SIGMA INVESTMENTS

Investment Manual
Table of Contents
About .............................................................................................................................. 3
The Investment Club................................................................................................................. 3
Long-term Investment Strategy................................................................................................. 3
Useful Sources ................................................................................................................. 4
Books ....................................................................................................................................... 4
Theory: .................................................................................................................................... 4
Market Data: ............................................................................................................................ 4
Economic/Financial News: ........................................................................................................ 4
Introduction to Finance .................................................................................................... 5
Balance Sheet........................................................................................................................... 5
Income Statement .................................................................................................................... 5
Statement of Cash Flows .......................................................................................................... 6
Guidelines for adjustments in working capital ................................................................................................6

Book Value Versus Market Value .............................................................................................. 7

Enterprise Value ....................................................................................................................... 7
Key Financial Ratios .................................................................................................................. 8
Profitability ......................................................................................................................................................8
Net Profit Margin .............................................................................................................................................8
Liquidity Ratios.................................................................................................................................................8
Working Capital Ratios ....................................................................................................................................9
Interest Coverage Ratios..................................................................................................................................9
Leverage Ratios ............................................................................................................................................. 10
Valuation Ratios ............................................................................................................................................ 10

Industries .......................................................................................................................12
Consumer Goods .................................................................................................................... 12
Consumer Staples and Consumer Discretionary .......................................................................................... 12
How Companies generate Sales and Growth in Consumer Goods .............................................................. 12
Checklist for Consumer Goods stocks: ......................................................................................................... 12

Financial Services ................................................................................................................... 12

Banks ............................................................................................................................................................. 12
Asset Management firms .............................................................................................................................. 14
Insurance Companies.................................................................................................................................... 14

Healthcare ............................................................................................................................. 14
Industrials .............................................................................................................................. 16
Metrics .......................................................................................................................................................... 17
Identifying Troubles ...................................................................................................................................... 17
Identifying Opportunities ............................................................................................................................. 17

1
 Technology............................................................................................................................. 17
Qualitative Analysis ........................................................................................................19
Introduction ........................................................................................................................... 19
Overall goal and vision of a firm .............................................................................................. 19
Analysing the Product portfolio .............................................................................................. 19
Financial statements............................................................................................................... 19
The Income Statement/ Cash Flow statement and the KPIs ..................................................... 20
Balance sheet ......................................................................................................................... 21
Macro view, Peer review ........................................................................................................ 21
Concluding words: .................................................................................................................. 22
Company Valuation ........................................................................................................23
Why Value a Company? .......................................................................................................... 23
Value of a Company to an Investor.......................................................................................... 23
What drives Future Cash Flows? ............................................................................................. 23
Unlevered Cash Flow Calculation ............................................................................................ 24
The discount factor: Weighted Average Cost of Capital ............................................................ 24
Cost of Debt .................................................................................................................................................. 25
Cost of Equity ................................................................................................................................................ 25

Forecasting Cash Flows ........................................................................................................... 26

Modelling P&L and Balance Sheet items ...................................................................................................... 26

The two stages of the DCF model ............................................................................................ 27

Discounting Cash Flows and Terminal Value ................................................................................................ 28
Calculating Enterprise and Equity Value ....................................................................................................... 28

Multiple Evaluation ................................................................................................................ 28

Selecting the universe of comparable companies ........................................................................................ 29
Adjusting financial statements ..................................................................................................................... 29
Make the ratios ............................................................................................................................................. 29
Apply the multiple to the company’s financials ........................................................................................... 29

Appendix ........................................................................................................................30

2
About
The Investment Club
The Sigma Investment Club is a student run organization with the goal to bridge the gap between
financial/macro-economic theory learned in university and the practice of value investing. The
Sigma Investment Fund generates return through diversified investments across global markets.
Finance enthusiasts will be prepared to land on an internship in the financial sector by applying
the theory they studied during their finance/economics courses.

The association is split up into 5 to 6 sectors/industries. Each industry is led by a senior analyst
and accompanied by 5 to 6 junior analysts. Every week another industry presents their stock
pitch of a company hey selected. These pitches are based on a top-down investment approach
consisting of a company overview, a peer-to-peer analysis and intrinsic (DCF) as well as
extrinsic (Multiples) valuation methods. After each pitch the non-pitching members critically
question the pitching team’s presentation in order to be able to make the most rational
judgement on adding or removing the stock from the Sigma Investments Fund.

Long-term Investment Strategy

Provide capital growth through diversified investment across global markets following the
regulations of the Sigma Investments Sustainability Policy. The aim of our Sustainability Policy is
that the Sigma Investments Fund only invests in equities, securities and bonds that meet the
stated ethical, ecological and social criteria. Investment decisions are made based on a top-
down investment strategy consisting of a general company overview, a peer-to-peer analysis,
intrinsic (DCF) and extrinsic (Multiples) valuation methods. The weight allocation of the
investment fund is based on both a Mean Variance optimization, as well as a Minimum
Conditional Value-at-Risk optimization and is rebalanced on a monthly base.

3
Useful Sources
Before we dive into financial theorems and explanations, we would like to point out the following
sources to find company news, industry specific news and market data. Moreover, we point out
some interesting books you must have read as a finance enthusiast. The intelligent Investor is
the most famous one and called the best investing book by Warren Buffet. A must read! If you
would like to read more about industry specific theory, we can recommend you read the five
rules of successful stock investing by P. Dorsey. To freshen up your knowledge about valuation
methods Rosenbaum (2013) is the way to go.

Books
Graham, Benjamin, and Jason Zweig. The Intelligent Investor: A Book of Practical Counsel. New
York: Collins Business Essentials, 2005.

Dorsey, P. (2004). The Five Rules for Successful Stock Investing: Morningstar's Guide to
building wealth and winning in the market. John Wiley & Sons.
Rosenbaum, J., & Pearl, J. (2013). Investment banking: Valuation, leveraged buyouts, and
mergers & acquisitions (Second edition, University edition.). Hoboken, N.J.: John Wiley & Sons.

Theory:
Investopedia:

For all definitions and explanations in finance.

Market Data:
Yahoo Finance, FactSet:

For all market data and news on companies and industries

Damodaran:

Indian statistic legend that analyses the market and uploads industry specific data. Perfect to find
EV/EBITDA or other multiples for the industry you are looking for.

Professional data providers (Reuters, Bloomberg):

Usually only accessible within companies, best market data on companies and industries

Economic/Financial News:
finimize.com

thestreet.com

finviz.com
seekingalpha.com

investing.com

4
Introduction to Finance
Every public company is required to produce four financial statements: the balance sheet, the
income statement, the statement of cashflows and the statement of stockholder’s equity. These
financial statements provide investors and creditors with an overview of the firm’s financial
performance. We will take a closer look at the content of the three main financial statements.

Balance Sheet
The balance sheet or the statement of financial position, lists all of the firm’s assets and
liabilities, providing a snapshot of the firm’s financial position at any point in time. Figure 1 below
shows the balance sheet for CVS health. Notice that the balance sheet is divided into two parts,
with the assets on the top half and the liabilities on the bottom. The assets list the cash, property,
equipment and other investments the company has made; the liabilities show the firm’s
obligations to creditors. Also shown with the liabilities at the bottom of the balance sheet is the
stockholder’s equity. Stockholders’ equity the difference between the firm’s assets and liabilities
is an accounting measure of the firm’s net worth. Because of the nature in which stockholder’s
equity is calculated the top and bottom parts of the statement must balance (assets must equal
liabilities plus stockholder’s equity). The Balance Sheet identity is as follows,

Assets = Liabilities + Stockholder’s Equity

As seen in figure 1 in the Appendix, total assets ($222,449) are equal to the total liabilities
($158,279) plus the total stockholder’s equity ($64,170).

Income Statement
Up next we have the income statement. Also known as the statement of financial performance, it
lists the firm’s revenues and expenses over a particular time period. The last line of the income
statement shows the firm’s net income (also referred to as the firm’s earnings) which is a
measure of its profitability during the specified period. As opposed to the balance sheet which
shows the firm’s assets and liabilities at a given point in time, the income statement shows the
flow of revenues and expenses generated by those assets and liabilities between two dates.
Figure 2 in the Appendix shows the CVS Health’s income statement for the years 2019, 2018
and 2017.

The first two lines of the income statement list the revenues from sales of products and services
and the costs incurred to make and sell the products. Costs of sales shows costs directly related
to producing the goods and services being sold by the firm, such as manufacturing costs. Other
costs such as administrative expenses, research and development, and interest expenses are
not included in the cost of sales. The difference between the sales revenue and sales cost is
known as gross profit.

The next group of items is operating expenses. These are expenses from the ordinary course of
running the business that are not directly related to the production of the goods and services
being sold. They include administrative expenses and overhead costs, salaries, marketing costs
and research and development expenses. The third type of operating expense, depreciation and
amortisation, is not an actual cash expense but represents an estimate of the costs that arise
from wear and tear or obsolescence of the firm’s assets. The firm’s gross profit net of operating
expenses is called operating net income.

Next, we include other sources of income expenses that arise from activities that are not the
central part of a company’s business. Income from the firm’s financial investments is one
example of other income that would be listed here. After we have adjusted for other sources of
income or expenses, we have the firm’s earnings before interest and taxes also known as EBIT.

From the EBIT, interest expenses related to outstanding debt are deducted to compute the firm’s
pre-tax income and after this the firm’s corporate taxes are deducted to determine the net

5
income. Net income represents the total earnings of the firm’s equity holders. It is often reported
on a per-share basis as the firm’s earnings per share (EPS). This is calculated by dividing the net
income by the total number of shares outstanding:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐸𝑃𝑆 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Statement of Cash Flows

This is probably the most important financial statement because indicates the amount of cash the
firm has generated, meaning it shows how much cash is available to be received as an investor.
Net income does not correspond to cash earned, there are two reasons for this. First, there are
non-cash entries on the income statement such as depreciation and amortisation. Second,
certain uses of cash such as the purchase of a building or expenditures on inventory, are not
reported on the income statement. The firm’s statement of cash flows utilizes the information
from the income statement and the balance sheet to determine how much cash the firm has
generated, and how that cash has been allocated during a set period.

The statement of cash flows is divided into three sections. Operating activities, investment
activities and financing activities. The first of these activities on the statement of cash flows is the
operating activities. It adjusts net income by all non-cash items related to operating activity. For
instance, depreciation is deducted when computing net income, but is not an actual cash outflow.
Thus, we add it back to net income when determining the amount of cash, the firm has
generated. Similarly, we add back any other non-cash expenses (for example, deferred taxes or
expenses related to stock-based compensation). Figure 3 in the Appendix shows the statement
of cashflows for CVS Health.

We then adjust for changes to net working capital that arise from changes to accounts
receivable, accounts payable, or inventory. When a firm sells a product, it records the revenue as
income even though it may not receive the cash from that sale immediately. Instead it may grant
the customer credit and let the customer pay in the future. The customer’s obligation adds to the
firm’s accounts receivable.

Guidelines for adjustments in working capital

Accounts receivable: When a sale is recorded as part of net income, but the cash has not yet
been received from the customer, we must adjust the cash flows by deducting the increases in
accounts receivable. This increase represents additional lending by the firm to its customers, and
it reduces the cash available to the firm.

Accounts Payable: We add increases in accounts payable. Accounts payable represents

borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm.
Inventory: We deduct increases to inventory. Increases to inventory are not recorded as an
expense and do not contribute to net income (the cost of the goods is only included in net
income when the goods are actually sold). However, the cost of increasing the inventory is a
cash expense for the firm and must be deducted.

Secondly, we have investment activities. Purchases of new property, plant, and equipment are
referred to as capital expenditures. Recall that capital expenditures do not appear immediately
as expenses on the income statement. Instead, firms recognize these expenditures over time as
depreciation expenses. To determine the firm’s cash flow, we already added back depreciation
because it is not an actual cash outflow. Now, we subtract the actual capital expenditure that the
firm made. Similarly, we also deduct other assets purchased or long-term investments made by
the firm, such as acquisitions or purchases of marketable securities.
Thirdly, we have financing activity. The last section from the statement of cash flows from the
financing activities. Dividends paid to shareholders are a cash outflow. As shown in figure 3 in

6
the Appendix CVS paid 2.6 billion dollars to its shareholders as dividends in 2019. The difference
between a firm’s net income and the amount it spends on dividends is referred to as the firm’s
retained earnings for that year:

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

Also listed under financing activity is any cash the company received from the sale of its own
stock, or cash spent buying (repurchasing) its own stock.

Book Value Versus Market Value

For the reasons cited above (under the balance sheet paragraph) the book value of equity while,
accurate from an accounting perspective, is an inaccurate assessment of the true value of the
firm’s equity. Successful firms are often able to borrow in excess of the book value of their assets
because creditors recognize that the market value of the assets is far higher than the book value.
Thus, it is not surprising that the book value of equity will often differ substantially from the
amount investors are willing to pay for the equity. The total market value of a firm’s equity equals
the number of shares outstanding times the firm’s market price per share:

Market Value of Equity = Shares Outstanding x Share Price

The market value of equity is often referred to as the company’s market capitalization (or “market
cap”). The market value of a stock does not depend on the historical cost of the firm’s assets;
instead, it depends on what investors expect those assets to produce in the future. The market-
to-book ratio for most successful firms substantially exceeds 1, indicating that the value of the
firm’s assets when put to use exceeds their historical cost. Variations in this ratio reflect
differences in fundamental firm characteristics as well as the value added by management.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜𝑛 =
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
In Fall 2015, Citigroup (C) had a market-to-book ratio of 0.76, a reflection of investors’
assessment that many of Citigroup’s assets (such as some mortgage securities) were worth far
less than their book value. At the same time, the average market-to-book ratio for major U.S.
banks and financial firms was 1.9, and for all large U.S. firms it was 2.9. In contrast, PepsiCo
(PEP) had a market-to-book ratio of 8.3, and IBM had a market-to-book ratio of 11.3. Analysts
often classify firms with low market-to-book ratios as value stocks, and those with high market-
to-book ratios as growth stocks.

Enterprise Value
A firm’s market capitalization measures the market value of the firm’s equity, or the value that
remains after the firm has paid its debts. But what is the value of the business itself? The
enterprise value of a firm (also called the total enterprise value or TEV) assesses the value of the
underlying business assets, unencumbered by debt and separate from any cash and marketable
securities. We compute it as follows:

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ

For example, a fictitious company global had a market capitalization in 2015 of $50.4 million. Its
debt was $116.7 million ($3.5 million of notes payable, $13.3 millions of current maturities of
long-term debt, and remaining long-term debt of $99.9 million). Therefore, given its cash balance
of $21.2 million, Global enterprise value is 50.4 + 116.7 - 21.2 = $145.9 million. The enterprise
value can be interpreted as the cost to take over the business. That is, it would cost 50.4 + 116.7
= $167.1 million to buy all of Globe’s equity and pay off its debts, but because we would acquire
Globe’s $21.2 million in cash, the net cost of the business is only 167.1 - 21.2 = $145.9 million.

7
Key Financial Ratios
Ratios in Finance and investing play a crucial role. They provide critical information about a firm
in a plain manner that makes for easy comparison to other firms using the same ratios. There are
seven main types of ratios that are used in finance, these are, profitability, liquidity, working
capital, interest coverage, leverage, valuation and operating ratios to name a few.

Profitability
The income statement provides very useful information regarding the profitability of a firm’s
business and how it relates to the value of the firm’s shares. The gross margin of a firm is the
ratio of gross profit to revenues (sales):
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
A firm’s gross margin reflects its ability to sell a product for more than the cost of producing it.
For example, in 2015, Global had gross margin of 33.3/186.7 = 17.8%. Because there are
additional expenses of operating a business beyond the direct costs of goods sold, another
important profitability ratio is the operating margin, the ratio of operating income to revenues:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
The operating margin reveals how much a company earns before interest and taxes from each
dollar of sales. We can similarly compute a firm’s EBIT margin = (EBIT/Sales). By comparing
operating or EBIT margins across firms within an industry, we can assess the relative efficiency
of the firms’ operations. In addition to the efficiency of operations, differences in operating
margins can result from corporate strategy. For example, in 2014, high-end retailer Nordstrom
(JWN) had an operating margin of 9.8%; Wal-Mart Stores (WMT, brand name Walmart) had an
operating margin of only 5.6%. In this case, Walmart’s lower operating margin was not a result of
its inefficiency. Rather, the low operating margin is part of Walmart’s strategy of offering low
prices to sell common products in high volume. Indeed, Walmart’s sales were nearly 36 times
higher than those of Nordstrom.

Net Profit Margin

Finally, a firm’s net profit margin is the ratio of net income to revenues:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
The net profit margin shows the fraction of each dollar in revenues that is available to equity
holders after the firm pays interest and taxes. One must be cautious when comparing net profit
margins, while differences in net profit margins can be due to differences in efficiency, they can
also result from differences in leverage, which determines the amount of interest expense, as
well as differences in accounting assumptions.

Liquidity Ratios
Next, we look at Liquidity Ratios, Financial analysts often use the information in the firm’s
balance sheet to assess its financial solvency or liquidity. Specifically, creditors often compare a
firm’s current assets and current liabilities to assess whether the firm has sufficient working
capital to meet its short-term needs. This comparison can be summarized in the firm’s current
ratio, the ratio of current assets to current liabilities:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A more stringent test of the firm’s liquidity is the quick ratio, which compares only cash and “near
cash” assets, such as short-term investments and accounts receivable, to current liabilities. A

8
higher current or quick ratio implies less risk of the firm experiencing a cash shortfall in the near
future. A reason to exclude inventory is that it may not be that liquid; indeed, an increase in the
current ratio that results from an unusual increase in inventory could be an indicator that the firm
is having difficulty selling its products. Ultimately, firms need cash to pay employees and meet
other obligations. Running out of cash can be very costly for a firm, so firms often gauge their
cash position by calculating the cash ratio, which is the most stringent liquidity ratio:
𝐶𝑎𝑠ℎ
𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Of course, all of these liquidity ratios are limited in that they only consider the firm’s current
assets. If the firm is able to generate significant cash quickly from its ongoing activities, it might
be highly liquid even if these ratios are poor.

Working Capital Ratios

We can use the combined information in the firm’s income statement and balance sheet to
gauge how efficiently the firm is utilizing its net working capital. To evaluate the speed at which a
company turns sales into cash, firms often compute the number of accounts receivable days,
that is, the number of days’ worth of sales accounts receivable represents:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠

Although the number of receivable days can fluctuate seasonally, a significant unexplained
increase could be a cause for concern (perhaps indicating the firm is doing a poor job of
collecting from its customers or is trying to boost sales by offering generous credit terms). There
are similar ratios for accounts payable and inventory. For these items, it is natural to compare
them to the firm’s cost of sales, which should reflect the total amount paid to suppliers and
inventory sold. Therefore, accounts payable days is defined as:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
Accounts Payable Days =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠

Similarly, inventory days = (inventory/average daily cost of sales). Turnover ratios are an
alternative way to measure working capital. We compute turnover ratios by expressing annual
revenues or costs as a multiple of the corresponding working capital account. For example,
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Similarly, accounts receivable turnover = (annual sales/accounts receivable) and accounts

payable turnover = (annual cost of sales/accounts payable). Note that higher turnover
corresponds to shorter days, and thus a more efficient use of working capital. While working
capital ratios can be meaningfully compared over time or within an industry, there are wide
differences across industries. While the average large U.S. firm had about 49 days’ worth of
receivables and 54 days’ worth of inventory in 2015, airlines tend to have minimal accounts
receivable or inventory, as their customers pay in advance and they sell a transportation service
as opposed to a physical commodity. On the other hand, distillers and wine producers tend to
have very large inventory (over 300 days on average), as their products are often aged prior to
sale.

Interest Coverage Ratios

Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings
with its interest expenses using an interest coverage ratio. One common ratio to consider is the
firm’s EBIT as a multiple of its interest expenses. A high ratio indicates that the firm is earning
much more than is necessary to meet its required interest payments. As a benchmark, creditors

9
often look for an EBIT/Interest coverage ratio in excess of 5* for high-quality borrowers. When
EBIT/Interest falls below 1.5, lenders may begin to question a company’s ability to repay its
debts. Depreciation and amortization expenses are deducted when computing EBIT, but they are
not actually cash expenses for the firm. Consequently, financial analysts often compute a firm’s
earnings before interest, taxes, depreciation, and amortization, or EBITDA, as a measure of the
cash a firm generates from its operations and has available to make interest payments EBITDA =
EBIT + Depreciation and Amortization We can similarly compute the firm’s EBITDA/Interest
coverage ratio.

Leverage Ratios
An important piece of information that we can learn from a firm’s balance sheet is the firm’s
leverage, or the extent to which it relies on debt as a source of financing. The debt-equity ratio is
a common ratio used to assess a firm’s leverage. We calculate this ratio by dividing the total
amount of short- and long-term debt (including current maturities) by the total stockholders’
equity:
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

We can calculate the debt-equity ratio using either book or market values for equity and debt.
Because of the difficulty interpreting the book value of equity, the book debt-equity ratio is not
especially useful. Indeed, the book value of equity might even be negative, making the ratio
meaningless. For example, Domino’s Pizza (DPZ) has, based on the strength of its cash flow,
consistently borrowed in excess of the book value of its assets. In 2014, it had debt of $1.8
billion, with a total book value of assets of only $600 million and an equity book value of -$1.2
billion! It is therefore most informative to compare the firm’s debt to the market value of its equity.
We can also calculate the fraction of the firm financed by debt in terms of its debt-to-capital ratio:
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

Again, this ratio can be computed using book or market values. While leverage increases the risk
to the firm’s equity holders, firms may also hold cash reserves in order to reduce risk. Thus,
another useful measure to consider is the firm’s net debt, or debt in excess of its cash reserves:

𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ & 𝑆ℎ𝑜𝑟𝑡 & 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

To understand why net debt a more relevant measure of leverage may be, consider a firm with
more cash than debt outstanding: Because such a firm could pay off its debts immediately using
its available cash, it has not increased its risk and has no effective leverage. Analogous to the
debt-to-capital ratio, we can use the concept of net debt to compute the firm’s debt-to-enterprise
value ratio:
𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝐸𝑉

A final measure of leverage is a firm’s equity multiplier, measured in book value terms as Total
Assets/Book Value of Equity. As we will see shortly, this measure captures the amplification of
the firm’s accounting returns that results from leverage. The market value equity multiplier, which
is generally measured as Enterprise Value/Market Value of Equity, indicates the amplification of
shareholders’ financial risk that results from leverage.

Valuation Ratios
Analysts use a number of ratios to gauge the market value of the firm. The most common is the
firm’s price-earnings ratio (P/E):

10
 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a total
basis or on a per-share basis. The P/E ratio is a simple measure that is used to assess whether
a stock is over- or under-valued based on the idea that the value of a stock should be
proportional to the level of earnings it can generate for its shareholders. P/E ratios can vary
widely across industries and tend to be highest for industries with high expected growth rates.
For example, in late 2015, the median large U.S. firm had a P/E ratio of about 21. But software
firms, which tend to have above-average growth rates, had an average P/E ratio of 38, while
automotive firms, which have experienced slower growth since the recession, had an average
P/E ratio of about 15. The risk of the firm will also affect this ratio, all else equal, riskier firms
have lower P/E ratios. Because the P/E ratio considers the value of the firm’s equity, it is
sensitive to the firm’s choice of leverage. The P/E ratio is therefore of limited usefulness when
comparing firms with markedly different leverage. We can avoid this limitation by instead
assessing the market value of the underlying business using valuation ratios based on the firm’s
enterprise value. Common ratios include the ratio of enterprise value to revenue, or enterprise
value to operating income, EBIT, or EBITDA. These ratios compare the value of the business to
its sales, operating profits, or cash flow. Like the P/E ratio, these ratios are used to make intra-
industry comparisons of how firms are priced in the market. The P/E ratio, or ratios to EBIT or
EBITDA, are not meaningful if the firm’s earnings are negative. In this case, it is common to look
at the firm’s enterprise value relative to sales. The risk in doing so, however, is that earnings
might be negative because the firm’s underlying business model is fundamentally flawed, as was
the case for many Internet firms in the late 1990s.

11
Industries

Consumer Goods
The consumer goods sector is a category of companies that relate to items purchased by
individuals and households rather than by manufacturers and industries. These companies make
and sell products that are intended for direct use by the buyers for their own use and pleasure.
The sector includes companies involved with food production, packaged goods, clothing,
beverages, automobiles and electronics.

Consumer Staples and Consumer Discretionary

When looking for investments in unstable economic periods, you might want to look at the brand
of your fridge, oven or any other household brand again as companies in the Consumer Goods
sector tend to be a good defensive haven during economic downturns. Consumers will still buy
clothes, their favourite beverage or use toothpaste. On the other hand, Consumers might
postpone their expenditures such as a fridge, oven or bike during an economic downturn.
Therefore, we can distinguish Consumer Staples from Consumer Discretionary. Consumer
staples are essential products that include typical products such as food & beverages, household
goods, and hygiene products. Consumer Discretionary are goods considered non-essential by
consumers, but desirable if their available income is sufficient to purchase them.

How Companies generate Sales and Growth in Consumer Goods

Consumer goods typically generate profits by making products and selling them to customers,
mainly supermarkets, warehouses and mass merchandisers. For example, Mars produces
chocolate bars and sells them to the Albert Heijn you can find around the corner. Since the
sector is highly competitive, companies within this sector tend to focus on marketing, advertising,
and brand differentiation for business strategy in this sector.

Checklist for Consumer Goods stocks:

- Find companies that enjoy the cost advantages of manufacturing on a larger scale than
most other competitors.
- Look for firms that consistently launch successful new products
- Check how the firm is handling its operating costs. Occasional restructuring can help
squeeze out efficiency gains and lower costs. If a firm is regularly incurring restructuring
costs and relying solely on this cost-cutting tactic to boost its business, be careful
because this might harm long term growth.
- Make sure management is taking its decision wisely. How much of the cash is turned
over to shareholders in the form of dividends or share repurchase agreements? How
much do managers get paid. Do managers look at ESG risks frequently to secure long-
term growth of the company or are they focussed on fast money?
- Keep in mind that investors may bid up a consumer goods stock during economic
downturns, making the shares pricey relative to its fair value.

Financial Services
Banks
General Information
Banks are different from usual companies as they do not have a fixed price for the services they
provide. The main revenue banks create come from a percentage spread on between the
borrowing costs they face and the interest rate they pass through to their customers. Banks get
most of their funds either from deposits, inter-bank loans or the central bank. The income they
earn through this spread is called interest income.
Traditionally this is largest part of income for a bank. Due to their size and expertise in the
financial sector banks also offer financial advisory services, also know as, investment banking

12
services. The income generate by these services is called non-interest income.
Adding net interest income (interest income – interest expense) and non-interest income
results in net revenue. Banks have different competitive advantages e.g Global Scope (Citi),
large deposits (Wells Fargo)

Risks
Banks face three main risks:

• Credit Risk
• Liquidity Risk
• Interest Risk
Credit Risk
The risk that the debtor defaults and is not able to repay the loan. Credit risk is natural in the
banking sector and banks try to minimize it through diversification into different loan categories,
locations and individuals. Furthermore, more conservative loan underwriting lead to lower credit
risk as the standards required for a loan get issued are higher. Lastly, how aggressive and
successful is the bank with collecting their loans.

Important research to be done:

• Loan categories (Some are more exposed to credit risk than others=

• Charge of rates (Percentage loss of loans that the bank thinks will not be repaid)

• Nonperforming loans (Loans that are not being repaid)

• Delinquency rates (Percentage of loans that are being paid late by deptors, 90-days
delinquency is considered as a default of the debtor)

Key take away:

Do your research and read news articles to see if you can spot any credit risk problems. They
are hard to spot, but really important as they determine the banks stability and performance.

Liquidity Risk
With their business model banks are doing a liquidity transformation. They take short-term
deposits and transform them to long-term assets. Therefore, Banks that do not have enough
reserves could get into liquidity crunch. Once the news come out the bank faces severe
problems and potential default. An example for this are bank runs. People panic and withdraw
their money from the bank, sucking all the liquidity of the bank. Thus, the bank cannot pay its
liabilities

Key take away:

Look at the cash on hand and other current assets. Check if their cochins are large enough to
ensure quick increases in cash demand. Also, analyze how liquid the rest of their assets are.
(Liquidity and Short- Ratio)

Interest Risk
As both assets and liabilities change with the key interest rates such as the interbank interest
rate (LIBOR). Now you need to analyze how interest rate sensitive the assets and liabilities are.
If the assets are more sensitive (Asset Sensitive) then an increase in the interest rates will be
profitable for the bank. If the interest decreases than the bank’s profits are hurt. If liabilities are
more sensitive, it is called liability sensitive.

Non-Interest-Bearing Income
Analyze the banks past successes and performance during crisis in their trading team e.g.
Goldman Sachs tends to perform well during crises (2008) as their risk management is excellent.

13
Investigate if they are underwriting any major IPO’s in the future or support any M&A processes.
Staying informed in the banking industry is important as it is fast moving. Their balance sheet
ratios and asset portfolios always need to have an eye on them.

Key take away:

Have an eye on the macroeconomic trends as well as the news and articles published by the
central banks. Once you know the interest trends analyze the banks’ balance sheet and see if
they are asset or liability sensitive.

Choosing companies for the multiple universe:

Take firms with a similar percentage of net interest income.

Take firms that show the same sensitivity profile.

Take firms that have a similar asset base.

Asset Management firms

Asset management firms are companies that manage the assets of companies and high net
worth individual for a fee that coincides with a small part of the invested assets. They face low
operational costs as their main expenses are for human capital. They are usual not exposed to
default risk as they will always earn money.

Key metrics:

• Asset under management (AUM) as it is their way of generating income.

• Asset stickiness (Loyalty) of the customers, do they change their asset manager at the
first signs of a worse financial year.

• Asset generation, do they mainly get new assets because of returns or because they
attract new individuals and firms.

• Portfolio Diversification

Insurance Companies
Insurance companies gain their money through efficient risk modelling. They generate revenues
through the premiums they price on their products such as life insurance (good premia) and
property/ casualty insurance (low margins, highly competitive). There costs are
mainly labour costs as well as cash outflows in case the insurance gets activated.

Key metrics:

• Premia growth rates that are about market average, in insurance underpricing is very
dangerous, as it could be that too aggressively priced insurance products do not cover
the potential costs in bad years

• ROE that is consistently higher than the cost of capital

• High credit rating goes hand in hand with ROE > WACC. The high credit rating
ensures cheap leverage and therefore significantly influences the WACC and keeps it
low

Healthcare
The healthcare industry consists of many different kinds of firms. It can be split into two main
categories. A firm in the industry can either be a manufacturer or a service provider. That is there

14
are firms that manufacture pharmaceuticals and medical devices, as well as others that provide
health insurance and run hospitals. Occasionally you may find companies such as CVS Health
that are a hybrid of both. Pharmaceuticals and hospital revenues may suffer during an economic
downturn, however, the overall demand for healthcare services is considered more resistant to
adverse economic conditions. Therefore, it is an industry that attracts bullish sentiments from the
market because it is perceived as a relatively stable industry by investors. It has also been one of
the best performing industries in terms of growth over the last decade making it a good target for
investors

There are many variables that may affect investments in this industry. The positive changes that
benefit the industry include but are not limited to demographic changes such as an aging
population (more senior citizens that depend on certain drugs to maintain healthy lifestyles),
lower mortality rate for people living with chronic diseases as well as higher incidences of
diabetes and obesity. Other positive trends include technological advances and personalised
medicine. Negative variable changes include but are not limited to improved healthcare systems
such as Medicare in America which enable all citizens over the age of 65 to get completely free
healthcare (this affects firms that provide health insurance to senior citizens), an increase in the
number of uninsured citizens and changes to the rules and regulations surrounding development
and testing of drugs and medical technology in a particular country.
Generally, the key performance indicators for the healthcare industry are as follows:

Cashflow coverage: It is a good metric for the industry because firms wait long periods of time to
obtain financial reimbursement from insurance companies and government agencies so having
sufficient cashflows and good cashflow management are essential to financial survival (NB:
Certain pharmaceutical companies can be a risky investment as they spend significant capital on
research and development (R&D) of a drug, and if that drug does not pass regulatory approval,
the company can suffer significant losses. It is more conservative to invest in pharma companies
that already have a number of viable drugs on the market.) This ratio is calculated by dividing
operating cash flow, a figure that can be obtained from a company's cash flow statement, by total
debt obligations. It reveals a company's ability to meet its financing obligations. It is also a ratio
considered particularly important by potential lenders and therefore impacts a company's ability
to obtain additional financing, if necessary. A ratio of 1 is generally considered acceptable, and a
ratio higher than 1, more favourable.

Debt-to Capitalisation: The long-term debt-to-capitalization ratio is an important leverage ratio for
evaluating companies that have significant capital expenditures, and therefore substantial long-
term debt, such as many healthcare companies. This ratio, calculated as long-term debt divided
by total available capital, is a variation on the popular debt-to-equity (D/E) ratio, and essentially
indicates how highly leveraged a company is in relation to its total financial assets. A ratio higher
than 1 can indicate a precarious financial position for the company, in which its long-term debts
are greater than its total available capital. Analysts prefer to see ratios of less than 1 since this
indicates a lower overall financial risk level for a company.

Operating Margin: Operating margin is one of the main profitability ratios commonly considered
by analysts and investors in equity evaluation. A company's operating profit margin is the amount
of profit it makes from the sales of its products or services after deducting all production and
operating expenses, but prior to consideration of the cost of interest and taxes. Operating margin
is key to determining a company's potential earnings, and therefore in evaluating its growth
potential. It is also considered to be the best profitability ratio to assess how well-managed a
company is since the management of basic overhead costs and other operating expenses is
critical to the bottom-line profitability of any company. Operating margins vary widely between
industries and should be compared between similar companies.

15
Medical Cost Ratio: This ratio is specific to health insurance firms. The calculation used to
determine the ratio is the cost of the total medical claims paid out, plus adjusted expenses, which
are then divided by the total premium collected. These figures are reported annually to the
secretary of Health and Human Services. Any reports indicating the limits are being exceeded
must be backed by supporting reports or proof of rebates to the customers. The medical cost
ratio should be 85% or less in order to indicate financial health for larger employer plans and
80% for smaller employers and individual plans. This indicates that the health insurer is spending
85% of its earnings paying out on healthcare costs and putting 15% towards non-medical costs
such as profits, overhead expenses and reinvesting into the company for larger plans. For
smaller and individual plans, the ratio should be 80% and 20% (sometimes known as the 80/20
rule).

When choosing a pharmaceuticals stock please be weary of the underlying diseases the
potential drug and their existing drugs treat, the number of people affected by the disease and
the number of compounds already available. Carefully monitor their discovery and market
release journey specifically the clinical trials and the requirements by regulatory bodies such as
the FDA in the USA. When it comes to analysing what may affect their market share and
therefore their earnings one must consider what patents they have and the duration left until their
expiry, as well as the availability of substitutes and profit sharing with other firms. All of these
factors affect their market share, which in turn affects revenue and earnings, which has its own
bearing on the DCF model.

Investing in healthcare stocks can provide good returns however, the task is quite daunting due
to all the factors that can affect the stock price. In order to make a good judgement a thorough
quantitative analysis as well as deep and extensive qualitative research are necessary to
encompass most of the important risk factors for the industry.

Industrials
The Industrial sector category of stocks of companies who produce capital goods used in
construction and manufacturing, e.g., automotive, chemicals, manufacturing and oil and gas.
Companies in this sector follow a fairly simple business model: they buy raw materials and
facilities to produce the inputs and machinery that other firms use to meet their customers’
expected demand. The sector is exposed to both established and emerging markets.

The industrial materials sector consists of two groups: (1) basic materials such as commodity
steel, aluminium, and chemicals and (2) value-added goods e.g., electrical equipment, heavy
machinery, and some specialty chemicals. The primary difference between the two groups is that
the commodity producers do not have a major influence on the price of the products they
produce, whereas the value-adding firms do.

Indicators such as asset turnover and debt ratios can provide insights into the companies’
performance and financial health. However, a vast number of segments of the industrial
economy, specifically commodity producers, face long-term price deflation, low cost competition,
and excess capacity.

The Industrial sector is largely driven by the demand for manufactured goods and supply and
demand for building construction. Thus, the industrial sector is said to be cyclical. As the demand
for economic inputs increases, the demand for capital rises too. Consequently, interest rates rise
too, eroding businesses margins and forcing firms to reduce capacity. Once the excesses are
worked off, expansion can begin again. One problem with cyclicality is that in uncertain times,
large purchases are often delayed.

When demand is high, firms can make a profit if they have high operating leverage. However,
when demand falls, high fixed costs pose a threat to the firm. The key to surviving periods of

16
economic downturn is to have low fixed costs in relation to sale volume. In a similar manner, a
firm creates a sustainable competitive advantage, e.g., by exploiting economies of scale. A
second way in which a firm can create competitive advantage is to create a differentiated
product.

The industrial sector has relatively high entry barriers: high PPE cost and low-price margins.
Additionally, this results in poor returns on capital and non-attractive circumstances for investors.

More specifically, factors such as the transformation in the automotive industry (shift to hybrid
vehicles), supply chain risks and more general the volatile investment environment, contribute to
upward and downward trends.

In general, strong profitability (measured by return on invested capital) can be achieved by

having high profit margins or high asset utilisation. As previously mentioned, the former is not
easy to achieve and hence, the firms who generate the most revenue from their assets will have
a better share performance.

Metrics
𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
Total asset turnover (TATO): 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

For every dollar that a company has invested in assets, it generates at least one dollar in
revenue each year. In general, a TATO ratio > 1 is good.
𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
Fixed asset turnover (FATO): 𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

For every dollar that a company has invested in net assets, it generates at least one dollar in
revenue each year. This ratio is often preferred over the TATO, as the FATO excludes the
impact of goodwill.

Industrial firms need to manage working capital efficiently. Metrics related to this, e.g., how many
days’ worth of inventory are sitting warehouse or lead times give information on a firm’s
operations. Highly efficient operations are key to sustainable long-term profitability in the
industrial sector.

Identifying Troubles
Given that many firms in the industrial sector follow a classic business model, most issues can
be identified by looking at debt, pension obligations and the planning of acquisitions.
𝑑𝑒𝑏𝑡
Debt-to-capital ratio:
𝑑𝑒𝑏𝑡+𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′𝑒𝑞𝑢𝑖𝑡𝑦

The higher the ratio, the riskier the firm’s financial position. In general, a ratio above 40% is
considered somewhat risky, whereas a ratio above 70% is a red flag. To get a better long-term
measure, sometimes current liabilities are excluded from the denominator.

Identifying Opportunities
Firstly, find firms that have undergone significant consolidation. Additionally, find firms with low
production costs and verify its financial health. Finally, value the company’s stock.

Technology
The technology industry has historically been the best performing sector since the mid-1990s
and has developed especially well since the world financial crisis in 2009 with a return of +400%
in the Nasdaq 100.

17
Technology firms usually have much higher margins than other industries do. Gross and Profit
margins can be up to 60 and 30%, respectively. The firms profit from economies of scale as
software or services, once set up, can be sold to customers without further direct costs for
manufacturing materials or labor costs. This effect/benefit has further implications. It makes it not
just easy for a firm to scale the business, but also to achieve high sales and revenue growth
without having to build or set up a new factory, machinery, or a supply chain. +40% revenue
growth can be realistic for a technology firm, while a y-o-y growth of more than +20% for an
industrial firm is rather unrealistic once reaching production limitation. (Operating, EBIT, net
income margin)

However, these advantages come at a price and lead to ambitious valuations by investors on the
market. The Enterprise-multiples, EV/Sales and EV/EBIT, can be many times higher than the
ones of other industries and PE-ratios far beyond 30 are common - 30 is the new 20 for tech
stocks -

A cost factor rather unusual compared to other industries are massive research & development
costs. While the R&D costs for retail or wholesale firms only make a small fraction of their
revenue, can the costs be as high as 20% of revenue for fabless technology companies like
NVIDIA or AMD. A good rule-of-thumb for R&D costs of a tech company is 10% of revenue in a
band of+-5%.
Tangible assets of technology firms are usually small, but the size of intangible assets can be
massive. The size of the balance sheet should not play too much of a role when evaluating tech
firms. It rather depends on how much money they can make with their few assets. A DCF
(intrinsic) and multiples (extrinsic) for valuating a tech firm within its industry is the right
approach.

Further thoughts: As revenue can grow up to 40% y-o-y and with the margins being high, the
traditional PE-ratio, which was a strong indicator in the past for over-/ or undervalued stocks, is a
rather weak multiple in the technology industry.

Important, however, are the product portfolios of these companies. Innovative products and
services determine sales in the present and guarantee success in the future. Technology firms
face the most elastic demand curves on the entire market. They do not rely as heavy on order/-
(books) as other industries, which makes revenue streams quite unforeseeable and switching
costs rather low for customers. It is, therefore, especially important to stay competitive with other
market players or elsewise fear of being left behind. The best way to think about the success of
these businesses are to think about the value a firm can create for its customers in the present
and future.

18
Qualitative Analysis
Qualitative Research is like doing homework. No one likes it as it is not as fancy as building
financial models and rather dull but absolutely necessary, in order to understand a firm and to
identify the winners from the losers.

Introduction
When conducting qualitative research on a public corporation, one has never heard of, it is
crucial to apply a top-down analysis. That means to first look at the individual company and form
a perception before putting it into perspective with peer firms and the (entire) industry.

Overall goal and vision of a firm

Usually the first task is to understand the vision and goals of the management and corporation
besides the business the firm is operating in. This may sound (stupid) and intuitive but goals can
heavily differ among industries and even between firms within the same industry. These goals
can vary from maximizing revenue and market share (Delivery Hero), over to optimizing cash
flow (Amazon), or paying high dividend yields (Telekom, BASF) or even developing disruptive
technology (Tesla, BioNtech). It helps to understand a firm ‘s investment-, revenue- or financing
decisions in the context of their effectiveness and success.

Analysing the Product portfolio

Probably the most important aspect of the qualitative research part is the analysis of the product
portfolio of a company. The products, services, or IP (intellectual property) determine sales or
revenue of the moment but also in the future. It is especially important for technology or industrial
companies to have revolutionary and up to date technology, in which the company constantly
needs to invest in. Resting on the success of earlier achievements can be deadly. A good
example, hereby, is Nokia, which failed to see the market opportunity of smartphones in the early
2010s.

Following questions should be answered when analysing the product portfolio:

- What products and services does a firm offer?

- What markets are the products/ services targeting?

- What are the strengths of the products/services?

- How are the products comparing to the peers? Are they ahead or running behind?

- Do they address future markets? (AI, IoT, autonomous driving, sustainability, etc.)

- Do they have valuable patents?

- What is the USP?

- Barriers to entry/produce? (High costs/ technology)

- What are current product developments?

Financial statements
The next step is to work through the past income statements and cash flow statements of the
company as they are the best indicators for the past performance and the development of a
business. A look at the balance sheet to inform about cash and financial positions can also be
interesting. However, the size of assets on the balance sheet should not necessarily be regarded
as something good and do not actually matter as much if they cannot earn revenue for the
company. A good example is McDonalds that has a negative book value but manages to earn
money very efficiently with their very few assets. However, it is nonetheless important to look at
the cash Position and financial structure of a company, which is only found on the balance sheet.

19
The Income Statement/ Cash Flow statement and the KPIs
Always keeping the vision or strategy in mind, one can start analysing revenue streams of the
firm by geographical allocation, product segment, margins, possible past development, and
future growth potential.

Information can be found on:

• company webpages under investor (relations)

o annual reports, news updates, ad-hoc messages

o firm presentations

• Analyst Reports

• For American firms: „10-K” or „8-K” reports at the United States Securities and Exchange
Commission (SEC)

• very detailed and even more precise than annual reports of the firms

• Financial news pages (Yahoo Finance, FactSet, Reuters, Bloomberg)

Revenue is a key-performance indicator as it shows the importance of the firm in its comparison
to its peers in the industry and shows essentially the market share.

„A firm can become more profitable by cutting costs or increasing revenue, but everyone can cut
costs.”

The next very important KPIs for a firm are margins. They vary significantly from industry to
industry, where Tech & Software companies tend to have much higher margins than industry
companies like car manufactures. It is therefore important to compare the margins of the firms
within the same industry. Two important efficiency measures that need to be looked at are:

• Gross Margin

• Net Margin

Margins show how many resources (personal, material) are needed to generate sales. The
more optimized supply chains, research & development and sales-teams are, the more profitable
is a firm and can return therefore more cash to its stakeholders. A firm can be market leader by
sales volume, but if the costs of achieving this volume is too high, the firm might even make
losses. Delivery Hero, a German delivery service, is currently this issue. The company shows
growth rates of +100% but the also the costs develop proportionally.

Research & development costs depend also heavily on the industry and firm. A consumer
goods company like Ahold Delhaize will spend a much smaller fraction of their revenue on R&D
than a fabless technology firm like Dialog Semiconductor does. The expenses should be in line
with the vision and goal of the firm and need to be interpreted individually. If a company wants to
make up for a technology gap or is interested in diversifying the portfolio, R&D expenses can
then be higher. Nonetheless expenses should not vary more than +-5% from the industry
average.

Free cash flow: According to Bill Ackman, the guy that shorted the entire market during the
covid-19 pandemic and returned 10,000% to his investors, says:

„Free cash flow is all you should care about. “

20
The same approach to cash flow is used by the DCF-model, whereby the present value of a firm
is determined by all its future cash flows discounted into the present. However, this does not
mean that a firm with a negative free-cash flow is not worth investing in. Every firm is at some
point in an investment phase, which might take up a shorter or longer period. Delivery Hero was
not even profitable and burning cash before it made it into the Dax-index and was valued at €12
billion. The free cash flow situation needs to be evaluated in context of the market situation and
the goal of the firm again. Growth companies tend to have negative cash flows, while blue chip
corporations that are established in the market, tend to try to optimize cash flows. A true value
investing approach would be to identify companies with strong cash flows that are trading at a
comparingly low price.

“Always try to buy the dollar for 50 cents.” – Warren Buffet

Balance sheet
Cash position: To be protected against cyclical or industrial downturns, companies should always
remain enough cash. A Cash-ratio above 1 is ideal.

Financial structure: refers to the mix of debt and equity that a company uses to finance its
operations. This composition directly affects the risk and value of the associated business. Debt
is comparingly cheaper than equity as debtholders will be served first in case of insolvency and
have short put option on the assets of a corporation. Furthermore, the financial structure
determines the discount rate (WACC). A certain level of debt can increase the value of a firm
with a tax shield.

Goodwill / M&A transactions: Are there any takeovers happening in the industry that are directly
or indirectly affecting the firm? Are there any symbioses? Can we maybe predict a takeover in
the future?

Macro view, Peer review

Important for evaluating the attractiveness of a company is to see it in the light of the industry. It
is necessary to give an outlook about the future of the overall market. Is it expected to grow in
the future? What are the drivers for this growth? Important thereby is also to indicate regional
growth. Will the company XZY benefit of the growth in region XYZ? What is the market share of
the company? Does it have a leading role or is it small and trying to steal market share? Does it
have a monopolistic position? What are the entry barriers? What is the total Market size?

Information can be found on:

• Databases: Statista, Factset

• Worldbank data

• IMF data

• Newspapers (Bloomber, Reuters)

• market research institutes (Gartner)

• Annual reports, firm presentations

Risk and opportunities factors: Last, but not least it is important to evaluate possible risk and
opportunity factors further affecting a company or an entire industry. (IF applicable)

Political risk: Goal setting and political party changes can have a major influence on the success
and failure of a business.

Currency risk: Further, the changes in exchange rates can have an affect on the revenue
streams and expose a firm to risk.

21
Event risk: Events of natural or unnatural nature can affect the performance of a firm. The
Terrorism attack on the twin-towers in New York lead to a double-digit decline in air travel
passenger numbers. Bayer settlement, ongoing lawsuits

Technology risk: The effect of digitalization on the industry (AI, automatization, 5G)

Liquidity risk: Without enough cash or cash-equivalent assets, a firm might not be able to pay its
obligations and file for insolvency.

Concluding words:
To conclude, it is important to say that one can never conduct too much research. It is easy and
also a person without too much knowledge in finance, can do market research and examine a
company. From experience, I can say that the more one gets to know a firm and its business, the
more confident one becomes about investing in the stock and will not fear temporarily setbacks
of 20-30% in share price as.

22
Company Valuation
Why Value a Company?
The valuation of a company is a very important tool in a number of situations that may occur in
the lifespan of a company. Namely, in Mergers & Acquisitions, Subsidiary Sales, Start-up
investments, establishing Joint Ventures, IPO’s and delisting from the Stock Exchange. We do
not explain these terms in depth here, you can easily find them on Investopedia.

Imagine the following situation: An investor wants to buy your company. During the negotiations
he want to know how much of your company is available and the price you expect him to pay. If
you give a too high number, he will find another start-up and negotiations end here. If you give a
too low number, you will practically give away your firm. A proper valuation that will show a close
approximation of the firm is needed to come to a good deal. Both parties (buyer and seller) must
have a precise idea about the pricing.

Value of a Company to an Investor

Obviously, an investor buys a company because he
expects the stock to promise a decent return on his
investment. The cost to acquire a company is the initial
investment (purchase the shares from the current owner).
The benefit after acquiring the shares is the payment of
regularly dividends, and if all goes well, the value of the
company will increase. The acquirement of a stock will
depend on the Purchase Price, Dividends and (Expected)
Selling Price of a stock as can be seen in the investment
horizon on the right. In Finance I you learn that the price of
a stock today is a function of the sum of the dividends the
stock pays in the future. The main driving force that determines a company’s dividends is the
cash flow. For example, if a company makes no money, its management has to decrease the
dividends it pays to investors, which indicates a company is going through hard times. Given that
a company’s share prices are a function of its expected dividends, we can conclude that
company’s share price depends on its expected future cash flows. In the coming section we will
show how to predict future cash flows.

What drives Future Cash Flows?

A company’s value is a function of its
future cash flows. In this section we will
determine what drives future cash
flows. In the figure you find an
approximation of a cash flow
calculation: Revenues –
Costs/Expenditures – Investments =
Operating Cash Flow. The proportion a
company can keep at the end of the
year after paying expenses and making investments is the Cash Conversion Ratio. The figure
suggests that there are two ways a company can increase its cash flows: increase in revenues or
improve its profitability. If one or both are applicable this can lead to an overall higher Operating
Cash Flow, which in turn leads to an increase in the dividends received by shareholders and a
higher valuation of the company. In short, the two functions that drive a firm’s future value are its
future growth and profitability.

23
Unlevered Cash Flow Calculation
Revenues
- COGS
- Operating Expenses (SG&A)
= EBITDA
- D&A
= EBIT
- Operating Taxes
= EBIAT
+ D&A
- △NWC
- CAPEX
= Unlevered Free Cash Flow

A company’s value is a function of the cash flows that the business is expected to produce. In
this section we will show how these cash flows can be calculated. We simply start with the
revenues from Revenue of a company, we subtract COGS (Cost of Goods Sold), Operating
Expenses (SG&A) to get EBITDA (Earnings before Interest, Tax and D&A). Then we subtract
D&A (Depreciation & Amortization) to get EBIT (Earnings before Interest and Tax) and apply an
operating tax rate to calculate taxes, this gives us EBIAT (Earnings Before Interest After Taxes).

We did not subtract interest expenses and did not apply their tax shield deductions to EBIT.
Why? The goal is to calculate the company’s Unlevered Free Cash Flow. This is a Cash Flow
measure that does not depend on financial structure. In an efficient market, the value of a firm is
unaffected by how the firm is financed. Therefore, we calculate Unlevered Free Cash Flow
disregarding interest expenses.

Starting from EBIAT, we have to add back D&A (Depreciation & Amortization). The reason we
subtract D&A first and then add it back is the calculation of operating taxes. Since D&A is a tax-
deductible cost, it needs to be considered when calculating taxes. We add it back as it is a cash
flow calculation.

Not only D&A affects the cash flow calculation. When you look at the Balance Sheet of a
company you find other cash movements. Next on the list deals with the three components of
working capital: account receivables, inventories and account/trade payables. We deduct an
increase in NWC (Net Working Capital) from EBIAT as an increase in Working Capital (Current
Assets – Current Liabilities) requires additional cash to be tied up in operations because an
increase in current assets is a net outflow. In contrary, a decrease in Working Capital means that
the firm has more cash available that can be used for other projects since an increase in current
liabilities is an inflow.
Then we subtract CAPEX (Capital Expenditures) as it is the cost sustained by a company to
replace old PP&E (Property Plant & Equipment) or acquire new PP&E. A reasonable assumption
here is that a growing business will need additional PP&E investments, hence CAPEX increases
if a business grows. Non-operating assets and liabilities are not used for the generation of
Operating Cash Flows, their value should be added or subtracted to the company’s Enterprise
Value and should not be considered in the calculation of the company’s Unlevered Free Cash
Flow. Finally, we have arrived at the Unlevered Free Cash Flow of a firm.

The discount factor: Weighted Average Cost of Capital

In the previous sections we saw that every firm’s value depends on its future cash flows. In
principle we can say the higher the expected cash flows, the more expensive the firm. But the
cash flows that a company produces today are more valuable than the cash flows the company

24
will produce the coming years. Money you hold now is worth more, because you can invest it and
earn interest. To account for this time value of money, we introduce a discount factor to calculate
the today’s value of the free cash flow a firm is expected to produce in the future. The question
is, which type of discount factor should we use? The discount factor must be determined
according to the type of cash flows it will discount. In other words, if the cash flow will be
available to equity holders only, we will use the cost of equity. If the cash flows will be available
to both equity and debt holders, we will use a weighted average blend of the cost of equity and
the cost of debt. This discount factor is called the Weighted Average Cost of Capital, or simply
WACC. It provides a sense of the average opportunity cost sustained by investors for investing
their fund in the firm. The formula consists of two components and is as follows:
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
𝑊𝐴𝐶𝐶 = (1 − 𝑇𝑎𝑥) ∙ ∙ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 + ∙ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
The formula has two main components. and . Obviously, the sum of these
𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦
components is equal to one. This shows us that in a firm that is prevalently financed with debt,
the cost of debt will have a higher weight. The cost of debt component includes a third factor:
(1 − 𝑇𝑎𝑥) that takes into account the fact that interest expenses are tax deductible, and the cost
of debt of the firm is lower than it seems. Let’s now look at the calculations of the cost of debt
and the cost of equity.

Cost of Debt
Cost of debt is the average interest rate a company pays on its borrowings. It is very easy to do if
everything is reported correctly on the company’s financial statements (Balance Sheet and
Income Statement).

A firm’s Balance Sheet contains a liability called “Financial Liabilities” or “Financial Borrowings”.
For some firms the listing of these elements can be broken down according to the maturity of the
loans. Therefore, they can have “Short-term financial liabilities” and “Long-term financial
liabilities”. The sum of the two amount gives us the total amount of debt a company has. The
interest expenses reported on the Income Statement are the cost being paid to use these funds.
We can calculate the cost of debt of the firm by dividing interest expenses and financial liabilities.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 =
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Cost of Equity
There are several ways to calculate a company’s cost of equity. The most used model in
Investment Banking is the Capital Asset Pricing Model, also known as CAPM. The CAPM suggests
a company’s Cost of Equity (Ke) is equal to the risk-free rate (rf) plus beta () multiplied by the
market risk premium (rm - rf).

𝐾𝑒 = 𝑟𝑓 + 𝛽 ∙ (𝑟𝑚 − 𝑟𝑓 )

The risk-free rate in an economy is the rate of return an investor would expect from a financial
security that contains zero default risk. This means he is certain he will be repaid the full rate of
return on time. Most practitioners use the yield of a 10-year government bond (10y T-Bill) to
approximate the risk-free rate.

The next component in the calculation is beta. Beta is a statistical measure. For the ones
interested in statistics and quant finance, we show the calculation below. It is used to show how
a financial security behaves regarding the rest of the market. That is exactly why the Covariance
with the rest of the market is divided by its variance. If you are not interested in these statistics,
you can also find the beta online as many financial providers calculate company betas. On the
summary tab of a company’s profile on Yahoo Finance you can directly read a company’s beta.

25
A beta less than one indicates the stock is less volatile than the market. A beta of one show that
a stock is just as volatile as the market. Stocks that have beta higher than one are considered
aggressive and more volatile than the market.
𝐶𝑜𝑣 (𝑥, 𝑦)
𝛽=
𝑉𝑎𝑟(𝑥)

The next component in the calculation of CAPM is the market risk premium. Theoretically, it is
given by the average expected return of the market minus the risk-free rate. Academic research
has shown the average market risk premium rate varies between 4.5% and 5.5%, therefore most
practitioners use 5% in their cost of equity calculations. The risk-free rate of a 10Y T-Bill can be
found on Google.

Looking at the CAPM, a financial security’s return should be composed of two parts. The risk-
free return as a minimum, compensating the investor the time value of money. The second
component compensates the investor for the additional risk for holding a security that is not risk-
free.

Forecasting Cash Flows

By now we have laid the groundwork and introduced all-important inputs necessary to do the
valuation method. Before we can start modelling the Discounted Cash Flow, we determine how
far out into the future we project cash flows. The closer we are to the present moment, the
greater the level of detail we have. The further away we model into the future, the less detail we
have. Hence, the less precise the model will be. A good time frame for modelling a Discounted
Cash Flow with the tools and access to information we have, is a 5-year time period.

The time frame of modelling a DCF analysis also depends on the state of the company. For
example, if the company we are valuing is rather young and has a fast-growing business, we
need a longer explicit forecast period. Instead, if we are dealing with a company that is mature,
and fewer spectacular events are expected to happen from year 5 to year 10, then we can use a
5-year explicit forecast period.

Now we have decided the time frame over which we model, it is time to work on the actual
projections of Income Statement/Profit & Loss and Balance Sheet items.

Modelling P&L and Balance Sheet items

The table below provides a suggestion on how the P&L and Balance Sheet items can be
forecasted. A prediction of many of these elements can be found in the Annual Reports of the
Valued Company. The Annual Report is your bible when projecting P&L and Balance Sheet
items.

Profit & Loss Item Forecast as

Revenues Perform a top-down and bottom-up forecast.

Research expected industry growth from
Consulting reports. Calculate the firm’s
historical growth rate.

Cost of Goods Sold As a % of Revenues

Operating expenses As a % of Revenues

Depreciation & Amortization As a % of Fixed Assets. Build a detailed fixed

asset roll forward schedule.

Interest expenses Interest rate * Financial Liabilities outstanding

26
 Extraordinary items Should be equal to zero in the model

Taxes Marginal tax rate * Earning Before Tax

Balance Sheet Item Forecast as

Cash Ending Cash = Beginning Cash + Net Cash

Flow. Use the Cash Flow Statement

Trade Receivables Calculate historical DSO (Days Sales

Outstanding) and model as the average
number of DSO observed historically

Inventory Calculate historical DIO (Days Inventory

Outstanding) and model as the average
number of DIO observed historically

Property, Plant & Equipment Build a detailed fixed asset roll forward.
Ending PP&E = Beginning PP&E + Capex –
D&A

Capex Calculate the historical Capex expenditures

and model as a % of the average historical
Capex expenditure

Other assets As a % of Revenue

Trade payables Calculate historical DPO (Days Payables

Outstanding) and model as the average
number of DIO observed historically

Other Liabilities As a % of Revenue

Financial Liabilities Build a detailed debt schedule. Debt

Outstanding = Debt at Beginning + Debt
drawdowns – Debt repayment.

Shareholders’ equity Ending equity = Beginning Equity + Increases

in capital – Dividend Payments + Net Income
(Loss)

Once you have made your projections, you have to verify that Assets are Equal to Liabilities and
Equity in the entire forecasting period. This is a final check that prevents you from making
mistakes.

The two stages of the DCF model

We have described all inputs of the Valuation model. At the end of the forecast period, we
assume that the company reaches a maturity stage of development. Its cash flows are stable,
growth slows down as the market is competitive. The company is still valuable, and we can
expect it will remain profitable and continue to make money in the terminal period. This
component must be captured in the valuation. This is also the moment where some mathematics
comes in. The present value of a cash flow growing into infinity is equal to the following formula.
𝐹𝐶𝐹5 ∙ (1 + 𝑔)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑊𝐴𝐶𝐶 − 𝑔

27
The formula considers the distance from the present. The further a Cash Flow is, the less
valuable it is (Remember the time value of money). FCF stands for Free Cash Flow. This is the
last cash flow we are projecting. WACC is the firm’s Weighted Average Cost of Capital. This is
the discount rate we explained in an earlier section. “g” is the long-term growth rate of the firm’s
cash flow after the explicit forecast period. Its purpose is to compensate for inflation and align the
company’s growth with the GDP growth of the economy in which it operates. The practitioner of
the valuation chooses this number himself. Its values can range between 1% and 4%, most
valuators apply 2% or 3%.

Discounting Cash Flows and Terminal Value

At this stage, we have projected the company’s cash flows in the choses forecast period.
Moreover, we calculated its terminal value and we estimated its WACC. We need to apply the
discount factor WACC to the cash flows we have obtained and to the Terminal Value. This will
give us their present values. To discount these values, we can apply the following Present Value
formula:
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 =
(1 + 𝑊𝐴𝐶𝐶)𝑛
A future value is divided by one plus a discount rate (we choose the WACC in the DCF), then the
whole denominator is elevated according to the number of years we stand from the present
moment. This formula allows us to obtain the present value of all the cash flows we have,
including the Terminal value.

Calculating Enterprise and Equity Value

We obtained the present value of the cash flows in the choses forecast period and the terminal
value. The sum of these values plus any non-operating assets (personal real estate or cars)
gives us the company’s Enterprise Value. This is a measure of a company’s total value,
comprising equity and debt holders’ claims. To obtain a company’s equity value, we need to
subtract its financial debt and add its cash. In addition, we need to consider debt-like items, like
pension liabilities or labilities from legal litigations.

Present Value of Cash Flows (Years 1 – 5)

+ Present Value of Terminal Value

+ Non- operating Assets

= Enterprise Value

- Financial Liabilities

+ Cash
- Debt – like items

= Equity Value

Finally, if we know how many shares have been issued by a firm, we can use the equity value to
divide it by the number of shares and obtain how much the firm’s shares are worth, according to
our valuation. This is the end of the DCF analysis. When you find that the value of a share is
much higher than the listed value on the stock exchange, you might be interested to invest your
money in the valued company.

Multiple Evaluation
The multiple valuation is a crucial part in every stock pitch as it gives an indication if the DCF
needs closer attention and it can show the differences in stocks quickly. Multiples are also the

28
main valuation method for small-to mid-cap investment decisions as their information coverage is
often too little for a proper DCF to work.

There are two main multiples, transaction multiples and trading multiples. They follow the same
procedure but are have different strengths. Transaction multiples is usually interesting in M&A
processes as strategic investors see how the synergy benefits were valued. Trading multiples
are more interesting for investing.

Selecting the universe of comparable companies

This is the crucial part that distinguishes a good multiple valuation from a bad one. It is advised
to have a very broad industry overview in the beginning and then narrow the field of companies
down slowly. Use criteria like:

- How similar is their business model?

- What is their focus of business?

- Target consumer group

- Exposure to cyclicality

- Is the geographical scope similar?

- Are their profitability ratios similar?

- Are the financial characteristics similar?

There are many more and sometimes really specific depending on the industry. It is important to
note that there is no right or wrong with this. There is just a better or worse. Once the universe of
comparable is finished it is time to adjust the financial statements.

Adjusting financial statements

In this step the financial statements are adjusted by non-recurring items such as amortizations.
This information is usually publicly accessible in their annual reports. Adjusting here means
adding up the amortization back to the income statement and therefore also adjust the cashflow
statement and balance sheet accordingly to get the right ratios in the end. Do the same with all
other non-recurring expenses.

Make the ratios

Create Revenue, EBIT and EBITDA Multiple for all the firms. Then create a range using min max
and mean of the multiples. You can weight the different multiples for a weighted mean in case
some companies are exceptionally comparable to the company you are valuing.

Apply the multiple to the company’s financials

Get the company’s value by applying the respective multiple.

29
Appendix

Figure 1: CVS Health Balance Sheet

30
Figure 2: CVS Health Income Statement

31
Figure 3: CVS Health Statement of Cash Flows

32