Interview Questions: Your Stock Market Knowledge

A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock).

2. When should a company buy back stock?

When it believes the stock is undervalued and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical industry (such as the semiconductor industry), and believes its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company will buy back its stock if investors are driving down the price precipitously. In this situation, the company is attempting to send a signal to the market that it is optimistic that its falling stock price is not justified. It's saying: "We know more than anyone else about our company. We are buying our stock back. Do you really think our stock price should be this low?"

3. Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?

The dividend paid on common stock is taxable on two levels in the U.S. First at the firm level, as a dividend comes out from the net income after taxes (i.e., the money has been taxed once already) and then at the shareholder level. The shareholders are taxed for the dividend as ordinary income (O.I.). Dividend for preferred stock is treated as an interest expense and is tax-free at the corporate level.

4. When should a company issue stock rather than debt to fund its operations?

There are several reasons for a company to issue stock rather than debt. The first is if it believes its stock price is inflated, and it can raise money (on very good terms) by issuing stock. The second is when the projects for which the money is being raised may not generate predictable cash flows in the immediate future. A simple example of this is a startup company. The owners of startups generally will issue stock rather than take on debt because their ventures will probably not generate predictable cash flows, which is needed to make regular debt payments, and also so that the risk of the venture is diffused among the company's shareholders. A third reason for a company to raise money by selling equity is if it wants to change its debt-to-equity ratio. This ratio in part determines a company's bond rating. If a company's bond rating is poor because it is struggling with large debts, they may decide to issue equity to pay down the debt.

5. Why would an investor buy preferred stock?

(1.) An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common stock. (2.) The preferred stock owner gets a superior right to the company's assets should the company go bankrupt. (3.) A corporation would invest in preferred stock because the dividends on preferred stock are taxed at a lower rate than the interest rates on bonds.

6. Why would a company distribute its earnings through dividends to common stockholders?

Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends can attract investors (shareholders). Finally, a company may distribute earnings to shareholders if it lacks profitable investment opportunities.

7.What stocks do you like?

This is a question often asked of those applying for equity research positions. (Applicants for investment banking and trading positions, as well as investment management positions have also reported receiving this question.) If you're interviewing for one of these positions, you should prepare to talk about a couple of stocks you believe are good buys and some that you don't. This is also a question asked of undergraduate finance candidates to gauge their level of interest in finance.

8. What did the S&P 500 close at yesterday?

Another question designed to make sure that a candidate is sincerely interested in finance. This question (and others like it - "What's the Dow at now?" "What's the yield on the Long Bond?") can be expected especially of those looking for sales and trading positions.

9. Why did the stock price of XYZ company decrease yesterday when it announced increased quarterly earnings?

A couple of possible explanations: 1) the entire market was down, (or the sector to which XYZ belongs was down), or 2) even though XYZ announced increased earnings, the Street was expecting earnings to increase even higher.

10. Can you tell me about a recent IPO that you have followed?

Read The Wall Street Journal and stay current with recent offerings.

11. What is your investing strategy?

Different investors have different strategies. Some look for undervalued stocks, others for stocks with growth potential and yet others for stocks with steady performance. A strategy could also be focused on the long-term or short-term, and be more risky or less risky. Whatever your investing strategy is, you should be able to articulate these attributes.

12. How has your portfolio performed in the last five years?

If you are applying for an investment management firm as an MBA, you'd better have a good answer for this one. Also, if you think you are going to say it has outperformed the S&P each year, you better be well prepared to explain why you think this happened.

13. If you read that a given mutual fund has given 50% returns last year, would you invest in it?

You should look for more information, as past performance is not necessarily an indicator of future results. How has the overall market done? How did it do in the years before? Why did it give 50% returns last year? Can that strategy be expected to work continuously over the next five to 10 years? You need to look for answers to these questions before making a decision.

14. You are in the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation states that the company's stock is doing as it has gone up 20% in the last 12 months. Is the company's stock doing well?

Another "trick" stock question that you should not answer too quickly. First, ask what the Beta of the company is. (Remember, the Beta represents the volatility of the stock with respect to the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone up 35%, the company actually has not done too well in the stock market.

15. What is your Beta?

Don't be too surprised if an interviewer asks you this question. He/she could be doing this to throw you off guard! Take it in the spirit and reply based on how "risky" you think you are!

16. What do you think is happening with ABC stock?

Expect to be asked this question if you say you like to follow the Internet sector or the pharmaceutical sector. Interviewers will test you to see how well you know your industry. In case you don't know that stock, admit it, and offer to describe a stock in that sector that you like or have been following.

17. Where do you think the DJIA will be in three months and six months - and why?

Nobody knows the answer to this one. However, you should at least have some thoughts on the subject and be able to articulate why you think this is the case. If you have been following the performance of major macroeconomic indicators (which will be reviewed in the next section), you can state your case well.

18. Why do some stocks rise so much on the first day of trading and others don't? How is that "money left on the table?"

By "money left on the table," bankers mean that the company could have successfully completed the offering at a higher price, and that the difference in valuation thus goes to initial investors rather than the company. Why this happens and when it will happen is not easy to predict from responses received from investors during roadshows. Moreover, if the stock rises a lot the first day it is good publicity for the firm. But in many ways it is money left on the table because the company could have sold the same stock in its initial public offering at a higher price. However, bankers must honestly value a company and its stock over the long-term, rather than simply trying to guess what the market will do. Even if a stock trades up significantly initially, a banker looking at the long-term would expect the stock to come down, as long as the market eventually correctly values it.

19. What is insider trading and why is it illegal?

Undergraduates may get this question as feelers of their business knowledge. Insider trading describes the illegal activity of buying or selling stock based on information that is not public information. This is to prevent those with privileged information (company execs, I-bankers and lawyers) from using this information to make a tremendous amount of money unfairly.

20. Who is a more senior creditor, a bondholder or stockholder?

The bondholder is always more senior. Stockholders (including those who own preferred stock) must wait until bondholders are paid during a bankruptcy before claiming company assets.