VALUATIONS I
Financial Metrics, Ratios, & Comparables Analysis
Agenda
A Quick Recap
Financial Metrics
Financial Ratios
B C I A N A LY S T T R A I N I N G P R O G R A M
Comparables Analysis
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Balance Sheet
Debt vs. Equity Financing
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How are the Statements Linked Together
How the Statements are Linked Together
Example
1. Suppose D&A increases by $100 (Assume a tax rate of 40%)
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Walk me through the 3 financial statements
Anybody want to give it a try?
1. Income Statement
1. D&A expense increase by $100
2. Tax expense reduced by $40 (=$100*40%, we no longer have to
pay this since our profit dropped)
3. Net Income down by $60
2. Cash Flow Statement
1. Start with Net Income of -$60
2. Add back D&A of $100 since it was a non-cash expense
3. Cash up $40 (this is what you saved on taxes)
3. Balance Sheet
1. Assets (-$60): Cash up $40, PP&E down $100 due to D&A
2. Equity (-$60): Retained Earnings down $60
Financial Metrics
Financial Metrics
The Income Statement
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These are
also called
Cost of Goods
Sold (COGS)
AKA: Earnings
Before Interest and
Taxes (EBIT) or
AKA: Net Income
Operating
Income
EBITDA = -335,579 + 97.9 = -$335,481.1
What about Earnings
Before Interest, Taxes,
Depreciation, and
Amortization (EBITDA)??
How the Statements are Linked Together
Why is EBITDA and EBIT important?
B C I A N A LY S T T R A I N I N G P R O G R A M
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EBITDA
• Reflects how a company operates by getting rid of some factors that
can distort how they are performing that make it hard to compare
companies
• Gets rid of how the company is taxed (tax expense)
• Gets rid of how much a company is paying on it’s debt (interest)
• Gets rid of how much a company is spending on Capital
Expenditures (D&A)
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Not everyone likes using EBITDA (Warren Buffett and Steve Wynn)
In some industries, it is very important to include D&A
Can anyone name an industry that might be like this?
What might these people use instead?
“Does management think the tooth fairy pays for capital expenditures?”
- Warren Buffett
Financial Metrics
B C I A N A LY S T T R A I N I N G P R O G R A M
Unlevered Free Cash Flow
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What if you want to know how much cash a company has before it makes
interest payments on it’s debt?
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You use Unlevered Free Cash Flows
Unlevered simply means, before interest payments
Free Cash Flows simply means, money available to spend on stuff
So, Unlevered Free Cash Flows is money available to spend on stuff
before you make interest payments
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Formula:
1. Start EBITDA (because it is before interest payments)
2. Minus Capital Expenditures (you already spent that money)
3. Minus Increase in Net Working Capital (You already spent that too)
4. Minus Taxes (Uncle Sam took his fair share)
5. Equals Unlevered Free Cash Flows
Financial Ratios
Financial Ratios
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Why do people use Financial Ratios?
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People want to be able to summarize some important take-aways from a
company’s financial statements without having to read through everything
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People also want to be able to compare companies of different sizes or
characteristics; ratios allow us to do this
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Key Point: Financial ratios do not tell you much when viewed on their
own, so what you need is
• Similar Companies to compare them to
• Historical Data on that company
• Understanding the Industry so you know what the ratios should be
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Lets go through some Financial Ratios
Financial Ratios
First Example
Debt / Equity
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How to Calculate
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1. Calculate the total amount of debt a company has
2. Calculate the total amount of equity a company has
3. Divide
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Banks typically like a lower debt/equity ratio because there is less risk of
them to be repaid
• The company could be missing better returns via more leverage
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A high debt/equity ratio may signal “over-leveraging” and a company may
not be able to pay down its debts
Financial Ratios
Second Example Example
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Current Ratio
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How to Calculate: Current Assets / Current Liabilities
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Recall, Working Capital = Current Assets – Current Liabilities
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Do you want a business that requires more or less working capital?
(HINT: Think back to unlevered free cash flow formula)
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What is the optimal amount of working capital for a business?
• Depends on the industry
• What might be a Working Capital-Light business?
• What about a Working Capital-Intensive business?
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Cash and Cash Equivalents
Accounts Receivable
Inventory & Surplus
Short-term investments
Accounts Payable
Deferred Revenue
Interest Payable
Short-term Debt
Current Long-term Debt
Current Assets
Current Liabilities
Financial Ratios
Income Statement Profitability
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Margins
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Gross Margin: Gross Profit / Sales
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EBITDA Margin: EBITDA / Sales
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EBIT Margin (Operating Margin): EBIT / Sales
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Net Margin (Profit Margin): Net Income / Sales
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Why do we care about margins
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Example:
EBITDA
EBITDA Margin
Company A
Company B
$50
$1,000
50%
30%
Financial Ratios
Cash Flow
Free Cash Flow Conversion
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• Free Cash Flow (FCF) Conversion is the proportion of some
metric that is ultimately converted to FCF
• You can calculate this relative to Sales, EBITDA, EBIT, or
Net Income
• It is usually calculated relative to EBITDA
• E.g. FCF Conversion = FCF / EBITDA
• Why do people care about FCF Conversion?
• Very similar to why people care about profitability margins
• They want to see how much proportion of EBITDA is left over
after interest payments, tax expenses, Capital Expenditures,
etc. then compare it this ratio to similar companies ratios
Financial Ratios
Balance Sheet Ratio
B C I A N A LY S T T R A I N I N G P R O G R A M
Price to Book (P/B)
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P/B = Market Capitalization / Book Value of Equity
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Market Capitalization = Price per share * Number of shares
outstanding
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Book Value of Equity = Equity account on the balance sheet
• Think of it this way: if a company sold all of their assets and paid
off their liabilities, this would be what is left over
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So what is better:
• Low P/B ratio
• High P/B ratio
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Value investors like low P/B ratios because it can indicate the market
has neglected the company
It can also mean
• The asset value is overstated
• Company is earning a very poor return on it’s assets
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Comparables Analysis
Comparables Analysis
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Introduction
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Also known as “Comps”
A relative valuation methodology
• A process used to value a company based on the metrics of
other similar companies
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Which Metrics or Ratios do we use to compare businesses?
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Also, how do we pick “comparable” businesses?
Comparables Analysis
Introduction
Enterprise Value
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B C I A N A LY S T T R A I N I N G P R O G R A M
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We are interested in more than just the equity portion of the
business
Investors use Enterprise Value (EV) to look at a business as a
whole
Think of EV as the amount of money required to purchase an entire
business (pay shareholders and pay down all debts)
EV = Market Capitalization + Debt – Cash
Market Cap + Debt makes sense… but why subtract out cash?
CASH
Debt
Enterprise
Value
Equity
Comparables Analysis
Introduction
B C I A N A LY S T T R A I N I N G P R O G R A M
Multiples
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When comparing companies, investors use “multiples”
These include:
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EV / EBITDA – most commonly used metric
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EV / EBIT – fairly common
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EV / Sales – typically used for companies with negative EBITDA
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Price / Earnings – Market Cap / Net Income
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Can be very volatile
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These multiples are determined by 3 things
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3.
Growth
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Higher Growth = Higher Multiple
Business Risk
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Higher risk adjusted return = Higher Multiple
Free Cash Flow Conversion
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Higher FCF Conversion = Higher Multiple
Comparables Analysis
B C I A N A LY S T T R A I N I N G P R O G R A M
Peer Group
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How do you find similar companies to compare?
Comparable companies have:
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Same industry
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Same business / operations
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Similar growth drivers
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Same geography
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Similar size
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Similar growth rate
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Similar business risk profile
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Both are publicly traded
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It is obviously difficult to find companies that have all of these
requirements so sometimes you have to relax these constraints
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In some cases, no companies are similar to your company
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Do not force a comps model
Comparables Analysis
B C I A N A LY S T T R A I N I N G P R O G R A M
Case Study
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Let’s make comps model for Noble Roman’s, the small pizza
company
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Business Description: Noble Roman's, Inc. sells and services
franchises and licenses for non-traditional foodservice operations
and stand-alone take-n-bake locations under the trade names Noble
Roman's Pizza, Noble Roman's Take-N-Bake and Tuscano's Italian
Style Subs
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We will have 4 groups of comps ranked by how good they are
1. Best: Small pizza restaurant franchising company
2. Next Best: Small restaurant franchising company
3. Third best: Pizza companies
4. Fourth best: Quick service restaurant companies, i.e. fast food
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Comparables Overview
Case Study
Comparables Overview
Case Study
Valuation
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Now we know they are “undervalued”, but by how much?
The median EV/EBITDA is 12.1x
Noble Roman’s EBITDA last year was $3M
So if Noble Roman’s was fairly valued, the enterprise value would be
12 * $3M = $36M
• So we know that the value of the entire company is $36M, but what
about the value of their equity so we know what a fair share price
would be?
• EV = Equity + Net Debt
• $31M = Equity + $5M
• Equity = $31M
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How do we get the share price?
Simple: Equity/Shares Outstanding
= 31M/20.7M
Implied Share Price = $1.50
Share price at time of comps analysis = $0.78
Comparables Overview
Importance of Comps
• Comparables Analysis is the most widely used valuation
methodology
• It is easier to value a company using a comps model than most other
valuation techniques
B C I A N A LY S T T R A I N I N G P R O G R A M
• Comps Models are worthless with a bad peer group