investment banking lesson 10 perfecting the financial ratios for investment banking investment...

INVESTMENT BANKING

LESSON 10 PERFECTING THE FINANCIAL RATIOS FOR INVESTMENT

BANKINGInvestment Banking (2nd edition) Beijing Language and Culture

University Press, 2013

Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN?

CHINA’S INFLATION RATE ROSE TO 1.5% IN APRIL

LESSON 10 TOPICS

A. INTRODUCTION – How are important are ratios and ratio analysis to the IB. The 4 main ratios.

B. VALUATION MULTIPLES - HOW MUCH IS A COMPANY WORTH?

C. LIQUIDITY MULTIPLES – HOW DOES A COMPANY KEEP GROWING?

LESSON 10 TOPICS

D. PROFITABILITY RATIOS – WHAT DOES A COMPANY’S “BOTTOM LINE” LOOK LIKE?

E. EFFICIENCY RATIOS – HOW WELL IS THE COMPANY USING INVESTORS’ MONEY?

F. CAlCULATING A COMPANY’S GROWTH RATE

LESSON 10 A. INTRODUCTION

How important are ratios to the IB?

From ratios IB get data from financial statements and compare them with each other and with the same type of companies.

This lesson will show how IB look at ratios and use ratio analysis to see what is going on with a company.

LESSON 10 A. INTRODUCTION

The 4 major types of multiples/ratios we will look at are:B. VALUATION MUTLIPLES – How much is a company worth?

C. LIQUIDITY MUTLIPLES – Which companies need cash?

D. PROFITABILITY RATIOS – How much money can a company make?

E. EFFICIENCY RATIOS – How well is management putting money to use?

LESSON 10 B. VALUATION MULTIPLES: How much is a Company Worth?

The first question investors ask is how much is a company worth. Most of the products IB offer is based on market valuation. This is always changing as company values rise and fall. Timing is critical as IB want to sell when the demand for securities is strong.


B. VALUATION MULTIPLES:

1. P/E ratio – price-to-earnings, is the favorite of IB.

P/E RATIO =

The P/E ratio tells IB how much bankers are willing to pay for a claim to a dollar ($) of a company’s earnings. The higher the P/E ratio the more value a company has.



2. Book value – This is the net worth of the company. A company’s book value is it’s material (buildings, equipment) minus it’s liabilities. The price-to-book ratio is the

This ratio tells IB how much investors are paying for every dollar the company were made if it were sold. Warren Buffett values this very highly.



3. Market value =

company’s stock price x number of shares outstanding

This is the most common way investors know how much a company is worth.



4. Enterprise value divided by EBITDA:

With the P/E ratio this better tells an IB how much a company costs.

What is Enterprise Multiple or Value? Look up the definition on the website under Financial Terms. www.businessatsias.weebly.com

Enterprise value = market value - Cash and Short-Term Investments + Total Debt

EBITDA = Net income + tax + Interest + Depreciation and amortization.



4.

Dividing enterprise value by EBITDA tells IB the total value placed on the company’s earnings adjusted items that don’t cost cash, like depreciation and amortization.


B. VALUATION MULTIPLES: One more valuation ratio:

5. EBIT (Earnings before taxes & interest

EBIT = Revenue – Cost of goods sold – operating expenses – depreciation – amortization.

This is an easier way to compare a company’s profit with other companies.


B. Summary of Valuation Multiples

1. P/E ratio

2. Book value

3. Market value

4. Enterprise multiple

5. EBIT

Now, let’s look at Liquidity Multiples!

LESSON 10 C. LIQUIDITY MULTIPLES: How does a Company Keep Growing?

IB definitely help companies who need help. But how do they help companies continue to grow or stay strong?

Here are some ways that IB use liquidity ratios to understand how a company is doing. IB help companies to see how they are doing on debt financing versus equity, or stock, financing. Thus, they use the:

1. DEBT-TO-EQUITY RATIO


2. In order to make sure a company can still pay all it’s bills, the QUICK RATIO will help.

3. The INTEREST COVERAGE RATIO will help a business account for their level of debt and se how much larger a company’s profit is than interest payments. So,

1. DEBT-TO-EQUITY RATIO

2. QUICK RATIO

3. INTEREST COVERAGE RATIO

Let’s look at these!


1. UNCOVERING DEBT-TO-EQUITY: We have already learned that using other people’s money (leveraging debt) can give a company a huge profit if things go well. But, it can also take a company down.

So, knowing a companies debt-to-equity ratio is key and it’s also easy. Simply, it’s the company’s:

The higher the debt-to-equity ratio, the greater the amount of financing comes from debt.


1. Debt-to-Equity like all other ratios must be compared against the industry it is in.

Debt-to-Equity Ratios by Industry

INDUSTRY DEBT-T0-EQUITY RATIO

Oil & Gas refining/marketing 27%

Industrial Conglomerates 103%

Technology Software 8%

Health care 10.2%


2. QUICK RATIO – Just as the word quick means fast, could a company pay off it’s bills if income suddenly went to zero (0)!

The higher the quick ratio, the more the company has in liquid assets that can be turned into cash to pay the bills.

Quick ratio=

The quick ratio does not include inventory. Inventory is an asset that can be sold but takes time to sell and the amount is uncertain.


3. INTEREST COVERAGE – IB need to know, not only how much debt a company has related to stock, using the debt-to-equity ratio, but also how much are the interest payments on the debt with respect to earnings. The best interest coverage ratio is:

Interest coverage =

Divide a company’s earnings before interest and taxes by the interest expense.

The higher a company’s interest coverage ratio, the more it is able to afford its interest payments.

LESSON 10 D. PROFITABILITY RATIOS: What does a Company’s “Bottom Line” Look Like?

Ratios that measure a company’s profitability come from the income statement. IB learn much from the income statement but the information is most useful when applied to ratios. There are many ratios but we will look at a few that matter the most.

1. GROSS MARGIN

2. INCOME FORM CONTINUING OPERATIONS

3. NET MARGIN



1. GROSS MARGIN =

This tells you how much of every dollar ($) in revenue the company keeps after paying it’s direct costs. The money that is left can then be used to pay overhead and provide a return to shareholders.

Overhead costs are more controllable than direct costs. What are these costs?


Overhead costs include things like: repairs and maintenance, office supplies, utilities, rent.Direct costs include labor, materials, third party expenses.


2. INCOME FROM CONTINUING OPERATIONS MARGIN shows the revenue that a company is able to keep after paying all its costs before interest expenses and smaller, extra costs.

Income from continuing operations = (total revenue -cost of revenue - operating expenses + Net interest expense + Unusual items – Income tax expenses)

Divided by Total Revenue.


3. NET MARGIN – A better way to measure profits than net income and easy to calculate:

Net margin =

This ratio tells you how much of every dollar earns after paying ALL its expenses. This ratio varies between industries.


Net Margin by Industry Industry Net Margin (5-year average)Energy 12.7%Technology 11.8%Healthcare 11.4%Industrials 9.7%

LESSON 10 E. EFFICIENCY RATIOS: How well is the Company Using Investors’ Money?

Efficiency ratios are a way for investors to know if a company’s management team is using their money wisely. These ratios compare data from both the balance sheet and the income statement. These include:

1. Return on Assets

2. Return on Capital

3. Return on Equity



1. RETURN ON ASSETS – This tells an IB how much profit is made on the company’s fixed investments such as plant, property, and equipment.

RETURN ON ASSETS =

To get the average total assets, add the value of the company’s assets at the end of the period of time you are looking at to the value at the beginning of the period and divide by 2. The higher the ROA ratio the better the company is getting profit from it’s assets.


2. RETURN ON CAPITAL – This is an important ratio to IB as it shows how much profit a company is making from the level of capital – both debt and equity – is put into the company.

Return on capital = How to get this ratio? Start with EBIT and multiply by 0.625. This takes out the tax rate. For average capital, take the capital invested in the co. during the most recent 12 months, add the capital invested in the previous 12 months and then divide by 2.


2. CALCULATING HERSHEY’S RETURN ON CAPITAL

Financial Measure 2012($millions)2013($millions)EBIT 1,208.32 Not needed

Total equity 1036.75 857.32

Minority Interest (debt) 11.62 23.63

Short-term debt 118.16 42.08

Current portion long-term

debt 257.73 97.59

Long-term debt 1,530.97 1,748.50

Total capital 2,955.24 2,769.12


2. Using the formula, now here is how you calculate return on capital:

Return on capital =

= $1,208.32 x 0.625

= 26.39

This tells us that Hershey generated a 26.4% return from the assets invested in it. As always, this number must be compared with same companies.


3. RETURN ON EQUITY – How well is a company making use of money invested by shareholders?

return on equity =

Calculating Income from continuing operations is on slide 24.

LESSON 10 F. CALCULATING A COMPANY’S GROWTH RATE

To IB financial statements are “old” information when they get them. IB look for trends to be able to determine where a company is headed in the future financially. Companies often do not include growth rates from their financial statements.

So, the IB wants to look at growth rates:

GROWTH RATE =

(for a period of time)

This formula can be used on any two numbers you will find on a financial statement to look for trends.


HERSHEY’S GROWTH TRENDS ($ millions)Financial Measure 2012 2011Growth Rate

Revenue $6,644.3 6,080.89.3%

Cost of Goods Sold $3,784.4 3,548.9 6.6%

Selling, marketing &

administrative costs $1,703.8 1,477.9 15.3%

Interest expense $95.6 92.2 3.7%

Net income $660.9 $629.0 5.1%

Looking at the growth rate gives an IB a different perspective from the financial statements. What do you see?


HERSHEY’S GROWTH TRENDS ANALYSIS

1.Hershey’s has near double-digit revenue growth in the chocolate business

2. They are keeping good control on its raw materials cost by 6.6% in COGS

3. 3. This also shows a potential trouble in the 15.3% increase in “overhead” costs. The IB will go back to 10K filings to find out what’s going on.


HERSHEY’S GROWTH TRENDS ANALYSIS

During 2012 Hershey’s costs increased in 2012 due to higher advertising costs, bonuses and costs due to buying another chocolate company, Brookside Foods, a Canadian-maker of chocolate-covered fruit-juice pieces – an example of growing to fill-out their product line.

This kind of information is critical for IB to know, so that they can possibly help Hershey with amother merger opportunity.

investment banking lesson 10 perfecting the financial ratios for investment banking investment...

Documents

company worth

company values

company costs

market valuation

valuation ratio

liquidity multiples

valuation mutliples

ratios ib