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 Page 1 of 28 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 Page 2 of 28 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. Page 3 of 28 INVESTMENT BANKING PRIMER • 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%. Page 4 of 28 INVESTMENT BANKING PRIMER 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 Page 5 of 28 INVESTMENT BANKING PRIMER 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. Page 6 of 28 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. ∞ πππ‘ ππππ πππ‘ ππππ’π = ∑ ππππ π πππ‘ππ πΆππ β πΉπππ€ (1 + π·ππ πππ’ππ‘ π ππ‘π)π π=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. Page 7 of 28 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. Page 8 of 28 INVESTMENT BANKING PRIMER • 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. π πΌπ π = πππ = 0 = −πΆ0 + ∑ πΆπ‘ (1 + π)π‘ π‘=1 where: πΆπ‘ = πππ‘ πΆππ β πΌπππππ€ ππ’ππππ π‘βπ ππππππ π‘ πΆ0 = πππ‘ππ ππππ‘πππ πππ£ππ π‘ππππ‘ πππ π‘π π = πβπ πππ πππ’ππ‘ πππ‘π π‘ = πβπ ππ’ππππ ππ π‘πππ πππππππ 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 Page 9 of 28 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, πΆππ π‘ ππ πΈππ’ππ‘π¦ = π ππ π πΉπππ π ππ‘π + π½ ∗ (πΈππ’ππ‘π¦ π ππ π ππππππ’π) πΎπ = π π + π½ ∗ (π π − π π ) 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 πΎπ¨πͺπͺ = π« π¬ ∗ ππ« ∗ (π − π) + ∗π π«+π¬ π«+π¬ π¬ Page 10 of 28 INVESTMENT BANKING PRIMER Where, π· = ππππππ‘ ππππ’π ππ π‘βπ π·πππ‘ πΈ = ππππππ‘ ππππ’π ππ π‘βπ πΈππ’ππ‘π¦ π = πππ₯ π ππ‘π ππ· πππ ππΈ = πΆππ π‘ ππ π·πππ‘ πππ πΈππ’ππ‘π¦ πππ ππππ‘ππ£πππ¦ 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 π· πΈ π½π = π½π· ∗ ( ) + π½πΈ ∗ ( ) π·+πΈ π·+πΈ 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 π½πΈ = π½π + (π½π − π½π· ) ∗ (π·⁄πΈ ) 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. Page 11 of 28 INVESTMENT BANKING PRIMER Interest tax shield: If the return on debt is rD and the market value of debt is D then: πΌππ‘ππππ π‘ πππ¦ππππ‘ πΌ = ππ· ∗ π· 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 πππ‘ πΌπππππ = (πΈπ΅πΌπ − πΌ) ∗ (1 − π) = πΈπ΅πΌπ ∗ (1 − π) − πΌ + πΌ ∗ π The difference between of I*T is called the interest tax shield. It arises because interest paid on debt is tax deductible. Furthermore, ππ(π‘ππ₯ π βππππ) = π∗πΌ = π∗π· ππ· 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. Page 12 of 28 INVESTMENT BANKING PRIMER • 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 Page 13 of 28 INVESTMENT BANKING PRIMER 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. Page 14 of 28 INVESTMENT BANKING PRIMER 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 Page 15 of 28 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 - Page 16 of 28 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. Page 17 of 28 INVESTMENT BANKING PRIMER • 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 π0 = π·πΌπ1 π−π • 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: π = ππππ€ππππ πππ‘ππ ∗ π ππΈ • 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. π0 = π·πΌπ1 π·πΌπ2 π·πΌππ» ππ» + + β―+ + 1 2 π» (1 + π) (1 + π) (1 + π) (1 + π)π» Where, π·πΌππ = π·ππ£πππππ ππ π‘βπ π π‘β ππππππ Page 18 of 28 INVESTMENT BANKING PRIMER ππ» = πΈπ₯ππππ‘ππ πππππ ππ π‘βπ π π‘πππ ππ‘ π‘βπ πππ ππ ππππππ π» 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 Page 19 of 28 INVESTMENT BANKING PRIMER 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. ππππππππ ππππ’π (ππ‘β π¦πππ) = πΉπΆπΉ(π) ∗ 1+π π€−π 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. Page 20 of 28 INVESTMENT BANKING PRIMER 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 Page 21 of 28 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. Page 22 of 28 INVESTMENT BANKING PRIMER 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 Page 23 of 28 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. πΆ(ππ‘ , π‘) = π(π1 )ππ‘ − π(π2 )ππ(πΎ) 1 ππ‘ π2 π1 = [ln ( ) + (π + ) (π − π‘)] πΎ 2 π√π − π‘ π2 = π1 − π√π − π‘ ππ(πΎ) = πΎπ −π(π−π‘) Where, πΆ(ππ‘ , π‘) = π‘βπ π£πππ’π ππ π‘βπ ππππ πππ‘πππ 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 π − π·, πππ¦πππ ππ ππππ’ππππ‘πππ = { 0, ππ π > π· ππ π ≤ π· Where, Page 24 of 28 INVESTMENT BANKING PRIMER π = π£πππ’π ππ π‘βπ ππππ π· = πΉπππ π£πππ’π ππ ππ’π‘π π‘ππππππ ππππ‘ This is similar to the payoff of a call option with current value S and strike price K πππ¦πππ = { π − πΎ, 0, ππ π > πΎ ππ π ≤ πΎ 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 π1 = 1.5994 ; π(π1 ) = 0.9451 π2 = 0.3345; π(π2 ) = 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 Page 25 of 28 INVESTMENT BANKING PRIMER On obtaining the above information, we can proceed with forecasting the key variables in the financial model to arrive at a suitable valuation. Page 26 of 28 INVESTMENT BANKING PRIMER 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 Page 27 of 28 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 Page 28 of 28