company to go public. The lifecycle of a company: When going public makes sense When a company is young, financing can get pretty dicey. It’s not unheard of for very early investors to pay for equipment and salaries of employees with any money they can get their hands on. Charging up credit cards, hitting up family members for loans, and tapping retirement savings are all ways that an entrepreneur with the burning passion to start a company gets the process started. Starting a company takes a tremendous amount of money. If the company proves to be successful, the options for raising money, or financing, grows. Prior to going public with an IPO, a growing company may consider a few options to raise money, including the following: Venture capitalists: Venture capitalists are investors who pool money from other investors looking for very high potential returns, and are willing to suffer huge losses in the process. Venture capitalists take the money they gather, usually from large institutions like insurance companies or pension funds, and bet money by buying stakes of young companies that have great prospects. Although many of these bets don’t pan out, if the venture capitalists hit it big with a few of their bets, the returns can be huge. You don’t need to invest in many Googles (which ultimately sold stock to the public in a huge payday for venture capitalists) to make the gambles worthwhile. Although venture capitalists can be a critical place for young companies to raise money, it comes at a steep price if the company pans out. The venture capitalists end up owning a big slice of the company, which reduces the ultimate payout for the entrepreneur. Bank loans: Commercial banks are in the business of lending to companies that need capital. Periodically, a bank may extend a line of credit to a small business, especially if the business is stable. Banks, though, tend to be skittish and won’t lend if there’s even a scent of risk with the company. Internet companies, which have little in the form of assets, for instance may be turned away for bank loans because there isn’t anything to be used as collateral. Crowdfunding: The idea of crowdfunding is very new but likely to become more important. Currently, an entrepreneur with an idea can use websites like Kickstarter to explain to the public what her idea is and how much money she needs to make it happen. Consumers interested in making the product come to life are able to pledge a dollar amount on the crowdfunding site. As soon as enough money is raised, the company can use the cash to build the product. Crowdfunding is currently only a way for consumers to donate money to new businesses, not invest in them. Typically, these crowdfunding donors are given a token of appreciation for their contributions, usually early dibs on the product after it’s released. Currently, though, companies aren’t allowed to sell stock using crowdfunding. That’s changing though. The 2012 Jobs Act contains a provision that opens the future to the idea of stock-based crowdfunding where companies can sell stock to the public. The SEC is tasked with the job of allowing companies to raise money with crowdfunding, while protecting investors. For much more information on crowdfunding, check out Crowdfund Investing For Dummies, by Sherwood Neiss, Jason W. Best, and Zak Cassady-Dorion (Wiley). There may be options for companies not ready for an IPO to raise money. But at some point, the companies with the best prospects outgrow the venture capitalists, don’t want to pay the onerous terms of bank loans, or need more capital than can be raised casually. When these things happen, it’s time for the company to go public. Going public is a relatively long and costly process that requires preparing statements for regulators and investors, getting the company’s story out, and actually selling the shares. IPOs tend to be lagging indicators, meaning investors are more willing to take a wager on a newly public company when the broader stock market is doing well. IPOs tend to ebb and flow quite a bit, as the table shows. Number of U.S. IPOs, 2014–2018 Year Number of U.S. IPOs Proceeds Raised 2018 192 $46.9 billion 2017 160 $35.5 billion 2016 105 $18.8 billion 2015 170 $30 billion 2014 275 $85.3 billion Source: Renaissance Capital The role of the investment banker in IPOs Investment bankers are involved in the very onset of a company going public, and they’re the keys to making the deal happen. When investment bankers assume the role of selling securities, especially in an IPO, they’re often called the underwriters. A typical IPO usually follows these steps: The company produces information about its stock sale. The company must give investors an extremely detailed outline of its opportunities, financial results, and risks. This filing is called the prospectus. Investment bankers assist in making sure the company includes all the material information investors need to know about the offering. The company takes its story to the streets. If companies are going to ask investors to pony up millions of dollars for the company, they’re going to have to convince them to buy. That’s the role of the roadshow. Roadshows are events and meetings investment bankers arrange between companies selling stock and prospective investors. The investment bankers gather up the investors in the book-building process. The traditional IPO is a process shrouded in a bit of secrecy. During the roadshows, investment bankers get an idea of how likely it is for specific investors to buy stock, how many shares, and at what price. The investment bankers record this indicated interest, or general idea of how much buyers want to invest, to gauge how many shares are likely to be bought when the IPO is sold. This process of tallying up how much interest there is in the stock is called book building. The book-building process is critical because it tells the investment banks selling the deal at what price the shares should be sold. Underwriters price the deal. Underwriters typically work late into the night before the stock starts to trade, assembling all the orders of investors. The underwriters look at all the orders for the stock and at what prices investors are interested. The underwriters then find the highest possible price at which all the shares would sell. The IPO is priced, or the initial price charged to these initial investors is set. Underwriters support the IPO. The initial price of the new stock is set by the investment bankers the night before, and all the shares are sold to the initial investors. The initial investors in IPOs are typically the friends and business partners of the underwriting firms. For instance, large institutions that use the investment bank’s other services are often given access to IPOs, as are wealthy individuals that may be clients of the investment banks. After the deal is priced, these initial investors are free to sell on the open market, in what’s called aftermarket trading. And it’s during the first day of regular trading when regular investors, customers of brokerages like TD Ameritrade and Charles Schwab of the world, are able to buy the stock. What matters in an IPO Underwriters stay involved in the process during this tenuous first day of trading. Investment banks want to do whatever they can to make sure the shares of the newly public company don’t break (close below the initial price). A broken deal is often looked at negatively by investors; plus, a broken deal makes it look like the investment bank didn’t set the initial price correctly. Investment bankers try to balance the needs and wants of the buyers and sellers. If the price of the IPO zooms upward, the investors who sold their shares may feel like they were shortchanged and missed out on gains. However, if the price drops after the stock starts trading, the buyers may feel cheated and avoid that investment banking firm’s deal in the future. There’s also a risk that if an investment bank prices shares too high, it might need to step in and buy the shares to stop them from falling too much. On the first day of trading of Internet stock Facebook in May 2012, for instance, underwriters had to step up and buy to hold the stock from closing below the $38-per-share offering price. Lastly, several months after the IPO has been trading, the investment bank’s research unit will initiate coverage on the new stock. A research analyst at the bank will write a report describing the company and the stocks, advising the investment bank’s clients on whether to invest in the new stock.

Article / Updated 05-19-2020

Mergers and acquisitions (M&A) is a key function of the investment banker. When companies get together and combine, which happens during mergers and acquisitions, the terms of a deal usually are straightforward. Typically, a larger company is looking to bolster a part of its business. The company could hire a team of people to build that company from scratch, pairing up researchers to design the product, finance people to price it right and control costs, marketing people to whet the consumers’ appetite, and operations people to get the product. But all that takes time and money. So instead, companies often buy already existing companies, saving themselves a lot of work. Why companies buy other companies Making widgets and selling them for a profit is why most companies exist. Microsoft, for instance, is in the business of making and selling computer software and hardware. So why do so many companies during the course of business wind up buying and selling businesses? There are many reasons why companies may consider using M&A, including the following: Getting big fast: Building a business takes time. There are people to hire, distribution to set up, and products to sell. Sometimes the time it takes to get up and running is too long, and the delay gives the rivals with the first-mover advantage an even bigger lead. A great example of a merger done for speed was Microsoft’s 2016 purchase of LinkedIn, a professional social media site. Microsoft bought the company for $29 billion. By buying LinkedIn, Microsoft was instantly a player in the online media business with an already established brand name. Filling out a product line: Some companies may have been hugely successful in a narrow product line. But to find growth, which investors are always clamoring for, companies may need to fill in some gaps. An old but classic example of using M&A to fill in a product-line hole came in 2001. Leading jelly maker J.M. Smucker bought the Jif peanut butter brand (along with Crisco oil) from Procter & Gamble for $813 million in stock. The deal solved a problem for J.M. Smucker — now the company could sell all the ingredients for a tasty peanut-butter-and-jelly sandwich. Talk about synergy. But at the same time, Procter & Gamble also wanted to reduce its holdings in the food business. Geographic expansion: Business is going global, and companies need to have a worldwide presence or risk getting beaten by rivals. M&A deals are a quick way to spread into other countries. The biggest proposed M&A deal of 2019 was a great example of a company looking to M&A deals for a product expansion push. Pharmaceuticals firm, Bristol-Myers Squibb, made a nearly $100 billion offer for U.S. biotech company Celgene. Bristol-Myers looks to the deal as a way to get a beachhead in the fast-growing cancer-treatment area. Biggest U.S. Merger Offers of 2019 Target Buyer Transaction Value ($ billions) Industry Celgene Bristol-Myers Squibb $59.5 Health Care Raytheon United Technologies $93.2 Industrials Allergan AbbVie $86.0 Health Care SunTrust Banks BB&T $29.3 Financials Viacom CBS $20.4 Communication Services Source: S&P Global Markets Intelligence The advantages of building versus buying Some large companies may decide it’s better to just buy another company to get in the new market quickly. Large companies that buy for this reason are called strategic buyers. Investment banks are often brought in during these typical M&A deals to advise on whether it makes sense or help come up with the money to make it happen. Sometimes the target — the company being eyed — doesn’t want to be bought. And that’s when deals often turn hostile, where the investors or management of the strategic buyer are hoping to make the deal happen, but the target is resisting. Again, investment banks are often pivotal in hostile M&A deals because the buying of a company that doesn’t want to be bought often requires more brinkmanship and cash. Pitfalls of ill-conceived mergers One of the reasons companies engaged in merger activities call in so many investment banks and advisors is that they don’t want to blow it. Mergers are often big bets that cost a great deal of money, either consuming cash or requiring the company to borrow or sell debt. Companies, and their shareholders, don’t want companies to blow it on deals that don’t work out.

Article / Updated 05-19-2020

If you’re like most people, you probably figure investment banking got its start in a towering office skyscraper in New York City. But the real story of the origin of investment banking is far less metropolitan, yet arguably even more interesting. Investment banking traces its roots to the age of kings and queens. Many of the most commonly used financial instruments trace their origins to centuries ago when bankers navigated the edicts of rulers and, believe it or not, religious leaders. But for now, just know that investment banking is, at its very core, pretty straightforward. Investment banking is a method of controlling the flow of money. The goal of investment banking is channeling cash from investors looking for returns into the hands of entrepreneurs and business builders who are long on ideas, but short on bucks. Investment bankers raise money from investors, by selling securities, and then transfer that money to people who need cash to start businesses, build buildings, run cities, or bring other costly projects to reality. There are many aspects of investment banking that muddy this fundamental purpose. But in the end, investment bankers simply find opportunities to unlock the value of companies or ideas, create businesses, or route money from being idle to having a productive purpose. The role investment banking plays Investment bankers get involved in the very early stages of funding a new project or endeavor. Investment bankers are typically contacted by people, companies, or governments who need cash to start businesses, expand factories, and build schools or bridges. Representatives from the investment banking operation then find investors or organizations like pension plans, mutual funds, and private investors who have more cash than they know what to do with (a nice problem to have) and who want a return for the use of their funds. Investment banks also offer advice regarding what investment securities should be bought or the ones an investor may want to buy. One of the trickiest parts of understanding investment banking is that it’s typically a menu of financial services. Some investment banking operations may offer some services, but not others. The services offered by investment banks typically fall into one of a few buckets. One of the best ways to understand investment banks is to examine all the functions that some of the biggest investment banks perform. For example, Morgan Stanley, one of the world’s largest investment banks, has its hands in several key business areas, including the following: Capital raising: This part of the investment banking function helps companies and organizations generate money from investors. This is typically done by selling shares of stock or debt. Financial advisory: In this role, the investment banking operation is hired to help a company or government make decisions on managing their financial resources. Advice may pertain to whether to buy another company or sell off part of the business. A common business decision tackled by this type of investment banking is whether to acquire another company or divest of a current product line. This is called mergers and acquisitions (M&A) advisory. Corporate lending: Investment banks typically help companies and other large borrowers sell securities to raise money. But large investment banks are also frequently involved in extending loans to their customers, often short-term loans (called bridge loans) to tide a company over while another transaction is in the works. Sales and trading: Investment bankers are a creative and innovative lot, in the business of constructing financial instruments to be bought and sold. It’s natural for investment bankers to also buy and sell stocks and other financial instruments either on the behalf of their clients or using their own money. Brokerage services: Some investment banking operations include brokerage services where they may hold clients’ assets or help them conduct trades. Research: Investment banks not only help large institutions sell securities to investors, but also assist investors looking to buy securities. Many investment banks run research units that issue research reports and advise investors on whether they should buy a particular investment. The terms investments and securities are pretty much interchangeable. Investments: Investment banks typically serve the role of a middleman, sitting between the entities that need money and those that have it. But periodically, units of investment banking operations may invest their own money in promising companies or projects. This type of investment, often made in companies that don’t have investments that the public can buy, is called private equity. Investment banking operations at one firm may be engaged in some of the preceding activities, but not all. There’s no rule that demands investment banking operations must perform all the services described here. As investment firms grow, though, they often add functions so they’re more valuable to their clients and can serve as a common source for a variety of services. How investment banking differs from traditional banking The critical part of the investment banking process is in the way cash is funneled from the people who have it to the people who need it. After all, traditional banks do essentially the same thing investment banks do — get cash from people who have excess amounts into the hands of those who have productive uses for it. Traditional banks take deposits from savers with excess cash and lend the money out to borrowers. The main types of traditional banks are commercial banks (which deal primarily with businesses) and retail banks (which deal mostly with individuals). The difference between traditional banks and investment banks, though, is the way money is transferred between the people and institutions that need it and the ones who have it. Instead of collecting deposits from savers, as traditional banks do, investment bankers usually rely on selling financial instruments (such as stocks and bonds), in a process called underwriting. By selling financial instruments to investors, the investment bankers raise the money that’s provided to the people, companies, and governments that have productive uses for it. Because banks accept deposits from Main Street savers, those deposits are protected by the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits. To protect itself, the FDIC along with the federal government puts very strict rules on banks to make sure they’re not being reckless. On the other hand, investment banks, at least until the financial crisis of 2007 (see the appendix), were free to take bigger chances with other people’s money. Investment banks could be more creative in inventing new financial tools, which sometimes don’t work out so well. The idea is that clients of investment banks are more sophisticated and know the risks better than the average person with a bank account. The meaning of the term investment bank got even more unclear after the financial crisis that erupted in 2007. Due to a severe shock to the bond market, many of the dedicated investment banks went out of business, including venerable old-line firms such as Lehman Brothers and Bear Stearns, or were bought by banks. Many of today’s largest investment banks are now units of banks or technically considered commercial or retail banks, although they still perform investment banking operations. Meanwhile, these banks will often say they perform investment banking functions. The term investment bank is somewhat of a misnomer, because the major financial institutions are now technically considered banks. Now that you see that the chief role of investment banks is selling securities, the next question is: What types of securities do they sell? The primary forms of financial instruments sold by investment banks include the following: Equity: If you’ve ever bought stock in a company, be it an individual firm like Microsoft or an index fund that invests in companies in the Standard & Poor’s (S&P) 500, you’ve been on the investor end of an equity deal. Investment bankers help companies raise money by selling ownership stakes, or equity, in the company to outside investors. After the securities are sold by the investment bank, the owners are free to buy or sell them on the stock market. Equity is first sold as part of an equity offering called an initial public offering (IPO). Debt capital: Some investors have no interest in owning a piece of the company, but they’re more than willing to lend money to it, for a price. That’s the role of debt capital. Investment banks help companies borrow money by issuing bonds, or IOUs, that are sold to investors. The company must pay the prearranged rate of interest, but it doesn’t give up any ownership of the company. If a company falls onto hard times, though, the owners of the debt have a higher claim to assets than do the equity owners if a liquidation of the company is necessary. Hybrid securities: Most of what investment banks sell can be classified as either debt or equity. But some securities take on traits of both, or are an interesting spin on both. One example is preferred shares, which give investors an income stream that’s higher than what’s paid on the regular equity. But preferred shares don’t come with as high a claim to assets as bonds, and this income stream can be suspended by the company if it chooses. The services investment banks provide Investment banks do much more than just raise capital by selling investments. Although selling securities to raise money is arguably the primary function of investment banks, they also serve several other roles. All the functions of investment banks typically fall into one of two primary categories: selling or buying. The sell side: Investment banks are best known for the part of their business that sells securities, or the sell side. This function of the investment bank is responsible for finding investors to buy the securities being sold, which raises the money needed by businesses and governments to grow and prosper. The buy side: Investment banks may also take the role of advising the large investors who are interested in buying financial instruments. Serving in its role on the buy side, the investment bank can offer suggestions to large institutional investors like mutual funds, pension plans, or endowments on which securities may be appropriate for it to buy in order to meet return targets. The dual role played by investment banking operations, serving both buyers and sellers of securities, raises constant worries of double dealing and conflicts of interest. Some people rightly question whether it’s possible for the same investment bank that makes money selling shares of an IPO, for instance, to give honest and unbiased investment advice to investors trying to decide whether they should buy or sell. The question of conflicts of interest in investment banking operations has become paramount since the financial crisis began in 2007. How investment banks are organized Investment banks may seem like financial behemoths that have their hands in just about any matter that involves large sums of money. And to a large degree, that’s true. Investment banks are usually involved in some fashion when it comes to financing major projects, conducting trading in financial instruments, or developing new ways to generate capital. With that said, nearly all major investment banks divide their operations into several key areas, including the front office, middle office, and back office. When you talk to someone about investment banking, or even listen to the heads of investment banks talk, they’ll often refer to these three common parts of a traditional investment bank: The front office: The front office is exactly what it sounds like. It’s not only the part of the investment bank that sells investments, but also the part that courts companies looking to do deals. Traditionally, companies that are looking to find a fast way to turbo-charge growth may think about buying another company (say, a rival with similar customers or complementary technology). From the front office, investment banks help usher along the M&A process by pairing up buyers and sellers. The front office is also the part of the investment bank that conducts trading (frenetic buying and selling of securities to take advantage of any mispricings — even if the holding period is for only a few seconds). Investment banks used to do some trading using complicated mathematical formulas and using the firm’s money (not the clients’ money). This type of trading is often called proprietary trading. Many investment banks used to operate a business where they bought and sold securities themselves. Proprietary trading was quite profitable for investment banks. But most types of so-called prop trading by investment banks were abolished in mid-2015 by the Volcker Rule. The rule is named after former Federal Reserve Board Chairman Paul Volcker. Volcker said risky trading put large financial institutions at risk. Such trading was blamed in part for the financial crisis of 2008. Investment banks will continue to wind down this part of their businesses into the early 2020s. Another part of the front office is the part of the business involved in conducting research on companies. The front office often employs sell-side analysts, whose job it is to closely monitor companies and industries and produce reports used by large investors trying to decide whether to buy or sell particular securities. The middle office: The middle office of an investment bank is generally out of the limelight. It’s the part of the bank with the job of cooking up new types of securities that can be sold to investors. Some innovations in investment banking are useful, but others can wind up putting investors and the markets in general in an unfavorable light. Some of the infamous financial instruments cooked up in the middle office of investment banks that came back to haunt the system include auction-rate securities and credit default swaps. Auction-rate securities are debt instruments that promise investors higher rates of return than are available in savings accounts. Instead of selling debt at a prearranged interest rate, the investment bank would conduct auctions, and the rate would be set by a bidding process. That’s great as long as there are willing buyers and sellers. But the auction-rate market relied on auctions, many of which weren’t successful during the financial crisis that erupted in 2007. Many investors holding the securities found they couldn’t sell them because the market had dried up, causing a huge headache for the investors and investment banks. Credit default swaps are tools that allow lenders to sell the risk that borrowers won’t be able to meet their obligations. Credit default swaps operate as a form of unregulated insurance policies. These instruments got so complicated, though, that they exacerbated the financial interdependencies between giant financial firms, worsening the financial crisis that erupted between 2007 and 2009. The back office: The back office is the part of the investment bank that is far from the glamour of the front office. It’s primarily made up of the systems and procedures that allow investment bankers to gather the data they need to do their jobs well. The back office, for instance, maintains the computer systems used by investment bankers to gauge interest in certain securities and provides traders the ability to make short-term bets on market movements. The parts of investment banking considered more operational in nature tend to fall into the back office. Investment banking operations are rarely identical between firms. Some banks and investment banks are engaged in some front-office areas, while others steer clear of them completely. There are also some peripheral areas of business some banks and investment banks include as part of their services that don’t fall in one of the traditional “offices.” One example of a service that is often grouped in investment banking is investment management. In an investment management unit, investment professionals are paid to invest money on behalf of individual clients or institutions. The current lay of the investment banking land After the tumultuous changes in the investment banking business following the financial crisis of 2007 through 2009, the entire landscape changed. Following the banking crisis, investment banks needed capital. Some of the most storied investment banks, unable to raise money, merged with other banks or became commercial banks themselves. Suddenly, the financial system was comprised of behemoth banks that have the deposit-taking abilities of banks but also engage in investment banking. The result is the formation of several mega-institutions that many people fear are “too big to fail,” including the ones shown in the table. Among the Last Banks Standing Firm 2018 Revenue ($ billions) JPMorgan Chase 104.0 Bank of America 88.7 Wells Fargo 84.7 Citigroup 65.5 Morgan Stanley 40.1 Goldman Sachs 35.9 Source: S&P Global Market Intelligence Types of investment banking operations Insiders in the investment banking business use all sorts of terms, some decidedly derogatory, to classify the players in the business. Some classifications that investment banks fall into include the following: Bulge bracket: Bulge bracket investment firms aren’t the ones that ate too many slices of cheesecake. Instead, bulge bracket is a commonly used slang term to describe the biggest of the big investment banking operations. The bulge bracket firms are the behemoths, like the ones in the table. They have their hands in most areas of investment banking. Boutique: Boutique investment firms are smaller investment banks and traditional banks that choose to focus on one or a select few areas of the business. Some firms, for instance, focus on selling securities for smaller companies. Regional: Regional firms typically focus on a particular part of the country. Whereas the bulge bracket firms continually try to grow and take market share from rivals, there seems to be plenty of room for smaller players like these. Some regional firms also often concentrate on a particular type of investment banking service, be it trading services or underwriting of securities. How investment banks get paid As you can imagine, although investment banking plays an important role in funding economic progress, there’s also lots of money to be made. Investment bankers can’t afford those fancy suits if they’re not getting paid. Investment bankers perform services for customers and collect money in a number of ways, include the following: Commissions: Investment banks sometimes collect fees in exchange for conducting a financial transaction between a buyer and seller. One of the more common forms of commissions is often collected in the brokerage operations by some traditional banks and investment banks. For instance, Merrill Lynch, the brokerage and investment banking unit of Bank of America, charges commissions when purchasing stock for its customers. But that’s just a small example. Underwriting fees: A lucrative area of investment banking generates fees for selling securities in the primary market (the collection of buyers’ and sellers’ interest in trading brand-new securities). When a company sells stock to the public for the first time, for instance, the investment banker who handles the deal, called the underwriter, collects a fee. Trading income: Investment banks usually handle other people’s money. But many investment banking operations also include a trading division. This unit attempts to take advantage of temporarily mispriced financial instruments. This high-risk proprietary trading is designed to generate profits for the firm. Asset management fees: Some investment banks help their clients make decisions on how to invest their money. Investment banks generate asset management fees when they help clients decide which securities they should buy or sell. Advisory fees: Companies often look to their investment banks for advice, especially in the cases of M&A deals. And in these cases, the investment bankers are brought in to provide in-depth, numerical analysis of a proposed deal. The companies pay substantial fees for this high-level assistance.

Article / Updated 05-19-2020

Investment bankers spend a great deal of time constructing financial models on spreadsheets and manipulating them to arrive at values for companies, divisions, and potential projects. These models are often very complex and involve many assumptions and inputs. This article provides some ideas on how investment bankers can improve their analyses and deliver greater value to clients. Financial analysis isn’t physics In many disciplines mathematical calculations need to be carried out to several significant digits and the results applied to complex processes. For instance, when NASA is launching rockets to “infinity and beyond,” calculations involving satellite orbits and descent angles need to be exact. Minor mistakes can be disastrous and result in aborted missions and losses of millions of dollars. Likewise, when engineers are building bridges and buildings, the calculations need to be quite precise. Given that physics and engineering are two of the more popular backgrounds for investment bankers, it isn’t surprising that many young investment bankers bring that precise quality to the spreadsheets when building their financial models. Should that sales growth rate be 7.65 percent or 7.6 percent? Should the after-tax cost of debt be 5.35 percent or 5.37 percent? These types of questions on inputs to the financial models are often agonized over, and models are revised with very minor changes. But financial analysis isn’t physics. The goal of any financial model is to provide a very rough estimate of the value of a company, division, or potential project — not a precise value. One of the biggest mistakes investment bankers make is to provide clients with an “illusion of precision.” Determining that the value of a share of company stock is $95.47 or that the internal rate of return on a project is 22.47 percent gives the false impression that the calculations are exact and can be trusted. In reality, the final number is the result of many estimates on many different parameters. Many very successful investors, including Warren Buffett, Benjamin Graham, and Seth Klarman, focus on a concept called margin of safety. This simple notion is that investors should not purchase a stock because they believe it is worth $95.37 a share and it’s selling in the market for $91.25. Instead, investors should buy a stock with a market price of $91.25 a share that they believe is worth in excess of $140. In other words, many of the assumptions the investor made in computing his value may be overly optimistic, yet there is enough wiggle room that the investment will still make him money even if his optimistic projections don’t pan out. Show your sensitive side Manipulating financial models involves making numerous assumptions on many variables. Sales growth rates and gross margin percentages are just two of the multitude of parameters that investment bankers need to forecast when making their cash flow forecasts. What investment bankers realize, however, is that not all values entered into financial formulas are created equally. Some inputted values have a much greater impact on bottom line estimates than others and it’s incumbent upon investment bankers to realize which estimates are more critical than others. They’ll then focus their efforts on making sure they spend more time on the more critical inputs than the less critical ones. The way investment bankers can discover which inputs truly matter is to perform a sensitivity analysis. With a sensitivity analysis, the analyst will simply vary one input at a time and see how much the bottom line cash flow forecast is affected — for instance, changing the sales growth rate from 8 percent to 9 percent, or changing the gross margin percentage from 20 percent to 21 percent. If changing the input has a negligible effect on the cash flow estimate, the analyst knows she doesn’t need to expend a great deal of time and effort making sure she has the best possible estimate of that variable. However, if a small change in an input results in a large change in the cash flow estimate, that’s a signal that the investment banker should invest a great deal of time and effort making sure that she can justify that particular input. Identification of the critical variables through sensitivity analysis will add a great deal of value to the process of estimating cash flows. Monte Carlo isn’t just for high rollers The advent of high-speed computers with large data storage ability has been a boon to investment bankers and their model making. Although any investment banking deal that is made will have only one ultimate outcome attached to it, technology allows investment bankers to develop financial models to provide a more complete analysis of potential outcomes of an investment banking deal and provide clients with a probability assessment that a deal will be profitable or have a return that exceeds a certain dollar amount or percentage return. The goal of Monte Carlo analysis is to simulate the process for a particular investment and run the analysis over and over again to obtain a range of likely outcomes to assess the attractiveness of a given investment. The investment banker and client can then make a more reasoned decision regarding a specific investment opportunity. With Monte Carlo analysis, the key is, of course, the financial model. The model should provide estimated ranges and probabilities for key variables — such as sales, interest rates, and the like. The model should also have important interrelationships (or correlations) between various inputs embedded in it. For instance, in certain industries when interest rates are high, sales may be low, or when interest rates are high, fuel prices may be high. In Monte Carlo analysis, the financial model is run literally thousands of times — ten thousand or more “What if?” simulations being generated is typical — and the results are summarized in a probability distribution of returns. This probability distribution is likely to look like what we all know as a “bell curve,” often associated with education and grading on the curve. The client and investment banker can make a more informed decision about the likelihood of success of a particular project. More important, perhaps, they can see the likelihood of failure and the potential cost of failure in terms of dollar amounts. They can also assess whether they’re willing to accept a worst-case scenario. What can go wrong will go wrong The poet Robert Burns once wrote that “the best laid schemes of mice and men often go awry.” He obviously wasn’t referring to investment bankers’ cash flow forecasts, but he certainly could have been. Investment bankers are often prone to making overly optimistic projections regarding cash flow forecasts and underestimating the risks of things not turning out the way they would like them to. Investment bankers often talk about pro forma financial statements. Pro forma simply means “for the sake of form.” But how often do things go as to form? How does an investment banker take into account the unexpected? After all, if you could anticipate something, you would input that into your model. Investment bankers aren’t required to be omniscient regarding unanticipated circumstances, but recognition that things likely won’t turn out as expected is important. There is no systematic or quantitative methodology to factor in the unexpected — remember, there are elements of both art and science to investment banking. The best remedy for the investment banker is to adopt a conservative bias in estimating cash flows. This may involve slightly tempering assumptions — perhaps something as simple as making a sales forecast a percentage point or two lower. Adopting a conservative bias in making estimates will lessen the chance that the client and investment banker will be negatively surprised and a relationship either strained or severed. Clients rarely complain when a deal turns out better than expected. Unless, of course, the client is a firm whose IPO immediately doubles in price and the firm believes that it left a lot of money on the table. It’s tough to make predictions, especially about the future Many wonderful quotes have been attributed to that great American baseball player and philosopher Yogi Berra, but none more fitting to the investment banker than “It’s tough to make predictions, especially about the future.” While Yogi was more at home behind home plate than in an investment banking war room, investment bankers should consider his sage wisdom. Many financial spreadsheets manipulated by investment bankers involve estimating and discounting cash flows for 5, 10, and even 15 years into the future. They involve assumptions about future sales growth that can be accurately characterized as nothing better than “wild guesses.” In fact, much of the value of the Internet companies that sold shares to the public in the late 1990s and early 2000s was estimated to be realized from cash flows that were only going to turn positive several years into the future. In the case of these firms, the positive cash flows never materialized. Mark Twain once said, “History doesn’t repeat itself, but it does rhyme.” According to Goldman Sachs, just 24 percent of companies going public in 2019 will report positive income — the lowest level since the tech boom and bust nearly two decades ago. For context, in 1999 and 2000, only 28 percent and 21 percent, respectively, of IPOs had positive net income. Most analysts agree that it’s very difficult to project a company’s earnings over the near term — the next quarter or year — much less several years into the future. In fact, the accuracy of financial forecasts — like other forecasts — decline with their time horizon. It’s much easier, for instance, to estimate Coca-Cola’s earnings next year than three years from today. Too much can change in the economy and industry that make yesterday’s forecasts wildly inaccurate. Imagine trying to predict the future earnings and cash flows of mortgage lenders in, say, early 2006. The takeaway for investment bankers of the difficulty of predicting the future is to shorten the time horizon of many models. Focusing on the near term — the next three years — and simply making a conservative assumption about long-term future growth will serve the analyst better than projecting cash flows over an extended time period. In the case of financial models, simpler is often better. The investor of today doesn’t profit from yesterday’s growth Investment bankers want to view the world out of the windshield instead of the rearview mirror. Yet, there is so much historical information available and the easiest assumption to make is that the past will continue into the future. It may seem as good a place as any to start in coming up with a sales growth estimate for next year for a firm that realized 18 percent sales growth last year is 18 percent, but such an assumption is fraught with peril. What simply extrapolating past growth into the future fails to take into account is a simple truism in economics: High returns in a particular industry often attract new competitors, and the influx of new competitors drives down returns in that industry. Quite simply, that’s the basis of the competitive free market economic model. Now, the influx of new competitors is driven by how easy it is to enter and succeed in a particular market — in effect, how high are the economic barriers of entry in a particular industry. Some industries have lower barriers to entry than others. For instance, if a particular kind or style of food becomes popular, you’ll see many restaurants serving that kind of cuisine springing up and the returns in that industry tend to fall. On the other hand, the aerospace and nuclear energy industries have very high barriers to entry due to the investment in plant and equipment and the long lead time it takes to enter a market and compete. Justifying abnormally high growth rates in industries with high barriers of entry is much easier than it is in those industries with lower barriers to entry. Those barriers to entry may also involve brand names, as well as physical investment. Coca-Cola and PepsiCo have built huge economic moats. These economic moats — big advantages the companies have that are difficult to copy, like brands — make it very difficult to compete with those two goliaths in the soft drink industry. Economic moats can be huge barriers to new competition, even though the physical barriers to entry in the soft drink industry are quite modest. Garbage in, garbage out With all the detailed financial models and computing capacity available to investment bankers, how can they make mistakes? How have financial pros been so wrong about valuing the complex real estate securities — mortgage-backed and asset-backed financial instruments — that were central to the financial crisis? How did investment bankers and the ratings agencies (like Moody’s and Standard & Poor’s) miss the boat on the valuation of these securities and not anticipate the housing bubble disaster that ultimately befell the residential real estate market? The simple answer is that the valuation models that both investment bankers and the ratings agencies used to value and rate these securities had a fatal flaw: They failed to take into account the likelihood that one mortgage will default is related to (or correlated with) the likelihood that many mortgages will default. In statistical terms, the likelihood that you’ll default on a mortgage is not independent of the likelihood that your neighbor will default on a mortgage. They’re positively correlated — and highly positively correlated at that. This is due to the fact that, among other factors, the valuations of real estate in a particular area are very much related to each other. When the market in a particular area softens, the valuation of all properties in the region falls even though some properties may decline in value more than others. When various entities were valuing these securities, they relied on the same principle that insurance companies use to price car insurance. That is, insurance companies know that some policyholders will experience losses, but that the large pool of policyholders allows the company to diversify and predict fairly accurately the level of claims. This is because auto insurance claims typically aren’t highly related to each other. This is not the case with valuing a large pool of mortgages. The probability of default on any one mortgage is related to the probability of default on other mortgages. The complex financial models employed by many of the firms involved in the financial crises failed to take that relatively simple relationship into account. And the results were disastrous. The moral of the story is that no matter how intricate the financial models are, if they’re flawed then it’s simply the case of “garbage in, garbage out.” Rates are falling — it’s a better deal! The mathematics of valuation seem to make it clear that when interest rates are low — or are in the process of declining — investment banking deals look more attractive. The cash flows are in the numerator of the valuation equation, and the discount rate is in the denominator. When interest rates are low or are falling, the analyst is dividing the cash flow by a lower number and — voilà! — the valuation is higher. But the linkage between interest rates and valuations isn’t as direct as it seems, and lower interest rates aren’t always better for the investor and the investment banker. In fact, investment bankers are often seduced by lower interest rates, and the volume of investment banking deals generally rises with falling interest rates. Investment bankers need to be very careful and recognize that the level of interest rates affects both the numerator and the denominator in the valuation equation. Falling interest rates are a reflection of a lower level of economic activity, which may be a signal for the investment banker to rein in the often overly optimistic cash flow estimates. This economic reality is reinforced by the phenomenon of negative interest rates — a concept unthinkable many years ago — existing for a time primarily in the European Union. Taken independently, negative interest rates would seem to raise valuations as discount rates (the denominator in valuation models) decrease. However, those negative interest rates are a reflection of fundamental weakness in the economy. Forecasted future profits and cash flows are likely very highly correlated with negative interest rates. There are two types of analysis that many stock analysts employ — top-down or bottom-up analysis. Oftentimes, the analyst adopts one orientation at the exclusion of the other. In top-down analysis, the analyst starts first with a projection of general economic activity, proceeds with an industry or sector analysis, and, finally, does an analysis of a company. In bottom-up analysis, the analyst begins with the company. Neither type of analysis is right or wrong — they’re simply different ways of getting to the same place. However, the danger of ignoring or mitigating the broad economic effects is that the analyst may ignore why rates are low and fail to adjust cash flow projections accordingly. Read your putt from several angles Investment bankers often have a vested interest in making a deal happen. After all, they’re paid to generate ideas for deals and to shepherd them through to fruition. If investment bankers can convince a client firm that the best course of action is to acquire another company or to spin off a division of the existing company, this leads to investment banking deals taking place, generates fee income for the investment banker, and results in higher year-end bonuses and larger bank accounts for the investment banker. However, just like a golfer who is well advised to read the break of a putt from several angles, the investment banker is well advised to look at the attractiveness of a deal from not only the investment banker’s perspective but also the company’s perspective. The weighting is the hardest part After cash flows from a firm or project are determined, they must be discounted back to a present value at the cost of capital. That is the method by which value is estimated and drives the entire valuation process. The concept of weighted average cost of capital (WACC) is very simple — the average cost of capital is a weighted average of the individual component costs. But things are rarely as simple as they seem. Investment bankers can and do differ upon the weights of each component cost of capital and how those weights are computed. Most analysts agree that basing the computation of WACC on book values of debt and equity is flawed. A better weighing scheme is based upon market values instead of the historical book values that you’ll find on financial statements. So, if the market value–to–book value ratio is two-to-one for a given firm, that firm actually has twice as much equity as it would seem by simply looking at historical book values listed on the financial statements. Likewise, if interest rates have risen substantially since debt was issued by the firm, the book value of debt could overstate the true amount of debt in the capital structure of the company. A second point of contention among investment bankers centers around using current weightings in the computation of cash flows versus using target weightings — weights the firm is likely to have in the future. If the investment banker believes a firm is changing its capital structure — and investment bankers are often well informed as to this fact because they often work with the firms on altering their capital structures — then using target weights makes the most sense to generate a WACC estimate.

Article / Updated 05-19-2020

Research reports aren’t exactly the kinds of things you start reading and can’t put down. J. K. Rowling probably doesn’t worry much about competing with the latest research report on IBM from a major investment bank. That said, oodles of important information about a company can be stuffed into a research report. And knowing how to read research reports has elements of both art and science for the investment banker. What to look for in the document Research reports don’t have to follow a specific formula. Analysts at different investment banks have some latitude in determining the look and feel of their reports. But more often than not, research reports follow a certain protocol of what investors expect them to look like. Many of the research reports from major research organizations follow somewhat of a pattern that contain key elements, making them easy for investors to find information they need. The following figure is a reprint of the first page of a research report from CFRA. To be clear, CFRA is not an investment bank, but a well-known and independent provider of stock research. What CFRA provides is technically independent equity research, not sell-side research, because the company doesn’t do any investment banking. Still the format of CFRA’s reports adhere to industry standards and are illustrative for that reason. The main sections of a research report Investors are busy people. They don’t have the time to read through a research report that buries the findings and disguises the analysts’ decisions. Research reports are designed to be highly functional and percolate to the top the information that’s most important so investors can find it quickly. Again, there’s no standard or required format for research reports to follow. But most of the time, they contain a number of key elements, including the following: Recommendation: Analysts don’t hide how they feel about stocks. Right at the top of most research reports is the recommendation, typically a phrase that tells investors what the analysts think about buying the investment. Most analysts use one of the following terms: “strong buy,” “buy,” “hold,” “sell,” or “strong sell.” Many beginning investors tend to place too much emphasis on the recommendation. Sure, it’s easy to just see if the analyst rates the stock a “strong buy” and then run out and buy it. But savvy investors know that most of the value of the research report is in the analysis of the company and the industry, and they don’t blindly follow the recommendation. Price target: If you visit a research analyst’s office, you may expect to find a crystal ball. Most analysts make a bold prediction of where they think the stock could be trading in the future, usually 12 months from the time of the report. The price target is usually derived using different techniques, some of which are covered later in this book, including discount cash-flow analysis. Key statistics: Buy-side analysts use research reports to save them time. Many investors are looking for quick, at-a-glance information to help them get a feel for a company’s future. The key statistics portion of a research report typically gives investors a summary of all the numerical data points that matter, ranging from the stock price to financial ratios such as price-to-earnings ratios. In this area of the report, you’ll also find the analyst’s forecast of the company’s future earnings, a key part of creating a price target. Highlights/summary: Research reports can get lengthy, sometimes spanning ten pages or even more if it contains in-depth information about the industry. The highlights or summary area attempts to boil all this information down to the bare essentials. Investment opinion: In the investment opinion area, the analyst gets some room to expound a bit on the rationale behind the recommendation. If the stock is a strong buy, the analyst makes a case for that recommendation in the investment opinion section. Business summary: Believe it or not, some investors just know companies by the trading symbol. In this part of the report, analysts usually show investors that the investment is backed by a company that generates profits and earnings. The business is summarized in this portion of the report so investors can understand the key drivers of the company. Ratio analysis and financials: One of the best ways for investors to really dig into a company to see if it’s a good investment is by using ratio analysis. Dozens of critical financial ratios help investors assess the value and trajectory of a company. You can find out how to calculate these ratios yourself in Chapter 8. But you can save yourself some trouble, too, because most analysts calculate many of the key ratios for you in this section. Industry outlook: One of the influences on the profitability of a company is the industry that it’s in. Stocks in the grocery-store industry, for instance, typically keep a small portion of revenue as profit, while technology companies that make software and Internet services tend to keep a much higher percentage of their revenue. This part of the research report explains the industry and goes into what bearing that line of business has for the company. Ways to look beyond the “buy” or “sell” Sell-side analysts working at firms that do investment banking sometimes get looked at somewhat suspiciously. There’s a concern, sometimes warranted, that the sell-side research analysts are being overly bullish on companies because they’re clients of the firm. And in the past, such wrongdoing has been found. But ignoring the work of sell-side analysts, simply because of a risk of conflict is a mistake. Sell-side analysts have the time to really dig into a company. Most sell-side analysts also follow several companies in the industry so they can spot broad trends that have ramifications on short-term movements of the stocks. Anyone who uses the research coming out of investment banks can put these reports to best use by Focusing on everything but the recommendation: Sure, it’s easy to just look at the front page of a report and scan for the buy or sell. But doing so leaves out much of the most valuable information sell-side analysts provide. Look at how the price target is arrived at. What assumptions is the analyst making? The thinking behind the recommendation is more valuable than the recommendation itself. Sell-side analysts are often criticized for never meeting a company they didn’t like and have a “buy” rating on seemingly every company in existence. And it’s true that sell-side analysts traditionally rank many more companies as strong buys than strong sells. That’s just a natural bias of the industry that anyone working with the investment banking industry needs to keep in mind. Also, remember that sell-side analysts rarely call stocks a “sell.” With many analysts, hold is actually the euphemistic term for “sell.” Not overlooking independent research: Although large Wall Street firms with giant investment banking operations dominate research, they’re not alone. There are firms, like CFRA and Morningstar, that generate research that aren’t connected with any investment banking. Compare the opinions of independent analysts with those of sell-side analysts to see where they differ. Concentrating on larger industry analysis reports: Many leading sell-side analysts periodically (sometimes once a year) put out monstrous reviews of an industry. These reports are usually the best work many analysts put out. Because the reports are broad, the analysts don’t have to be as mindful about potentially upsetting companies that happen to be big clients of the firm. These reports also give the analysts more freedom to share their insights about the business. And don’t overlook the research from boutique investment banking firms, which typically focus on a narrow number of industries. These firms can share profound insights about an industry you don’t want to miss.