Investment Banking

Investment Banking

Investment banking, or I-banking, as it is often called, is the term used to describe the business of raising capital for companies and advising them on financing and merger alternatives. Capital essentially means money. Companies need cash in order to grow and expand their businesses;

investment banks sell securities to public investors in order to raise this cash.

The biggest investment banks include Goldman Sachs, Merrill Lynch, Morgan Stanley, Credit Suisse First Boston, Citigroup’s Global Corporate Investment Bank, JPMorgan Chase and Lehman Brothers, among others.

Generally, the breakdown of an investment bank includes the following areas:

·        Corporate Finance (equity)

·        Corporate Finance (debt)

·        Mergers & Acquisitions (M&A)

·        Equity Sales

·        Fixed Income Sales

·        Syndicate (equity)

·        Syndicate (debt)

·        Equity Trading

·        Fixed Income Trading

·        Equity Research

·        Fixed Income Research

Corporate finance

The bread and butter of a traditional investment bank, corporate finance generally performs two different functions: 1) Mergers and acquisitions advisory and 2) Underwriting. On the mergers and acquisitions (M&A) advising side of corporate finance, bankers assist in negotiating and structuring a merger between two companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth  transaction. The underwriting function within corporate finance involves shepherding the process of raising capital for a company. In the investment banking world, capital can be raised by selling either stocks or bonds (as well as some more exotic securities) to investors.

Sales

Sales is another core component of any investment bank. Salespeople take the form of: 1) the classic retail broker, 2) the institutional salesperson, or 3) the private client service representative. Retail brokers develop

relationships with individual investors and sell stocks and stock advice to the average Joe. Institutional salespeople develop business relationships with large institutional investors. Institutional investors are those who

manage large groups of assets, for example pension funds, mutual funds, or large corporations. Private Client Service (PCS) representatives lie somewhere between retail brokers and institutional salespeople, providing

brokerage and money management services for extremely wealthy individuals. Salespeople make money through commissions on trades made through their firms or, increasingly, as a percentage of their clients’ assets with the firm.

Trading

Traders also provide a vital role for the investment bank. In general, traders facilitate the buying and selling of stocks, bonds, and other securities such as currencies and futures, either by carrying an inventory of securities for

sale or by executing a given trade for a client. A trader plays two distinct roles for an investment bank:

(1) Providing liquidity: Traders provide liquidity to the firm’s clients (that is, providing clients with the ability to buy or sell a security on demand). Traders so this by standing ready to immediately buy the client’s

securities (for sell securities to the client) if the client needs to place a trade quickly. This is also called making a market, or acting as a market maker. Traders performing this function make money for the firm by selling securities at a slightly higher price than they pay for them. This price differential is known as the bid-ask spread. (The bid price at any given time is the price at which customers can sell a security, which is usually slightly lower than the ask price, which is the price at which customers can buy the same security.)

(2) Proprietary trading: In addition to providing liquidity and executing traders for the firm’s customers, traders also may take their own trading positions on behalf of the firm, using the firm’s capital hoping to benefit

from the rise or fall in the price of securities. This is called proprietary trading. Typically, the marketing-making function and the proprietary trading function is performed by the same trader for any given security. For example, Morgan Stanley’s Five Year Treasury Note trader will typically both make a market in the 5-Year Note as well as take trading  positions in the 5-Year Note for Morgan Stanley’s own account.

Research

Research analysts follow stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. They also forecast companies’ future earnings. Stock analysts (known as equity analysts) typically focus on one industry and will cover up to 20 companies’ stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as a particular industry’s high yield bonds.

Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Corporate finance bankers rely on research analysts to be experts in the industry in

which they are working. Reputable research analysts can generate substantial corporate finance business for their firm as well as substantial trading  activity, and thus are an integral part of any investment bank.

Syndicate

The hub of the investment banking wheel, the syndicate group provides a vital link between salespeople and corporate finance. Syndicate exists to facilitate the placing of securities in a public offering, a knock-down dragout affair between and among buyers of offerings and the investment banks managing the process. In a corporate or municipal debt deal, syndicate also determines the allocation of bonds.

Commercial Banking vs. Investment Banking

While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a

typical investment bank and a typical commercial operate bank can be simplified: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank does not.

Commercial banks

A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations. The typical commercial banking process is fairly straightforward. You deposit money into your bank, and the bank loans that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the dry cleaner on the corner to a multinational conglomerate. The commercial bank generates a profit by paying depositors a lower interest rate than the bank charges on loans.

Investment banks

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of

stocks and bonds with buyers of stocks and bonds.

Private Debt vs. Bonds – An Example

Let’s look at an example to illustrate the difference between private debt and bonds. Suppose Acme Cleaning Company needs capital, and estimates its need to be $200 million. Acme could obtain a commercial bank loan from Bank of New York for the entire $200 million, and pay interest on that loan just like you would pay on a $2,000 personal finance loan from Bank of New York. Alternately, it could sell bonds publicly using an investment bank such as Merrill Lynch. The $200 million bond issue raised by Merrill would be broken into many smaller bonds and then sold to the public. (For example, the issue could be broken into 200,000 bonds, each worth $1,000.) Once sold, the company receives its $200 million (less Merrill’s fees) and investors receive bonds worth a total of the same amount.

Over time, the investors in the bond offering receive coupon payments (the interest), and ultimately the principal (the original $1,000) at the end of the life of the loan, when Acme Corp buys back the bonds (retires the bonds). Thus, we see that in a bond offering, while the money is still loaned to Acme, it is actually loaned by numerous investors, rather than from a single bank.

Because the investment bank involved in the offering does not own the bonds but merely placed them with investors at the outset, it earns no interest – the bondholders earn this interest in the form of regular coupon payments. The investment bank makes money by charging the client (in this case, Acme) a small percentage of the transaction upon its completion. Investment banks call this upfront fee the “underwriting discount.” In contrast, a commercial bank making a loan actually receives the interest and simultaneously owns the debt.

The Buy-Side vs. the Sell-Side

The traditional investment banking world is considered the “sell-side” of the securities industry. Why? Investment banks create stocks and bonds, and sell these securities to investors. Sell is the key word, as I-banks continually sell their firms’ capabilities to generate corporate finance business, and salespeople sell securities to generate commission revenue. Who are the buyers (“buy-side”) of public stocks and bonds? They are individual investors (you and me) and institutional investors, firms like Fidelity and Vanguard, and organizations like Harvard University and state and coporate pension funds. The universe of institutional investors is appropriately called the buy-side of the securities industry.

Fidelity, T. Rowe Price, Janus and other mutual fund companies now represent a large portion of the buy-side business. Insurance companies like Prudential and Northwestern Mutual also manage large blocks of assets

and are another segment of the buy-side. Yet another class of buy-side firms manage pension fund assets – frequently, a company’s pension assets will be given to a specialty buy-side firm that can better manage the funds and hopefully generate higher returns than the company itself could have. There is substantial overlap among these money managers – some, such as Putnam and T. Rowe, manage both mutual funds for individuals as well as pension fund assets of large corporations.

Big-cap and small-cap

At a basic level, market capitalization or market cap represents the company’s value according to the market, and is calculated by multiplying the total number of shares by share price. (This is the equity value of the

company.) Companies and their stocks tend to be categorized into three broad categories: big-cap, mid-cap and small-cap.

While there are no hard and fast rules, generally speaking, a company with a market cap greater than $5 billion will be classified as a big-cap stock. These companies tend to be established, mature companies, although with

some IPOs rising rapidly, this is not necessarily the case. Sometimes huge companies with $25 billion and greater market caps, for example, GE and Microsoft, are called mega-cap stocks. Small-cap stocks tend to be riskier, but are also often the faster growing companies. Roughly speaking, a small-cap stock includes those companies with market caps less than $1 billion. And as one might expect, the stocks in between $1 billion and $5 billion are referred to as mid-cap stocks.

What moves the stock market?

Not surprisingly, the factors that most influence the broader stock market are economic in nature. Among equities, corporate profits and the interest rates are king.

Corporate profits: When Gross Domestic Product slows substantially, market investors fear a recession and a drop in corporate profits. And if economic conditions worsen and the market enters a recession, many

companies will face reduced demand for their products, company earnings will be hurt, and hence equity (stock) prices will decline. Thus, when the GDP suffers, so does the stock market.

Interest rates: When the Consumer Price Index heats up, investors fear inflation. Inflation fears trigger a different chain of events than fears of recession. Most importantly, inflation will cause interest rates to rise.

Companies with debt will be forced to pay higher interest rates on existing debt, thereby reducing earnings (and earnings per share). And compounding the problem, because inflation fears cause interest rates to rise, higher rates will make investments other than stocks more attractive from the investor’s perspective. Why would an investor purchase a stock that may only earn 8 percent (and carries substantial risk), when lower risk CD’s and government bonds offer similar yields with less risk? These inflation fears are known as capital allocations in the market (whether investors are putting money into stocks vs. bonds), which can substantially impact stock and bond prices. Investors typically re-allocate funds from stocks to low-risk bonds when the economy experiences a slowdown and vice versa when the opposite occurs.

What moves individual stocks?

When it comes to individual stocks, it’s all about earnings, earnings, earnings. No other measure even compares to earnings per share (EPS) when it comes to an individual stock’s price. Every quarter, public companies must report EPS figures, and stockholders wait with bated breath, ready to compare the actual EPS figure with the EPS estimates set by Wall Street research analysts. For instance, if a company reports $1.00 EPS for a quarter, but the market had anticipated EPS of $1.20, then the stock will almost certainly be dramatically hit in the market the next trading day. Conversely, a company that beats its estimates will typically rally in the markets.

It is important to note at this point, that in the frenzied Internet stock market of 1999 and early 2000, investors did not show the traditional focus on nearterm earnings. It was acceptable for these companies to operate at a loss for a year or more, because these companies, investors hoped, would achieve long term future earnings. However, when the markets turned in the spring of 2000 investors began to expect even “new economy”  companies to demonstrate more substantial near-term earnings capacity. The market does not care about last year’s earnings or even last quarter’s earnings. What matters most is what will happen in the near future. Investors maintain a tough, “what have you done for me lately” attitude, and forgive slowly a company that consistently fails to meet analysts’ estimates (“misses its numbers”).

Stock Valuation Measures and Ratios:

P/E ratio

You can’t go far into a discussion about the stock market without hearing about the all-important price to earnings ratio, or P/E ratio. By definition, a P/E ratio equals the stock price divided by the earnings per share. In

usage, investors use the P/E ratio to indicate how cheap or expensive a stock is.

Consider the following example. Two similar firms each have $1.50 in EPS. Company A’s stock price is $15.00 per share, and Company B’s stock price is $30.00 per share.

Company	Stock Price	Earnings Per share	P/E RATIO
A	15	1.5	10
B	30	1.5	20

Clearly, Company Ais cheaper than Company B with regard to the P/E ratio because both firms exhibit the same level of earnings, but A’s stock trades at a higher price. That is, Company A’s P/E ratio of 10 (15/1.5) is lower than Company B’s P/E ratio of 20 (30/1.5). Hence, Company A’s stock trades at a lower price. The terminology one hears in the market is, “Company A is trading at 10 times earnings, while Company B is trading at 20 times earnings.” Twenty times is a higher multiple.

PEG ratio:

Because companies grow at different rates, another comparison investors often make is between the P/E ratio and the stock’s expected growth rate in EPS. Returning to our previous example, let’s say Company A has an expected EPS growth rate of 10 percent, while Company B’s expected growth rate is 20 percent.

Company	Stock Price	Earnings Per share	P/E RATIO
A	15	1.5	10
B	30	1.5	20

We might propose that the market values Company A at 10 times earnings because it anticipates 10 percent annual growth in EPS over the next five years. Company B is growing faster – at a 20 percent rate – and therefore justifies the 20 times earnings stock price. To determine true cheapness, market analysts have developed a ratio that compares the P/E to the growth rate – the PEG ratio. In this example, one could argue that both companies are priced similarly (both have PEG ratios of 1).

Sophisticated market investors therefore utilize this PEG ratio rather than just the P/E ratio. Roughly speaking, the average company has a PEG ratio of 1:1 or 1 (i.e., the P/E ratio matches the anticipated growth rate). By

convention, “expensive” firms have a PEG ratio greater than one, and “cheap” stocks have a PEG ratio less than one.

Cash flow multiples:

For companies with no earnings (or losses) and therefore no EPS (or negative EPS), one cannot calculate the P/E ratio – it is a meaningless number. An alternative is to compute the firm’s cash flow and compare that

to the market value of the firm. The following example illustrates how a typical cash flow multiple like Enterprise Value/EBITDA ratio is calculated.

EBITDA:

 A proxy for cash flow, EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To calculate EBITDA, work your way up the Income Statement, adding back the appropriate items to net income. (Note: For a more detailed explanation of this and other financial caculations, see the Vault Guide to Finance Interviews.) Adding together depreciation and amortization to operating earnings, a common subtotal on the income statement, can serve as a shortcut to calculating EBITDA.

Enterprise value (EV) = market value of equity + net debt. To

compute market value of equity, simply multiply the current stock price

times the number of shares outstanding. Net debt is simply the firm’s

total debt (as found on the balance sheet) minus cash.

Enterprise value to revenue multiple (EV/revenue):

If you follow startup companies or young technology or healthcare related

companies, you have probably heard the multiple of revenue lingo.

Sometimes it is called the price-sales ratio (though this technically is not

correct). Why use this ratio? For one, many firms not only have negative

earnings, but also negative cash flow. That means any cash flow or P/E

multiple must be thrown out the window, leaving revenue as the last

positive income statement number left to compare to the firm’s enterprise

value. Specifically one calculates this ratio by dividing EV by the last 12

months revenue figure.

Return on equity (ROE):

ROE = Net income divided by total shareholders equity. An important

measure, especially for financial services companies, that evaluates the

income return that a firm earned in any given year. Return on equity is

expressed as a percentage. Many firms’ financial goal is to achieve a

certain level of ROE per year, say 20 percent or more.

Value Stocks, Growth Stocks and Momentum Investors

It is important to know that investors typically classify stocks into one of two categories – growth and value stocks. Momentum investors buy a subset of the stocks in the growth category.

Value stocks are those that often have been battered by investors. Typically, a stock that trades at low P/E ratios after having once traded at high P/E’s, or a stock with declining sales or earnings fits into the value category. Investors choose value stocks with the hope that their businesses will turn around and profits will return. Or, investors perhaps realize that a stock is trading close to or even below its “break-up value” (net proceeds upon liquidation of the company), and hence have little downside.

.

Growth stocks are just the opposite. High P/E’s, high growth rates, and

often hot stocks fit the growth category. Technology stocks, with

sometimes astoundingly high P/E’s, may be classified as growth stocks,

based on their high growth potential. Keep in mind that a P/E ratio often

serves as a proxy for a firm’s average expected growth rate, because as

discussed, investors will generally pay a high P/E for a faster growing

company.

Momentum investors buy growth stocks that have exhibited strong upward

price appreciation. Usually trading at or near their “52-week highs” (the

highest trading price during the previous two weeks), momentum investors

cause these stocks to trade up and down with extreme volatility.

Momentum investors, who typically don’t care much about the firm’s

business or valuation ratios, will dump their stocks the moment they show

price weakness. Thus, a stock run-up by momentum investors can

potentially crash dramatically as they bail out at the first sign of trouble.

Basic Equity Definitions

Common stock: Also called common equity, common stock represents an ownership interest in a company. The vast majority of stock traded in the markets today is common. Common stock enables investors to vote on company matters.

Convertible preferred stock: This is a relatively uncommon type of

equity issued by a company, often when it cannot successfully sell

either straight common stock or straight debt. in a manner similar to the way a bond pays coupon payments. However, preferred stock

ultimately converts to common stock after a period of time. Preferred

stock can be viewed as a mix of debt and equity, and is most often used as a way for a risky company to obtain capital when neither debt nor equity works.

Non-convertible preferred stock: Sometimes companies (usually those with steady and predictable earnings) issue non-convertible preferred stock that pays steady dividends. This stock remains outstanding in perpetuity and trades similar to bonds. Utilities represent the best example of non-convertible preferred stock issuers. Preferred stock pays a dividend,