Investment
Banking
Primer
INVESTMENT BANKING PRIMER
Contents
Advanced Accounting concepts .......................................................................... 3
Consolidation .................................................................................................. 3
Minority Interest ............................................................................................... 3
Joint Venture ................................................................................................... 4
Associate......................................................................................................... 4
Deferred Tax ................................................................................................... 5
Dilution of EPS ................................................................................................ 6
Time Value of Money .......................................................................................... 6
NPV................................................................................................................. 6
Adjusted Present Value ................................................................................... 7
IRR .................................................................................................................. 8
Discount Rates ................................................................................................ 9
Cost of debt ....................................................................................................10
Cost of equity .................................................................................................10
Weighted average cost of capital ....................................................................10
Interest tax shield ...........................................................................................12
Capital Structure Considerations........................................................................12
Optimal Capital Structure Considerations .......................................................12
Tax Considerations ........................................................................................13
Cost of Capital Considerations .......................................................................13
Marginal Cost of Capital .................................................................................14
Trade-off between Debt & Equity....................................................................14
Pecking Order of Capital Sources ..................................................................14
Ratio Analysis ....................................................................................................15
Types of Ratios ..............................................................................................15
Profitability Ratios ...........................................................................................15
Activity Ratios .................................................................................................16
Liquidity Ratios ...............................................................................................16
Debt Management Ratios ...............................................................................17
Market Ratios .................................................................................................17
Valuation Methodology ......................................................................................17
Dividend Discount Model ................................................................................17
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INVESTMENT BANKING PRIMER
Discounting Cash Flow Method (DCF) ...........................................................19
Relative Valuation ..........................................................................................20
Consistency of Ratios .....................................................................................21
Industry Specific Ratios ..................................................................................22
How to read ratios ..........................................................................................23
Option Valuation: Black Scholes model ..........................................................24
How to approach a valuation model? .................................................................25
Checklist for Preparation ....................................................................................27
Exhaustive List of Preparation Material ..............................................................28
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INVESTMENT BANKING PRIMER
Advanced
Accounting
concepts
While basic accounting concepts are covered in FRA, there are certain other concepts
that are important while analyzing a company’s financials. These concepts are used
extensively in valuation as well in making investment decisions.
Consolidation:
Consolidated financial statements are the combined financial statements of a parent
company and its subsidiaries. Consolidated financial statements present an aggregated
look at the financial position of a parent company and its subsidiaries, and they provide a
picture of the overall health of an entire group of companies as opposed to one
company's standalone position.
• Consolidated Statement of Income: The consolidated financial statements only report
income and expense activity from outside of the economic entity. Any revenue earned
by the parent company that is an expense of a subsidiary is omitted from the financial
statements. This is because the net change in the financial statements is $0. The
revenue generated from one legal entity is offset by the expenses in another legal
entity. To avoid overinflating revenues, all internal revenues are omitted.
• Consolidated Balance Sheet: Certain account receivable balances and account
payable balances are eliminated from the consolidated balance sheet. These
eliminated amounts relate to the amounts owed to or from parent or subsidiary
entities. Like the income statement, this is to reduce the balances reported as the net
effect is $0. All cash, receivables, and other assets are reported on the consolidated
statements, as well as all liabilities owed to external parties.
Minority Interest:
• A minority interest is ownership or interest of less than 50% of an enterprise. The term
can refer to either stock ownership or a partnership interest in a company. The
minority interest of a company is held by an investor or another organization other
than the parent company.
• A minority interest shows up just below the shareholder’s equity and above the
noncurrent liabilities on the balance sheet of companies with a majority interest in a
company. This represents the proportion of its subsidiaries owned by minority
shareholders.
• While the majority stakeholder—in most cases, the parent company—has voting
rights to set policy and procedures, the minority stakeholders generally have very little
say or influence in the direction of the company. That's why it's also referred to as
non-controlling interests (NCIs).
• In the corporate world, a corporation lists minority ownership on its balance sheet. In
addition to being reflected on the balance sheet, a minority interest is reported on the
consolidated income statement distinctly as a share of profit belonging to minority
equity holders.
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• Example: ABC Corporation owns 90% of XYZ Inc., which is a $100 million company.
ABC records a $10 million as minority interest to represent the 10% of XYZ Inc. it
does not own. XYZ Inc. generates $10 million in net income. As a result, ABC
recognizes $1 million—or 10% of $10 million—of net income attributable to minority
interest on its income statement. Correspondingly, ABC marks up the $10 million
minority interest by $1 million on the balance sheet. The minority interest investors do
not record anything unless they receive dividends, which are booked as income.
Joint Venture:
• Joint Venture can be described as a business arrangement, wherein two or more
independent firms come together to form a legally independent undertaking, for a
stipulated period, to fulfil a specific purpose such as accomplishing a task, activity or
project. In other words, it may be a temporary partnership or a permanent one,
established for a definite purpose, which may or may not uses a specific firm name.
• JVs are typically between corporates and are set up as companies / Special Purpose
Vehicles. They are different from partnerships where partnerships are low scale
collaborations typically between individuals.
• For example, Maruti Ltd. of India and Suzuki Ltd. of Japan come together to set up
Maruti Suzuki India Ltd.
• Another example is for JV between Taj and GVK for Taj-GVK Hotels in India
• The firms joining hands in a joint venture are called Co-ventures, which can be a
private company, government company or foreign company. The co-ventures come to
a contractual agreement for carrying out an economic activity, which has shared
ownership and control. They contribute capital, pooling the financial, physical,
intellectual and managerial resources, participating in the operations and sharing the
risks and returns in the predetermined ratio.
• A JV is different from a merger in a way that the operations of a JV are different from
the core operations of the co-ventures. This creates a distinction in the businesses of
the companies. In case of a merger, all the businesses are merged together without
any distinction.
Associate:
• An associate is an entity over which the investor has significant influence.
• Significant influence means the power to participate in the financial and operating
policy decisions of the investee but is not control or joint control of those policies.
Significant influence is usually acquired by purchasing more than 20% of voting power
but less than 50%.
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Deferred Tax:
• Deferred tax refers to the tax effect of temporary differences between accounting
income that is calculated by taking into consideration the provisions of reporting
standard and income tax standards.
• Temporary Differences: While calculating taxable income, certain expenses debited to
Profit or Loss A/c are disallowed in one period and gets reversed in future period in
accordance with provisions of the Income-tax Act. In the same manner, certain
incomes credited in one period to Profit or Loss A/c form part of the income in future
period. Such items are considered as temporary differences.
• For example:
o
In case of treatment of deferred revenue expenditure (say, advertisement
expenses incurred in one year but the benefit of which extends in subsequent
years also), the expenditure incurred is amortized over a period of time but as
per tax laws, it is allowed wholly in first year in which such deferred revenue
expenditure is made.
o
In case of advance incomes received (say, advance rent), the disclosure of
same is mandatory for the purpose of calculating taxable income. However,
this income is recognized in the books of account when actually earned.
o
In case of different book and tax depreciation which could arise due to
difference in depreciation rates or methods of calculating depreciation i.e.
SLM or WDV or differences in composition of actual cost of assets.
o
In case of provisions made in anticipation of liabilities where the liability is
allowed in the subsequent period when it crystalizes.
o
Illustration:
o
A computer manufacturing company estimates, based on previous
experience, that the probability a computer may be sent back for warranty
repairs in the next year is 2 percent out of the total production. If the
company's total revenue in year one is $3,000 and the warranty expense in its
books is $60 (2% x $3,000), then the company's taxable income is $2,940.
However, most tax authorities do not allow companies to deduct expenses
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based on expected warranties, thus the company is required to pay taxes on
the full $3,000.
o
If the tax rate for the company is 30 percent, the difference of $18 ($60 x 30%)
between the taxes payable in the income statement and the actual taxes paid
to the tax authorities is a deferred tax asset.
Dilution of EPS:
• Earnings per share, the value of earnings per share of outstanding common stock, is
a very important measure to assess a company's financial health. When reporting
financial results, revenue and EPS are the two most commonly assessed metrics.
• Apart from the existing shares outstanding, a company may have other potential
dilutive instruments outstanding as well like ESOPs, convertible warrants, convertible
debt, etc. This results in dilution of the company’s EPS. Diluted EPS considers what
would happen if dilutive securities were exercised. Dilutive securities are securities
that are not common stock but can be converted to common stock if the holder
exercises that option. If converted, dilutive securities effectively increase the weighted
number of shares outstanding, which decreases EPS.
• Diluted EPS is a calculation used to gauge the quality of a company's earnings per
share (EPS) if all convertible securities were exercised. Unless a company has no
additional potential shares outstanding, the diluted EPS will always be lower than the
simple or basic EPS.
Time Value of
Money
NPV:
• Because of the time value of money, cash inflows and outflows only can be compared
at the same point in time.
• NPV discounts each inflow and outflow to the present, and then sums them to see
how the value of the inflows compares to the other.
• A positive NPV means the investment is worthwhile, an NPV of 0 means the inflows
equal the outflows, and a negative NPV means the investment is not good for the
investor.
• When inflows exceed outflows and they are discounted to the present, the NPV is
positive. The investment adds value for the investor. The opposite is true when NPV is
negative.
• An NPV of 0 means there is no change in value from the investment.
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INVESTMENT BANKING PRIMER
• In theory, investors should invest when the NPV is positive and it has the highest NPV
of all available investment options.
• In practice, determining NPV depends on being able to accurately determine the
inputs, which is difficult.
Advantages
• When NPV is positive, it adds value to the firm. When it is negative, it subtracts value.
An investor should never undertake a negative NPV project.
• As long as all options are discounted to the same point in time, NPV allows for easy
comparison between investment options. The investor should undertake the
investment with the highest NPV, provided it is possible.
• An advantage of NPV is that the discount rate (explained below) can be customized to
reflect a number of factors, such as risk in the market.
Disadvantages
• NPV is based on future cash flows and the discount rate, both of which are hard to
estimate with 100% accuracy.
• There is an opportunity cost to making an investment which is not built into the NPV
calculation.
• Other metrics, such as internal rate of return, are needed to fully determine the gain or
loss of an investment.
∞
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = ∑
𝑌𝑒𝑎𝑟 𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
(1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒)𝑛
𝑛=0
Where “n” is the year whose cash flow is being discounted.
Adjusted Present Value:
The adjusted present value is the net present value (NPV) of a project or company if
financed solely by equity plus the present value (PV) of any financing benefits, which
are the additional effects of debt. By taking into account financing benefits, APV
includes tax shields such as those provided by deductible interest.
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INVESTMENT BANKING PRIMER
IRR:
• The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows from a particular project equal to
zero. IRR calculations rely on the same formula as NPV does.
• The higher a project’s IRR, the more desirable it is to undertake the project.
• A firm (or individual) should, in theory, undertake all projects or investments available
with IRRs that exceed the cost of capital. Investment may be limited by availability of
funds to the firm and/or by the firm’s capacity or ability to manage numerous projects.
Advantages
• The IRR method is very clear and easy to understand. An investment is considered
acceptable if its internal rate of return is greater than an established minimum
acceptable rate of return or cost of capital.
• The IRR method also uses cash flows and recognizes the time value of money.
• The internal rate of return is a rate quantity, an indicator of the efficiency, quality, or
yield of an investment.
Disadvantages
• The first disadvantage of IRR method is that IRR, as an investment decision tool,
should not be used to rate mutually exclusive projects, but only to decide whether a
single project is worth investing in.
• IRR overstates the annual equivalent rate of return for a project whose interim cash
flows are reinvested at a rate lower than the calculated IRR.
• IRR does not consider cost of capital; it should not be used to compare projects of
different duration.
• In the case of positive cash flows followed by negative ones and then by positive
ones, the IRR may have multiple values.
Multiple IRRs
• In certain exceptional cases of positive cash flows being followed by negative ones
and then by positive ones again, the IRR may have multiple values.
• It has been shown that with multiple internal rates of return, the IRR approach can still
be interpreted in a way that is consistent with the present value approach provided
that the underlying investment stream is correctly identified as net investment or net
borrowing.
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• NPV remains the “more accurate” reflection of value to the business. IRR, as a
measure of investment efficiency may give better insights in capital constrained
situations. However, when comparing mutually exclusive projects, NPV is the
appropriate measure.
𝑇
𝐼𝑅𝑅 = 𝑁𝑃𝑉 = 0 = −𝐶0 + ∑
𝐶𝑡
(1 + 𝑟)𝑡
𝑡=1
where:
𝐶𝑡 = 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
𝐶0 = 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠
𝑟 = 𝑇ℎ𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒
𝑡 = 𝑇ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
Discount Rates:
To value future cash flows today, we need to use a discount rate. The discount rate
should reflect the time value of money, risk of cash flows and should be market based.
Few points to note:
• For Free cash to firm (Defined on Page XX below), WACC is the appropriate discount
rate while Cost of Equity is appropriate for Free cash flow to equity (Defined on Page
XX below).
• If Company ABC is valuing an acquisition target XYZ, it should discount using XYZ’s
Cost of Capital (Not ABC’s)
o
Consistency of cash flows with discount rate should be maintained
o
Currency of discount rate to match that of cash flows
o
Discount rate and cash flows should both be real/nominal
o
Cost of capital changes with change in leverage since it changes the risk
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INVESTMENT BANKING PRIMER
Cost of debt:
Cost of debt reflects the return that the debt investors require. Cost is supposed to reflect
the target long term capital structure.
There are various ways to compute the same, keeping the following in mind:
• Debt which is listed on stock exchanges – Yield to maturity
• Debt which is rated but not listed on stock exchanges – Government bond (for the
relevant number of years as per instrument) + Spread
• Neither of the above – Understand the credit profile and benchmark against peers
Cost of equity:
Cost of equity (rE) is the rate of return demanded by the investors. It is effectively the
opportunity cost of investing in the firm for equity holders.
Since, creditors have the first claim on the assets of the company; cost of equity is
greater than the cost of debt.
Estimation of cost of equity presents considerably more challenge compared to the cost
of debt.
The method most commonly used is CAPM.
As per CAPM,
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒 + 𝛽 ∗ (𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚)
𝐾𝑒 = 𝑅𝑓 + 𝛽 ∗ (𝑅𝑚 − 𝑅𝑓 )
Refer to the BMA book to understand Rf, Beta and Rm in detail
Weighted average cost of capital:
In the absence of taxes, ra is also the Weighted Average Cost of Capital (WACC). With
the presence of tax, however, the interest paid by the firm on its debt is tax deductible
and thus the after tax cost of debt becomes rD*(1-T) and thus for the firm, the weighted
average cost of capital comes out to be
𝑾𝑨𝑪𝑪 =
𝑫
𝑬
∗ 𝒓𝑫 ∗ (𝟏 − 𝒕) +
∗𝒓
𝑫+𝑬
𝑫+𝑬 𝑬
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Where,
𝐷 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐷𝑒𝑏𝑡
𝐸 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐸𝑞𝑢𝑖𝑡𝑦
𝑇 = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒
𝑟𝐷 𝑎𝑛𝑑 𝑟𝐸 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦
Example:
Consider a firm for which cost of debt = 8%, cost of equity = 15%, tax rate = 35% and
D/E =9.
According the formula, WACC = 0.08*(1-0.35)*(0.9)+0.15*0.1 = 0.62 = 6.2%
In order to gain a better understanding of WACC, following terms need to be understood:
Since Kd is normally lower than Ke, does it mean that increasing debt will keep
reducing WACC?
The obvious answer is No.
The reason comes from Modigliani Miller theorem. With increase in leverage, the cost of
equity rises (since with rising debt, the risk for equity holders increases). Exactly how
much does the cost of equity increase can be calculated as follows:
The firm’s asset Beta can be written as
𝐷
𝐸
𝛽𝑎 = 𝛽𝐷 ∗ (
) + 𝛽𝐸 ∗ (
)
𝐷+𝐸
𝐷+𝐸
Now, when D/E ratio changes, since ra does not depend on financing decision of the firm
(MM), βa remains unchanged. Thus, for the original D/E ratio and using original βE,
calculate the βa. This is called un-levering the β.
Equity for new leverage ratio can then be calculated as
𝛽𝐸 = 𝛽𝑎 + (𝛽𝑎 − 𝛽𝐷 ) ∗ (𝐷⁄𝐸 )
This process is called re-levering the β. Once we have the new equity β, we can calculate
the new cost of equity (using CAPM) and then calculate the new WACC.
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Interest tax shield:
If the return on debt is rD and the market value of debt is D then:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝐼 = 𝑟𝐷 ∗ 𝐷
This interest is tax deductible, which leads to following implications. If interest were not
tax deductible, we would have had to pay entire I from EBIT *(1-T) and thus out net
income would have been, net income = EBIT(1-T) – I
Now, due to the tax laws, we can play interest from EBIT and they pay taxes, therefore
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = (𝐸𝐵𝐼𝑇 − 𝐼) ∗ (1 − 𝑇) = 𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇) − 𝐼 + 𝐼 ∗ 𝑇
The difference between of I*T is called the interest tax shield. It arises because interest
paid on debt is tax deductible. Furthermore,
𝑃𝑉(𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) =
𝑇∗𝐼
= 𝑇∗𝐷
𝑟𝐷
Thus, the effective payment becomes rD*D – T*D = (rD-T)*D and hence, we see that
effective cost of debt become rD*(1-T) as was mentioned earlier.
Capital
Structure
Considerations
Optimal Capital Structure Considerations:
• Capital structure categorizes the way a company has its assets financed.
• Miller and Modigliani developed a theory which through its assumptions and models,
determined that in perfect markets a firm's capital structure should not affect its value.
o
The Modigliani-Miller theorem (M&M) states that the market value of a
company is calculated using its earning power and the risk of its
underlying assets and is independent of the way it finances investments
or distributes dividends. There are three methods a firm can choose to
finance: borrowing, spending profits (versus handing them out to
shareholders in the form of dividends), and straight issuance of shares.
While complicated, the theorem in its simplest form is based on the idea
that with certain assumptions in place, there is no difference between a
firm financing itself with debt or equity.
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•
In the real world, there are costs and variables that create different returns on
capital and, therefore, give rise to the possibility of an optimal capital structure for
a firm.
•
The cost of capital is the rate of return that capital could be expected to earn in
an alternative investment of equivalent risk.
•
For an investment to be worthwhile, the expected return on capital must be
greater than the cost of capital.
•
The weighted average cost of capital multiplies the cost of each security ( debt or
equity ) by the percentage of total capital taken up by the particular security, and
then adds up the results from each security involved in the total capital of the
company
Tax Considerations:
•
Tax considerations have a major effect on the way a company determines its
capital structure and deals with its costs of capital.
•
Under a classical tax system, the tax deductibility of interest makes debt
financing valuable; that is, the cost of capital decreases as the proportion of debt
in the capital structure increases. The optimal structure, then would be to have
virtually no equity at all.
•
In general, since dividend payments are not tax deductible but interest payments
are, one would think that, theoretically, higher corporate tax rates would call for
an increase in usage of debt to finance capital, relative to usage of equity
issuance.
•
There are different kinds of debt that can be used, and they may have different
deductibility and tax implications. This will affect the types of debt used in
financing, even if corporate taxes do not change the total amount of debt used.
Cost of Capital Considerations
•
For an investment to be worthwhile, the expected return on capital must be
greater than the cost of capital. The cost of capital is the rate of return that capital
could be expected to earn in an alternative investment of equivalent risk.
•
Once cost of debt and cost of equity have been determined, their blend, the
weighted average cost of capital (WACC), can be calculated. This WACC can
then be used as a discount rate for a project's projected cash flows.
•
The weighted average cost of capital multiplies the cost of each security (debt or
equity) by the percentage of total capital taken up by the particular security, and
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then adds up the results from each security involved in the total capital of the
company.
Marginal Cost of Capital:
•
The marginal cost of capital is calculated as being the cost of the last dollar of
capital raised.
•
When raising extra capital, firms will try to stick to desired capital structure, but
once sources are depleted, they will have to issue more equity. Since this tends
to be higher than other sources of financing, we see an increase in marginal cost
of capital as capital levels increase.
•
Since an investment in capital is logically only a good decision if the return on the
capital is greater than its cost, and a negative return is generally undesirable, the
marginal cost of capital often becomes a benchmark number in the decision
making process that goes into raising more capital.
Trade-off between Debt & Equity:
•
An important purpose of the trade-off theory is to explain the fact that
corporations are usually financed partly with debt and partly with equity. It states
that there is an advantage to financing with debt.
•
The marginal benefit of further increases in debt declines as debt increases while
the marginal cost increases, so that a firm that is optimizing its overall value will
focus on this trade-off when choosing how much debt and equity to use for
financing.
•
One would think that firms would use much more debt than they do in reality. The
reason they do not is because of the risk of bankruptcy and the volatility that can
be found in credit markets-especially when a firm tries to take on too much debt.
Pecking Order of Capital Sources:
•
When it comes to methods of raising capital, companies will prefer internal
financing, debt, and then issuing new equity, respectively.
•
Outside investors tend to think managers issue new equity because they feel the
firm is overvalued and wish to take advantage, so equity is a less desired way of
raising new capital. This then gives the outside investors an incentive to lower
the value of the new equity.
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Ratio Analysis
Ratio analysis consists of the calculation of ratios from financial statements and is a
foundation of financial analysis. A financial ratio, or accounting ratio, shows the relative
magnitude of selected numerical values taken from those financial statements.
The numbers contained in financial statements need to be put into context so that
investors can better understand different aspects of the company’s operations. Ratio
analysis is one method an investor can use to gain that understanding.
Types of Ratios:
•
Profitability ratios measure the firm’s use of its assets and control of its expenses
to generate an acceptable rate of return.
•
Liquidity ratios measure the availability of cash to pay debt.
•
Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s
use of resources, or assets.
•
Debt, or leverage, ratios measure the firm’s ability to repay long-term debt.
•
Market ratios are concerned with shareholder audiences. They measure the cost
of issuing stock and the relationship between return and the value of an
investment in company’s shares.
Profitability Ratios:
•
Operating Margin: The operating margin equals operating income divided by
revenue. The operating margin shows how much profit a company makes for
each dollar in revenue. Since revenues and expenses are considered ‘operating’
in most companies, this is a good way to measure a company’s profitability.
Although It is a good starting point for analyzing many companies, there are
items like interest and taxes that are not included in operating income. Therefore,
the operating margin is an imperfect measurement a company’s profitability.
•
Profit Margin: Profit margin is the profit divided by revenue. There are two types
of profit margin: gross profit margin and net profit margin. A higher profit margin
is better for the company, but there may be strategic decisions made to lower the
profit margin or to even have it be negative.
•
Return on Total Assets: ROA is net income divided by total assets. The ROA is
the product of two common ratios: profit margin and asset turnover. A higher
ROA is better, but there is no metric for a good or bad ROA. An ROA depends on
the company, the industry and the economic environment. ROA is based on the
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INVESTMENT BANKING PRIMER
book value of assets, which can be starkly different from the market value of
assets.
•
Return on Equity: ROE is net income divided by total shareholders’ equity. ROE
is also the product of return on assets (ROA) and financial leverage. ROE shows
how well a company uses investment funds to generate earnings growth. There
is no standard for a good or bad ROE, but a higher ROE is better.
Activity Ratios:
•
Inventory Turnover: Inventory turnover = Cost of goods sold/Average inventory.
Average days to sell the inventory = 365 days /Inventory turnover ratio. A low
turnover rate may point to overstocking, obsolescence, or deficiencies in the
product line or marketing effort. Conversely, a high turnover rate may indicate
inadequate inventory levels, which may lead to a loss in business as the
inventory is too low.
•
Days Sales Outstanding: Days sales outstanding is a financial ratio that
illustrates how well a company's accounts receivables are being managed. DSO
ratio = accounts receivable / average sales per day, or DSO ratio = accounts
receivable / (annual sales / 365 days). Generally speaking, higher DSO ratio can
indicate a customer base with credit problems and/or a company that is deficient
in its collections activity. A low ratio may indicate the firm's credit policy is too
rigorous, which may be hampering sales.
•
Fixed Asset Turnover: Days sales outstanding is a financial ratio that illustrates
how well a company's accounts receivables are being managed. DSO ratio =
accounts receivable / average sales per day, or DSO ratio = accounts receivable
/ (annual sales / 365 days). Generally speaking, higher DSO ratio can indicate a
customer base with credit problems and/or a company that is deficient in its
collection activity. A low ratio may indicate the firm's credit policy is too rigorous,
which may be hampering sales.
Liquidity Ratios:
•
Current Ratio: Days sales outstanding is a financial ratio that illustrates how well
a company's accounts receivables are being managed. DSO ratio = accounts
receivable / average sales per day, or DSO ratio = accounts receivable / (annual
sales / 365 days). Generally speaking, higher DSO ratio can indicate a customer
base with credit problems and/or a company that is deficient in its collections
activity. A low ratio may indicate the firm's credit policy is too rigorous, which may
be hampering sales.
•
Quick Ratio: Quick Ratio = (Cash and cash equivalent + Marketable securities +
Accounts receivable ) / Current liabilities. Acid Test Ratio = ( Current assets -
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INVESTMENT BANKING PRIMER
Inventory ) / Current liabilities. Ideally, the acid test ratio should be 1:1 or higher,
however this varies widely by industry. In general, the higher the ratio, the
greater the company's liquidity.
Debt Management Ratios:
•
Total Debt to Assets: The debt ratio measures the firm's ability to repay long-term
debt by indicating the percentage of a company's assets that are provided via
debt. Debt ratio = Total debt / Total assets. The higher the ratio, the greater risk
will be associated with the firm's operation.
•
Interest Coverage Ratio: Times interest earned (TIE) or Interest Coverage ratio is
a measure of a company's ability to honor its debt payments. It may be
calculated as either EBIT or EBITDA divided by the total interest payable.
Interest Charges = Traditionally "charges" refers to interest expense found on the
income statement. EBIT = Revenue - Operating expenses (OPEX) + Nonoperating income. EBITDA = Earnings before interest, taxes, depreciation and
amortization. Times Interest Earned or Interest Coverage is a great tool when
measuring a company's ability to meet its debt obligations.
Market Ratios:
•
P/E Ratio: P/E ratio = Market price per share / Annual earnings per share. The
P/E ratio is a widely used valuation multiple used as a guide to the relative values
of companies; for example, a higher P/E ratio means that investors are paying
more for each unit of current net income, so the stock is more expensive than
one with a lower P/E ratio. Different types of P/E include: trailing P/E or P/E ttm,
trailing P/E from continued operations, and forward P/E or P/Ef.
•
P/B Ratio: The calculation can be performed in two ways: 1) the company's
market capitalization can be divided by the company's total book value from its
balance sheet, 2) using per-share values, is to divide the company's current
share price by the book value per share. A higher P/B ratio implies that investors
expect management to create more value from a given set of assets, all else
equal. Technically, P/B can be calculated either including or excluding intangible
assets and goodwill.
Valuation
Methodology
Dividend Discount Model:
•
Another method for valuing a firm would be to calculate the value of equity and
then add the value of debt.
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•
To calculate the value of Equity, we need the price of a share. Let us see how it
can be calculated.
•
We know that price of any project/investment is equal to the discounted cash
flows in future years.
•
For an equity investor (who does not sell his share) the cash flows from equity
investment are the dividends and thus the value of share is the discounted
present value of all the future dividends.
•
This is known as the dividend discount model.
•
Under this model, if DIV1 is the dividend paid out at the end of first term, r is the
hurdle rate and g is the rate of growth of dividends, then current price
𝑃0 =
𝐷𝐼𝑉1
𝑟−𝑔
•
And why do the dividends grow? That is because the firms do not pay out all of
the earnings as dividends.
•
Some of the earnings are reinvested into the business and earn incremental
income leading to growth in dividends as well. Recall, that the ratio of earnings
paid out as dividends is called the payout ratio = DIV/EPS (where EPS is
earnings per share).
•
Thus, 1- DIV/EPS represents the fraction of income reinvested in the business.
This is called the plowback ratio. The ploughed back capital would earn a return
equal to the Return on Equity earned by the company and thus if the payout ratio
stays constant, the income and hence the dividend would grow at:
𝑔 = 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 ∗ 𝑅𝑂𝐸
•
A major assumption that we have made in the above discussion is that all these
ratios remain constant which is rarely the case in real life scenarios. For stocks
with variable growth rates we find dividends for each year separately and then
sum the discounted value to get the price of stock. The process is similar to that
in DCF.
𝑃0 =
𝐷𝐼𝑉1
𝐷𝐼𝑉2
𝐷𝐼𝑉𝐻
𝑃𝐻
+
+ ⋯+
+
1
2
𝐻
(1 + 𝑟)
(1 + 𝑟)
(1 + 𝑟)
(1 + 𝑟)𝐻
Where,
𝐷𝐼𝑉𝑖 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑖 𝑡ℎ 𝑝𝑒𝑟𝑖𝑜𝑑
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𝑃𝐻 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝐻
Usually H is chosen to be the time when the firm’s growth is expected to stabilize.
Example: Consider a firm that has an EPS of Rs. 10 and a payout ratio of 0.5.
Furthermore, the ROE is 15%, and discount rate is 10%Then, g = 0.5*0.15 = 0.075; P =
Price of share = 10*0.5/(.1-0.075) = Rs. 200
Discounting Cash Flow Method (DCF):
Valuation using Discounted Cash Flow Method is usually more time consuming than
other methods.
DCF Method helps estimate the intrinsic value of an asset based on cash flows and their
likely certainty. The Enterprise Value is estimated by discounting expected cash flows
using a suitable discount rate
There are two commonly used methods to estimate DCF:
1. Free Cash Flow to Firms
2. Free Cash Flow to Equity
Free Cash Flow to Firms
FCFF, or Free Cash Flow to Firm, is the cash flow available to all funding providers. It is
referred to as unlevered free cash flow.
Free Cash Flow to Firm = NOPAT + Depreciation & Amortization (-) Capex (-) Change in
working capital
Free Cash Flow to Equity
This method is commonly used in Leverage Buyout models and by some financial
services firms. FCFE measures the amount of cash that is available for distribution to
equity shareholders.
FCFE = Cash from operations (-) Capital expenditures + Net debt issued
What is more commonly used?
Normally, FCFF is used since it is not affected by non-operating expenses.
Also, the discounting factor (WACC) is not affected by leverage when compared with
discounting factor for cash flows to equity (cost of equity). However, this does not hold
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true when we take away the constant debt assumption and we change the capital
structure keeping in mind the target debt for each year.
In such case, the WACC ought to change every year. This method is typically not used
for sake of simplicity except in cases of highly volatile leverage of LBOs.
Terminal value – different ways of calculations
There can be two ways to compute Terminal Value as follows:
1. Growing perpetuity
2. Terminal EV multiple
Growing perpetuity method
This method computes the present value of the cash flow assuming the same were to
be earned into perpetuity.
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 (𝑛𝑡ℎ 𝑦𝑒𝑎𝑟) = 𝐹𝐶𝐹(𝑛) ∗
1+𝑔
𝑤−𝑔
Hence, a point to note is that FCF of (n+1) th years is divided by (w-g) to get
Terminal Value for nth year
Terminal EV multiple (a relative valuation, to that extent)
The last year EBIT/EBITDA can be multiplied by a suitable multiple that reflects
fundamentals in the steady state.
Relative Valuation:
•
A relative valuation model is a business valuation method that compares a
company's value to that of its competitors or industry peers to assess the firm's
financial worth. Relative valuation models are an alternative to absolute value
models, which try to determine a company's intrinsic worth based on its
estimated future free cash flows discounted to their present value, without any
reference to another company or industry average. Like absolute value models,
investors may use relative valuation models when determining whether a
company's stock is a good buy.
•
Relative valuation is also used in investment banking extensively where the value
of the target is triangulated with the help of industry multiples. The most common
multiples are EV/Sales, EV/EBITDA, P/E, P/B.
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Advantages
•
It can be undertaken quicker and is more efficient than DCF valuation.
•
The intuitive nature of relative valuation is attractive to prospective investors than
the technical nature of DCF.
Disadvantages
•
For some companies, it is difficult to find true value because of low trading
pattern and small market capitalization.
•
Also, volatile market sentiments may lead to stock prices that are not true
reflection of a company’s intrinsic value.
Consistency of Ratios
Valuation ratios are broadly of two kinds:
•
Enterprise level
•
Equity level
Equity level ratios can be affected by changes in the capital structure without any
change in the Enterprise value. Enterprise level ratios help compare companies
with different leverage ratios. Also, Enterprise level ratios are generally less
affected by accounting changes/ differences as the denominator is higher than
that in the case of equity ratios
Eg: Equity Level: P/E, PEG, P/B
Enterprise level: EV/EBIT, EV/ EBITDA
What about ratios like EV/Price, EV/Earnings?
The numerator in the ratio is not affected by the capital structure. However, the
denominator is affected by leverage. Hence, these ratios are inconsistent cannot
be used to compare two companies with different leverage levels or even the
same company at different points in time.
This principle is applicable even for non- financial ratios. For example, EV/tonne
is a popular metric used in the cement industry. This ratio is consistent as both
the numerator (EV) and denominator (capacity) are firm level metrics and are not
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INVESTMENT BANKING PRIMER
affected by the capital structure. However, a Price/tonne would be an inconsistent
ratio as price is an equity level metric unlike capacity.
Industry Specific Ratios:
•
Technology (Internet): EV / Unique Visitors, EV / Pageviews
•
E-Commerce: EV/Gross Merchandise Value, EV/Revenue
•
Cement: EV/Tonne; EV/EBITDA, Capacity utilization
•
Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation,
Amortization & Rental Expense)
•
Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation,
Amortization & Exploration Expense), EV / Daily Production, EV / Proved
Reserve Quantities
•
Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per
Share (Funds From Operations, Adjusted Funds From Operations)
•
Hotel Industry: Average Daily Rate (ADR), Revenue per available room
(RevPAR), Occupancy
•
Retail Industry: Revenue per sq feet, revenue per employee,
•
For Banks and NBFCs, you look at metrics like ROE (Return on Equity, Net
Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total
Assets), and Price to Book Value and Tangible Book Value rather than Revenue,
EBITDA, and so on.
•
Technology and Energy should be straightforward – you’re looking at traffic and
energy reserves as value drivers rather than revenue or profit.
•
For Retail / Airlines, you add back Rent because some companies own their own
buildings and capitalize the expense whereas others rent and therefore have a
rental expense.
•
For Energy, all value is derived from companies’ reserves of oil & gas, which
explains the last 2 multiples; EBITDAX exists because some companies
capitalize (a portion of) their exploration expenses and some expense them. You
add back the exploration expense to normalize the numbers.
•
For REITs, Funds From Operations is a common metric that adds back
Depreciation and subtracts gains on the sale of property. Depreciation is a noncash yet extremely large expense in real estate, and gains on sales of properties
are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of
the cash flow the REIT is generating.
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How to read ratios and complementary variables to judge whether the company is
overvalued:
1. PE Ratio
PE Ratio is often read in conjunction with expected growth to judge how stocks
are relatively valued. Favorable stock is one with Low PE Ratio and High
expected growth rate in earnings per share
2. PBV Ratio
PBV Ratio is often read in conjunction with ROE to judge how stocks are
relatively valued. Favorable stock is one with Low PBV Ratio and High ROE
3. PS Ratio
PS Ratio is often read in conjunction with Net Margin to judge how stocks are
relatively valued. Favorable stock is one with Low PS Ratio and High net profit
margin
4. EV/EBITDA
EV/EBITDA is often read in conjunction with Reinvestment Rate to judge how
stocks are relatively valued. Favorable stock is one with Low EV/EBITDA and low
reinvestment needs
5. EV/Capital
EV/Capital is often read in conjunction with Return on Capital to judge how
stocks are relatively valued. Favorable stock is one with Low EV/Capital Stock
and high return on capital
6. EV/Sales
EV/Sales is often read in conjunction with After-Tax operating margin to judge
how stocks are relatively valued. Favorable stock is one with Low EV/Sales and
high After-Tax operating margin
Ways to compute/read various ratios
1. LTM: LTM stands for Last Twelve Months (Trailing Twelve Months), is a measure
used to evaluate the company’s performance in the last twelve months. This is
with reference to immediately preceding twelve months. This is a more accurate
measure in comparison to values as per financial statements as these are more
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INVESTMENT BANKING PRIMER
recent. LTM is usually used when the company has uniform growth prospects
and isn’t very volatile.
2. NTM: NTM stands for Next Twelve Months. This is normally used to forecast the
company’s performance in the next twelve months. This is normally used when
the company’s earnings have cyclical nature, volatile growth prospects or is
technology oriented.
3. 1-year forward: A one-year forward ratio typically takes into account the
earnings/financial metrics as projections for the next one year.
Option Valuation: Black Scholes model
This model is used to calculate the value of a call option with an underlying asset with
value St and volatility σ. The strike price is K.
𝐶(𝑆𝑡 , 𝑡) = 𝑁(𝑑1 )𝑆𝑡 − 𝑁(𝑑2 )𝑃𝑉(𝐾)
1
𝑆𝑡
𝜎2
𝑑1 =
[ln ( ) + (𝑟 + ) (𝑇 − 𝑡)]
𝐾
2
𝜎√𝑇 − 𝑡
𝑑2 = 𝑑1 − 𝜎√𝑇 − 𝑡
𝑃𝑉(𝐾) = 𝐾𝑒 −𝑟(𝑇−𝑡)
Where,
𝐶(𝑆𝑡 , 𝑡) = 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛
Application in Equity valuation
Option pricing models find their application in valuation as well. They can be used in the
following scenarios
1. Valuing the equity of a distressed company
2. Value of undeveloped reserves for natural resource firms
3. Value of patents/Licenses
Equity in a distressed company with high leverage can be viewed as a call option. The
equity lay claim to the left-over assets once all the debt-holders have been paid. Also, by
the principle of limited liability even in case the value of the assets is lower than the value
of the outstanding debts, the equity holders cannot lose more money.
Therefore, payoff to equity investors can be written as
𝑉 − 𝐷,
𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑛 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 = {
0,
𝑖𝑓 𝑉 > 𝐷
𝑖𝑓 𝑉 ≤ 𝐷
Where,
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𝑉 = 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
𝐷 = 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑑𝑒𝑏𝑡
This is similar to the payoff of a call option with current value S and strike price K
𝑝𝑎𝑦𝑜𝑓𝑓 = {
𝑆 − 𝐾,
0,
𝑖𝑓 𝑆 > 𝐾
𝑖𝑓 𝑆 ≤ 𝐾
Therefore, we can use option pricing models to value the equity.
Example
Assume a firm with $100m in assets with 40% standard deviation in asset value. The
face value of the company’s debt is $80m (zero coupon bond with 10-year maturity). 10year risk free rate is 10%.
In this case we need to find the value of the equity and debt.
In this case
𝑑1 = 1.5994 ; 𝑁(𝑑1 ) = 0.9451
𝑑2 = 0.3345; 𝑁(𝑑2 ) = 0.6310
Value of the call option = 100*(0.9451) - 80e(-0.1)10 *(0.6310) = $75.94
Therefore, value of the outstanding debt = $100-$75.94=$24.06
How to
approach a
valuation
model?
To begin a Valuation model, we first need to carry out the industry analysis:
Read the following reports to gain more information about the industry:
•
Broker Reports from Bloomberg, etc.
•
Industry Reports like IBEF, Consultant’s reports, Industry Association reports,
etc.
•
News about the industry
•
Govt regulation/ Policy Changes
Once all industry factors are in place, we need to obtain Company specific Info. In order
to collect that, we use the following information:
•
Management Discussion & Analysis
•
Investor Presentations
•
Analyst Call Transcripts
•
Historical Financial Data to set the base for the forecasts. Sources: Bloomberg,
EIKON, Datastream, Capitaline, CapIQ
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On obtaining the above information, we can proceed with forecasting the key variables in
the financial model to arrive at a suitable valuation.
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Technical knowledge
Checklist for
Preparation
•
FRA concepts MUST be clear
•
Also know essential ratios used to evaluate performance of a business
Valuation methods used in the industry
•
DCF valuation
•
Relative valuation
Preparation of minimum two industries
•
Current landscape - major players, recent developments, current trends
•
Important performance parameters used in the industry
•
Relative valuation multiples used in the industry - Which multiples are used, and
why they are used (for example, you should know why EV/EBITDA is being used
instead of P/E ratio)
•
Regulations existing in the industry; recent changes, if any
•
Recent major deals in the industry - not just knowledge about deal casefacts,
must develop your own opinion about the deal (who got the better deal, what
valuation you would attribute, your opinion about the multiple)
•
Lastly, any deal idea you can come up with in this industry - must also think of
value proposition to both stakeholders on the deal
Pick one stock and follow it from here on
•
Develop a clear opinion on its value (must be able to justify with evidence and
logic)
•
Follow news events about it, about its leadership, major changes
•
Formulate an outlook on the stock (how you think it will perform)
•
This stock may be from the same industries you have prepared, to make work
easier
Practice DCF valuation of at least one company
•
May be asked during buddy calls or interviews
•
Be prepared with reasonable explanations for all the assumptions made (WACC
calculations, growth rate or exit multiple, operating margins, tax rate, etc.)
Company specific preparation
•
Read about recent news and deals of the bank for which you have been
shortlisted
•
The underlying reason for the deal (what was in it for both players), try to
understand why the deal made sense, what the strategic motive was
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INVESTMENT BANKING PRIMER
•
Formulate an opinion of the deal, and you may discuss with buddy calls whether
the valuation is justified. You may also ask questions about the deal if you have
doubts or are unable to understand something
Exhaustive
List of
Preparation
Material
•
Valuation methods used, how the market responded
•
How the deal affects the industry, what it means for the other players, regulators,
consumers, etc
Read JDs of the companies - KYCs also shared in the PlaceCom repository by BETA
Technical:
•
Damodaran Videos - YouTube channel
•
Damodaran Book - “Valuation”
•
BETA IB REM sessions
•
BETA Primers
•
Investopedia - to clarify any finance jargon you come across in other sources
Industry Reports:
•
CRISIL
•
EuroMonitor
News/Deals:
•
Dealcurry
•
Venture Intelligence
•
Merger Market
•
Mint, FT, ET, BS, Hindu BL, any other newspaper that covers the deal
extensively
•
Macroeconomic reports of countries published by WB, IMF, Banks
•
Websites – NYTimes, Business Insider
Networking:
•
Talk to as many IB interns as possible to understand everyone’s
interview/process experience, try to connect most to a senior with similar
education / work-ex background as yours.
•
Placecom repository for interview experiences
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