3. Goals
1. Learn basic finance acumen
Career guidance
Personal investing
2. Teach tools to valuate an equity at a beginner level
Value Investing, Basic Accounting, Comparables, Discounted Cash Flow
Searching for intrinsic value of an equity
4. Stock Pitch Utility
Why do we try to determine the intrinsic value of a stock?
To buy undervalued stocks as an investor
Determine merger/acquisition price
Determine price for stock issuance
6. Value Investing
Seeks companies that are undervalued by the financial markets
Key Assumptions:
Stocks can be neglected and value discrepancy can exist
Entry point in short run does not matter
Efficient market hypothesis in the long run
7. Value Investing Criteria
High margin of safety (33%)
Low trading multiples: P/E < 15, P/B < 1.5
Healthy balance sheet and low amount of debt
Predictable free cash flows
Simple, understandable business model
Defensible economic moat
9. Picking a Company
What do you like? What do you understand?
Read the news, Seeking Alpha, Motley Fool, ThomsonONE
Consumer
Media and Financial Natural
Retail Healthcare Technology Industrials Real Estate
Telecom Institutions Resources
Goods
10. Overview and Business Model
Overview
What is the business? Metrics
Business Model Ticker PBSN
Investment Thesis
Basic numbers and company statistics IPO Date Sep-11
Current Price $50.00
Internal
What do they do? Be thorough! Target Price $10.00
External
Revenues $500 MM
Valuation Market Cap $1000 MM
Catalysts
Risks
11. Investment Thesis
Overview
Why is this a good company to buy?
Business Model
Investment Thesis
Give a couple of reasons that summarize the best features
Internal
“Summary” slide of what you’ll say
External
Valuation
Why is the market wrong?
Catalysts
Risks
12. Internal
Overview
Internal:
Business Model
Investment Thesis
Who runs the business? Management team?
Internal
Examine balance sheet and debt maturity
External
Valuation
Microeconomic factors, company specific
Catalysts
Risks
13. External
Overview
External:
Business Model
Investment Thesis
What is the condition of this industry?
Internal
What is going on in the macroeconomy that affects this business?
External
Valuation
Activity of competitors?
Catalysts
Risks
14. Catalysts and Risks
Overview
Catalysts are specific events that will occur that support your thesis
Business Model
Investment Thesis
E.g. drug release, new movement to China, new legislation
Internal
Risks are things that prevent your investment thesis from being realized
External
Valuation
E.g. currency risk, business risk, management sucks
Catalysts
Risks
16. Why are Financial Statements Important?
Allows investors and creditors to use the financial information provided to
evaluate:
Financial conditions
Asset investments
Operating results
Potential problems
Projections
Equity
Etc.
17. Filings
Annual Report
Includes financial statements, company performance, etc. and is intended for
shareholders and other interested parties
10-K
More detailed annual report
Released annually
10-Q
Released quarterly
18. Income Statement
Measures financial performance over a period of time
Shows a business incurs its revenues and expenses
Revenues
- COGS
= Gross Profit
- Expenses
= EBIT
- Interest
- Taxes
= Profit
19. Balance Sheet
Shows a financial position at a specific point in time
Fundamental balance sheet equation:
Assets = Liabilities + Owner’s Equity
Shows asset investments and how they are supported, revealing a lot
about the company’s financial health
20. Statement of Cash Flows
Cash inflows and outflows over a period of time
Cash impact of the operations and decisions of a business
Shows how well positioned a company is to fund its future growth
through existing operations
Important to note sources and uses of cash as well as the matching of
these sources and uses
21. Flow Through Question
How does a $10 decrease in depreciation affect all the financial statements?
22. Flow Through Question
How does a $10 decrease in depreciation affect all the financial statements?
Income Statement:
Operating income would increase by $10
With a 40% tax rate, net income would increase by $6
Cash Flow Statement:
Net income goes up by $6 and depreciation decreased by $10
Subtract the non-cash depreciation increase ($4)
Balance Sheet:
Fixed assets increase by $10, but cash is down $4 (assets are up by $6)
Increase of $3 from net income flows to retained earnings to balance (A = L + E)
23. Market Value vs. Book Value
Book Value Market Value
• price paid for a particular asset • current price of the asset
• historical cost • determined by demand and supply of the
• price shown on a balance sheet market
• useful to help track profits and losses • is a more accurate value of the asset’s current
value
24. Equity vs. Enterprise Value
Equity Value Enterprise Value
• also the market capitalization of the • enterprise value = market capitalization +
company preferred equity + minority interest + net
• value attributable to shareholders debt (total debt – cash and cash equivalents)
26. Ratio Analysis
Used to analyze the historical trends and compare these trends to that of
the industry
Categories:
Profitability
Investment utilization
Liquidity
Stability
Growth
27. Ratio Examples
Profitability Investment Liquidity Stability/Leverage Growth
Utilization
• Vertical Analysis • Inventory • Current Ratio • Net Worth to • Sales Growth
• Return on Assets Turnover • Acid Test Assets • Profit Growth
• Return on Equity • Fixed Asset • Age of • Debt to Assets • Asset Growth
Turnover Receivables • Debt to • EBITDA Growth
• Total Asset • Age of Inventory Capitalization
Turnover • Age of Accounts • Debt to Equity
Payble • Lon-Tem Debt
Interest Coverage
29. Comparable Companies Analysis
What is a multiple?
An expression of market value relative to a key statistic to relate to that value
Advantages Disadvantages
Useful Simplistic
Relevant Static
Simple Difficult to compare
30. Common Multiples
Enterprise Multiples Equity Multiples
Enterprise Value/Sales Price/Earnings
Enterprise Value/EBITDA Price/Book Value
Enterprise Value/EBIT Price/Sales
31. Multiples: An Example
Price to Earnings (P/E) multiple
Example
Price per Share = $12
Share Count = 1,000,000
Market Capitalization = $ 12,000,000
Net Income = $3,000,000
Price per Share Market Capitalization
OR
Earnings per Share Net Income
32. Multiples: An Example
Price to Earnings (P/E) multiple
Example
Price per Share = $12
Share Count = 1,000,000
Market Capitalization = $ 12,000,000
Net Income = $3,000,000
Price per Share Market Capitalization
OR
Earnings per Share Net Income
Price /Earnings = 4.0x
33. Trailing vs. Forward
Trailing
Compares the current value of a metric to its historical values
TTM : Trailing Twelve Months
Forward
Compares the current value of a metric to its projected values
Use consensus estimates (from ThomsonONE, Bloomberg, etc.)
34. An Example
Comparable Companies Analysis
Share Market LTM 2013E 2014E LTM 2013E 2014E
Price Capitalization EV/EBITDA EV/EBITDA EV/EBITDA Price/EPS Price/EPS Price/EPS
Company A $15.00 $1,675 8.1 7.8 7.4 15.1 14.5 14.1
Company B $20.00 $2,230 6.6 6.5 6.4 12.3 12.1 11.5
Company C $12.00 $1,523 7.2 7.3 7.1 16.5 16.3 15.4
Company D $10.00 $1,084 7.7 6.9 6.9 12.8 12.2 12.1
Company E $18.00 $985 6.5 6.3 5.9 11.2 10.8 10.1
Mean 7.22 6.96 6.74 13.58 13.18 12.64
Median 7.2 6.9 6.9 12.8 12.2 12.1
36. Selecting Comps
Company Documents
Management Information Circulars
Company presentations
Annual and quarterly reports
Other Resources
Google Finance
ThomsonOne
Bloomberg
38. Selecting Comps: An Example
Found at www.sedar.com (or www.edgar.com for American companies)
Go to ‘Search Database’
Search
Company Name: ‘Royal Bank of Canada’
Document Type :‘Proxy Circular
Open latest Management Information Circular
Key word search: ‘Comparator Group’
40. The Discounted Cash Flow Analysis
A company is worth the present value of all of its future cash flows
Can reveal how the drivers work such as margins, growth
Strengths:
Extremely useful when no other pure play companies exist
Utility as a sanity check
Weaknesses:
Heavily assumption based and easily manipulated
Forecasting future projections is extremely difficult
41. Present Value
What do we need?
1. Value of Forecasted Cash Flows Free Cash Flows for Free Cash Flows beyond
forecasted period forecasted period
2. Value of Terminal Value
3. Weighted Average Cost of Capital
4. Present Value of Forecasted Cash Flows
5. Present Value of Terminal Value
42. Free Cash Flow
The cash available after laying out money related to operations and
expanding its asset base
Sales • Top line of revenue, starting figure
- COGS • Operational expenses
- SG&A • Operational expenses
= EBITDA • Earnings Before Interest, Tax, D&A
- D&A • Not a use of cash
= EBIT • EBIT, good proxy for cash flow
43. Free Cash Flow
EBIT (1-t) • Account for the effect of tax
+D&A • Not a cash item
- CapEX • Deduct costs that are needed to expand asset base
• Net Working Capital accounts for changes in balance
- Increase in NWC sheet
Free Cash Flow • What is available to us
45. Operating Model Assumptions
Analyst estimates
Items as a % of historical basis of sales
Items historically identical
Growth of the economy
46. Terminal Value
Total value of all cash flows beyond the operating model time period
1. Exit Multiple Method
Used for most companies with a tangible exit period
Multiply terminal year EBITDA by LTM EV/EBITDA
2. Gordon Growth Method
Used for largest companies that could “grow indefinitely”
Apply growth rate to terminal year cash flow in perpetuity
Terminal FCF * (1+ Growth Rate)/(Discount Rate – Growth Rate)
3. Liquidation Value
Book value of company, the most conservative approach
48. Weighted Average Cost of Capital
Firm’s cost of capital, will be discount rate used
Use market value instead of book value to reflect actual valuation
WACC = % of Equity in Capital Structure * Cost of Equity
+ % of Debt in Capital Structure * Cost of Debt (1 – tax)
Capital Structure = Long Term Debt/Long Term Debt + Equity
49. Capital Asset Pricing Model
Cost of Equity is how much return stockholders expect from company
Risk Free Rate: 10 or 20 U.S Treasury Yield
Beta: Google Finance
Expected Market Return: 5-10%
50. Cost of Debt
Cost of debt is the yield the company could raise in the public market
Getting Cost of Debt:
Use a Bloomberg Terminal and look it up
Apply a % spread based on its credit rating on top of risk-free rate (Yahoo)
If no credit rating, a synthetic risk can be derived from its financial ratios (interest
coverage)
Look at current yield of bonds (Morningstar)
If no debt, base it on comparables
Then use (1-t) to account for the effect of tax
Usually historical basis
Can weight taxes in different regions based on income yielded
51. Discounting Those Cash Flows
Discount Year 1 Discount Year 2 Discount Year 3 Discount Year 4 Discount Year 5
Discount
Cash flow by 1 Cash flow by 2 Cash flow by 3 Cash flow by 4 Cash flow by 5
Terminal Value
year years years years years
52. Enterprise to Equity
We have arrived at enterprise value
Enterprise Value • How much to take over the entire company
- Debt • Debt would make it more difficult for us to pay
- Minority Interest • Our stake in another company, does not affect us
- Preferred Shares • We do not own them
+ Cash • Would “help buy the company”
= Equity Value • Also known as Market Capitalization
53. Intrinsic Value
Treasury Stock Method: count number of “in-the-money” call options to
determine the diluted shares outstanding
Equity Value/Number of Shares Outstanding = Stock Price
55. Other Popular Valuations
Precedent Transaction
Use whenever applicable
Leveraged Buy-Out Model
Use in private equity or acquisition is likely
Net Asset Value Model
Use for REITs, natural resources
Dividend Discount Model
Use for dividend focused companies, FIG
Real Options Valuation
Use for companies with multiple decisions and to impress your friends
Sometimes companies have low multiples for a reason. Multiples reflect what investing populace believes about a certain stock.Growth can already be “priced in”, which is why we look at multiples
Brief explanation of businessExplain capital structure, organization, existence of unique sharesWhere do their revenues come from? Who are their customers? What are their key drivers? Porters five forces is a good tool here
Don’t just say “management is good”, give specific examples of what they’ve done. Where did they work before?Look at historical balance sheet to show if behaviour has been historical or notShareholder value returned?Do they have skin in the game?Liquidity of both stock and business?
These future cash flows is what we are concerned about, it is what we as shareholders have access to
This is the figure that can be used to help increase shareholder value
Business will grow sales in line with current operations
Accounts for capital structure, so each WACC has different inputs based on amount of debt and shares it hasTypical WACC is about 5-10%, higher WACC means it’s more costly to take out cash.Higher WACC means you will have a lower company value because it will be discounted back more
Beta is fluctuation with market. You are supposed to unlever betas of comparables and then relever with our company’s capital structure, but too time consuming
Only use interest bearing debt (no accounts payable, or short term)We are looking for the after tax cost of debt; tax can distort our decisionDo NOT overinflate debt… it reduces WACC and makes it less conservative
Enterprise value is how much it would take to buy the entire company (including debt and cash)Enterprise value is for both creditors and shareholders, we are ONLY concerned about shareholdersEnterprise value is capital structure neutral (if you issue equity to pay off your debt, EV stays the same)Minority interest is a % of the business we have a less than 50% stake in that we do not own. Rarely public companies
Some apply a “liquidity” discount at the end. DO NOT DO THIS, the problems of management/illiquidity should be baked into the other business model assumptions
