1 VALUATIONS I Financial Metrics, Ratios, & Comparables Analysis Fall 2015 Comp Week 6
2 CODE: COMPS
3 Timeline Date Topic 9/10/15 Introduction to Finance 9/17/15 Qualitative Analysis: SWOT and Porter s Five Forces 9/24/15 Income Statement 10/1/15 Balance Sheet 10/8/15 Cash Flow Statement and Linking the Financial Statements 10/15/15 Financial Metrics, Ratios, and Comparables Analysis 10/22/15 The Discount Rate: CAPM and WACC 10/29/15 Discounted Cash Flow Analysis (DCF) 11/5/15 DCF Practical 11/12/15 Review & Stock Selection 11/19/15 Fundamentals of Investing and Sample Stock Pitches 12/3/15 Stock Pitch Competition
4 Outline for Today I. A Quick Recap 1) Linking the 3 Statements 2) Accounting: The Big Picture II. Financial Metrics 1) Income Statement Metrics 2) Capital Structure III. Financial Ratios 1) Why ratios? 2) Balance Sheet ratios 3) Income Statement ratios 4) Cash Flow Conversion IV. Comparables Analysis 1) Multiples 2) HFAC Case Study: NROM
5 Linking the Financial Statements
6 Linking the Financial Statements 1) Income Statement 1. Revenues minus expenses to get Net Income 2) Cash Flow Statement 1. Net Income becomes top line of the Cash Flow Statement 2. Add back non-cash charges like D&A, and make adjustments for changes in working capital to get Cash Flow from Operations 3. Take into account all Investing and Financing activities, and end up with Net Change in Cash 3) Balance Sheet 1. Assets: Cash equals beginning cash balance plus Net Change in Cash, any changes to PP&E from CapEx 2. Liabilities: Any changes from Investing/Financing Activities 3. Equity: Net Income enters as Retained Earnings 4. Make sure you re balanced! (Assets = Liabilities + Equity)
7 Accounting: The Big Picture The financial statements are the way a business communicates to us: 1) How it operates 2) Its financial health 3) and ultimately helps us determine whether or not the business can sustainably make money
8 FINANCIAL METRICS
9 Income Statement Metrics 1) (+) Revenues 2) (-) Cost of Goods Sold (COGS) 3) = Gross Profit 4) (-) Operating Expenses a. Research & Development b. Selling, General, & Administrative 5) = EBITDA (Earnings before interest, taxes, and D&A) a. Depreciation & Amortization 6) = EBIT (Earnings before interest and taxes) 7) (-) Other a. Non-recurring b. Interest 8) (-) Taxes 9) = Net Income
10 Income Statement Metrics 1) Gross Profit 2) EBITDA (Earnings before interest, taxes, D&A) 3) EBIT (Earnings before interest, taxes) 4) Net Income Why might each of these be important?
11 Income Statement Metrics 1) Gross Profit 2) EBITDA (Earnings before interest, taxes, D&A) 3) EBIT (Earnings before interest, taxes) 4) Net Income Why might each of these be important? Answer: They allow us to evaluate a company in different ways. In particular, EBITDA and EBIT give us a way to compare the performance of companies with different capital structures (i.e. proportion of debt vs. equity)
12 Capital Structures The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
13 Unlevered Free Cash Flow 1) EBITDA 2) (-) CapEx 3) (-) Increase in Net Working Capital 4) (-) Taxes 5) = Unlevered Free Cash Flow (FCF) 1) EBITDA is earnings assuming no debt financing (i.e. no interest expenses) and before taxes and non-cash D&A 2) Increase in NWC a. E.g. if current assets increased more than current liabilities, cash is needed to fund that, and vice versa 3) Taxes are a cash expense and subtracted last 4) Unlevered FCF because we act as though there is no debt or interest payments
14 FINANCIAL RATIOS
15 Why Financial Ratios? We ve learned about the income statement, balance sheet, and cash flow statement But each of these statements contain a lot of information We want a way to summarize some important take-aways from each statement with a few numbers We also want a way to compare companies of different sizes or with different characteristics, and ratios allow us to normalize for this. Key Point: Financial ratios often don t tell you much when viewed on their own. You either need: (a) comparable companies to compare to (b) historical data on the company or (c) an understanding of the business that tells you what the ratios should be
16 A First Example: Debt / Equity This is fairly straightforward Calculate the total amount of debt a company has Subtract debt from assets to get equity Divide A close analogue of this is Debt / Total Capitalization, which is just Debt divided by total Assets Back to key point: Company A s Debt/Equity is 4x. Interpretation? Think back to the capital structure diagram
17 A First Example: Debt / Equity This is fairly straightforward Calculate the total amount of debt a company has Subtract debt from assets to get equity Divide A close analogue of this is Debt / Total Capitalization, which is just Debt divided by total Assets Back to key point: Company A s Debt/Equity is 4x. Interpretation? Think back to the capital structure diagram A low debt/equity ratio is typically more attractive to banks since there is less risk for them to be repaid. However, the company is potentially missing out on better returns via more leverage. A high debt/equity ratio may signal there is over-leveraging, and a company may not be able to pay down its debts.
18 Balance Sheet Ratios Recall that Working Capital = Current Assets Current Liabilities A useful ratio is the Current Ratio Current Ratio = Current Assets / Current Liabilities Do you want a business that requires more or less working capital? (Hint: think back to your free cash flow formula) But how do we determine how much working capital a business requires, i.e. the optimal amount of working capital for the business? What are examples of a Working Capital-light business? How about a Working Capital-intensive business?
19 Liquidity Current Ratio: Current Assets / Current Liabilities Meant to determine near-term liquidity of the business. >1: Positive interpretation? Negative interpretation? <1: Positive interpretation? Negative interpretation? Quick Ratio: (Current Assets Inventory) / Current Liabilities Meant to determine ability to meet near term obligations. >1: Positive interpretation? Negative interpretation? <1: Positive interpretation? Negative interpretation?
20 Income Statement: Profitability (Margins) Gross Margin: Gross Profit / Sales EBITDA Margin: EBITDA / Sales EBIT Margin (Operating Margin) = EBIT / Sales Net Margin (Profit Margin) = Net Income / Sales Why is it important to always look at margins?
21 Income Statement: Profitability (Margins) Gross Margin: Gross Profit / Sales EBITDA Margin: EBITDA / Sales EBIT Margin (Operating Margin) = EBIT / Sales Net Margin (Profit Margin) = Net Income / Sales Margins give us a way to normalize the performance for companies of different sizes E.g. we can t say that a company with an EBIT of $50 million is performing 10x better than a company with an EBIT of $5 million But we can say that a company with an EBIT margin of 50% is operating far more efficiently than a company with an EBIT margin of 5%
22 Income Statement: Coverage Ratios Coverage ratios give us a sense of a company to meet its financial obligations 1) Debt Coverage 1) Net Debt / EBITDA 2) Net Debt / (EBITDA Capex) Interpretation? 2) Interest Coverage 1) EBITDA / Interest Payments 2) EBIT / Interest Payments Interpretation? What does it mean if this ratio is <1? Exception to our general rule of interpretation You want this to be high, always, without reference to the peer group or any historical stats A company must be able to service its interest/debt payments
23 Income Statement: Other Return On Equity (ROE) & Return on Assets (ROA) ROE = Net Income / Equity ROA = Net Income / Average Total Assets These sound better than they actually are. In most cases, they actually tell you nothing and you should ignore them (the exception is with banks and insurance companies). Return on Invested Capital (ROIC) is a related interesting metric. This is a better version of the Return on Equity / Return on Assets metric ROIC = (EBIT - taxes) / Total Capital To be clear, none of these metrics tell you about the return you get by actually investing in the stock! They tell you at what rates the company can reinvest capital in its own operations.
24 Cash Flow Free Cash Flow Conversion is the proportion of some metric that is ultimately converted to FCF You can calculate this relative to Sales, EBITDA, EBIT, or Net Income Most often is calculated relative to EBITDA FCF Conversion = FCF / Selected Metric May want to average this over a few years, since FCF can be very volatile from year to year and you want a general picture of how much of the selected metric is converted to FCF. Interpretation?
25 One more Ratio: Price to Book (P/B) P/B = Market Capitalization / Book Equity (i.e. equity account on BS) Tells you how much you are paying for each $1 that is stated on the books as Equity (i.e. Assets Liabilities) Note: Market Capitalization is also know as Market Value of Equity Example of a company that you think should have a low P/B? Example of a company that you think should have a high P/B? HFAC typically tries to buy stocks with P/B < 1, i.e. getting the stock for less than it would take if the company sold its assets and paid off its liabilities
26 COMPARABLES ANALYSIS
27 Comparables Analysis Also known as Comps A relative valuation methodology A process used to value a company of interest based on the metrics of other similar businesses But which metrics / ratios do we use to compare the businesses? And how do we even pick comparable businesses in the first place?
28 Enterprise Value Suppose we aren t only interested in the equity portion of the business, but instead with the business as a whole (think of the cap structure diagram) Then we need to think of Enterprise Value (EV) EV = Market Capitalization + Debt Cash Note: cash is not included since we wouldn t pay for cash (in Market Cap) with cash Think of EV as the amount of money it would take to acquire an entire business (i.e. pay of shareholders and pay down all of its debts) Most important thing to remember is that EV is capital structure independent, meaning that the proportion of debt and equity does not affect its value
29 Multiples These include EV/EBITDA, EV/EBIT, EV/Sales, Price/Earnings Reminder: Enterprise Value = Market Cap + Debt Cash It s how much the operating business of the company is worth. EV/EBITDA This is the most commonly used metric. It is independent of the capital structure and EBITDA is a good proxy for cash flow. Think: If the business stays the same size (constant EV), how many years does it take me to get paid back with earnings? EV/EBIT also fairly common EV/Sales typically used for companies that have negative EBITDA Price/Earnings = Market Cap / Net Income Can be very volatile / subject to one-time items. Also dependent upon capital structure. Beware!
30 Multiples Remember, we don t care what these multiples were historically. We care about what they are in the future. We don t get earnings from previous years. There are only 3 things that determine these multiples. 1) Growth Higher growth = Higher multiple 2) Business Risk (or alternatively required return if you think in terms of risk-reward) Lower business risk = Higher multiple 3) Free Cash Flow Conversion Higher FCF conversion = Higher multiple Multiples are largely determined by the market s perception of the business, since this will affect the Market Cap (and thus EV)
31 Comparables Analysis I keep referencing to this peer group or comparable companies - what does this mean? What makes a comparable company: Must be publicly traded Same industry Similar business / operations Similar drivers Same geography Similar size Similar growth rate Similar business risk profile (often comes with the industry) Similar FCF conversion rates You may have to go broader / relax the constraints if you don t find anything
32 Comparables Analysis The key is finding companies that are similar to your company in the relevant respect similar business, growth, business risk, and free cash flow conversion. Sometimes no such publicly traded companies exist. Don t use comps that aren t similar in this case, as you will just be wrong. Only use comps when there are actually good comps for your company. Ex: What is a good comp for Apple? HP? Microsoft? You have to know the businesses that you are comping well enough to know that they are similar. Sometimes when no great comps, just think about how your business compares to the others on Growth, Business Risk, and Free Cash Flow Conversion and adjust *Potential issue: perhaps everything (the whole market, the industry, etc.) is overvalued. This is a relative valuation technique!
33 HFAC Case Study: Noble Roman s Noble Roman s is a small ($20M Enterprise Value) pizza restaurant franchising company. Its stores are basically 100% franchises (i.e. they just pay a royalty to Noble Roman s, so FCF conversion is basically 100%) It has positive EBITDA that reflects the earnings of the business Can you give some specific examples about companies (or categories of companies) that you would use as comps for Noble Romans?
34 HFAC Case Study: Noble Roman s Our comp categories are as follows: Best: Small pizza restaurant franchising companies Next Best: Small restaurant franchising companies 3 rd Best: Pizza companies 4 th Best: Quick service restaurant companies, i.e. fast food So let s try to determine what a reasonable EV/EBITDA multiple for this company is.
36 Valuation All signs point to the fact that an EV/EBITDA multiple of 12x is appropriate based on the comps. A multiple range of 10-13x seems appropriate if you look back at the last slide. Last year s EBITDA was $3M. So the enterprise value of this business should be 12 x $3M = $36M. Converting EV to equity value, we see that the equity is worth $31M (since there is $5M of Debt Cash), vs current Market Cap of $15M An EV range would be $30M to $39M (depending upon 10x or 13x EV/EBITDA multiple).
37 Importance of Comps Comparables Analysis is the most widely used valuation methodology It is easy to do a comps model. It is hard to do a good one. The most difficult aspect is picking the right comp set Once you know can nail down a multiple (or a small range of multiples), you can value a company using the basic algebra you saw on the previous slide Remember, always be thinking about growth, business risk, and free cash flow conversion when you are thinking about multiples / comps.
38 Extensions of the Comps Model Instead of using comparable publicly traded companies, we can use other comps Historical comps compare the company to itself historically Precedent transactions compare the company s multiples to the multiples that were paid for similar companies that were bought out.
39 Final Announcements Be sure to submit the attendance form with code COMPS Homework and lecture slides will be sent out tonight Homework due by start of next comp lecture, Thursday at 6pm Any questions?
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