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Course Report
By :
Rocky Leroy Lumowa
⚫ What is Finance?
All corporations, whether large or small, new or old, confront fundamental decisions about
how to deploy capital — that is, what to invest in — and how to raise funds needed for
investment. These choices are central to the discipline of corporate financial management.
Fundamentally, the study of corporate finance covers the principles, analytical tools, and
institutional knowledge a manager needs to make good investment and financing decisions. In
addition, however, a well- run corporation needs a financial infrastructure — systems for
monitoring cash and cash flow, for creating operating and financial budgets, for measuring and
reporting its financial and operating performance, for managing its current and expected tax
liabilities, and so forth. Defined broadly, the field of finance covers all these topics, and many
related ones as well, such as the markets in which financial contracts are priced and traded, and
the institutions that use, support, and regulate them.
⚫ What is a Accounting?
Accounting is the process of recording financial transactions pertaining to a business. The
accounting process includes summarizing, analyzing and reporting these transactions to
oversight agencies, regulators and tax collection entities. The financial statements used in
accounting are a concise summary of financial transactions over an accounting period,
summarizing a company's operations, financial position and cash flows. Accounting is one of
the key functions for almost any business. It may be handled by a bookkeeper or an accountant
at a small firm, or by sizable finance departments with dozens of employees at larger
companies. The reports generated by various streams of accounting, such as cost accounting
and managerial accounting, are invaluable in helping management make informed business
decisions.
⚫ What is Valuation?
Valuation is the analytical process of determining the current (or projected) worth of an asset or
a company. There are many techniques used for doing a valuation. An analyst placing a value
on a company looks at the business's management, the composition of its capital structure, the
prospect of future earnings, and the market value of its assets, among other metrics.
Fundamental analysis is often employed in valuation, although several other methods may be
employed such as the capital asset pricing model (CAPM) or the dividend discount model
(DDM). A valuation can be useful when trying to determine the fair value of a security, which
is determined by what a buyer is willing to pay a seller, assuming both parties enter the
transaction willingly. When a security trades on an exchange, buyers and sellers determine the
market value of a stock or bond. The concept of intrinsic value, however, refers to the
perceived value of a security based on future earnings or some other company attribute
unrelated to the market price of a security. That's where valuation comes into play. Analysts do
a valuation to determine whether a company or asset is overvalued or undervalued by the
market. Absolute valuation models attempt to find the intrinsic or "true" value of an investment
based only on fundamentals. Looking at fundamentals simply means you would only focus on
such things as dividends, cash flow, and the growth rate for a single company, and not worry
about any other companies. Valuation models that fall into this category include the dividend
discount model, discounted cash flow model, residual income model, and asset-based model.
Relative valuation models, in contrast, operate by comparing the company in question to other
similar companies. These methods involve calculating multiples and ratios, such as the
price-to-earnings multiple, and comparing them to the multiples of similar companies. For
example, if the P/E of a company is lower than the P/E multiple of a comparable company, the
original company might be considered undervalued. Typically, the relative valuation model is
a lot easier and quicker to calculate than the absolute valuation model, which is why many
investors and analysts begin their analysis with this model.
An income statement helps business owners decide whether they can generate profit by
increasing revenues, by decreasing costs, or both. It also shows the effectiveness of the
strategies that the business set at the beginning of a financial period. The business owners can
refer to this document to see if the strategies have paid off. Based on their analysis, they can
come up with the best solutions to yield more profit.
Following are the few other things that an income statement informs.
1. Frequent reports: While other financial statements are published annually, the income
statement is generated either quarterly or monthly. Due to this, business owners and
investors can track the performance of the business closely and make informed
decisions. This also enables them to find and fix small business problems before they
become large and expensive.
3. Overall analysis of the company: This statement gives investors an overview of the
business in which they are planning to invest. Banks and other financial institutions can
also analyze this document to decide whether the business is loan worthy.
There are two main groups of people who use this financial statement: internal and external
users. Internal users include company management and the board of directors, who use this
information to analyze the business’s standing and make decisions in order to turn a profit.
They can also act on any concerns regarding cash flow. External users comprise investors,
creditors, and competitors. Investors check whether the company is positioned to grow and be
profitable in the future, so they can decide whether to invest in the business. Creditors use the
income statement to check whether the company has enough cash flow to pay off its loans or
take out a new loan. Competitors use them to get details about the success parameters of a
business and get to know about areas where the business is spending an extra bit, for example,
R&D spends.
The following information is covered in an income statement. The format for this document
may vary depending on the regulatory requirements, the diverse business needs and the
associated operating activities.
Revenue or sales: This is the first section on the income statement, and it gives you a summary
of gross sales made by the company. Revenue can be classified into two types: operating and
non-operating. Operating revenue refers to the revenue gained by a company by performing
primary activities like manufacturing a product or providing a service. Non-operating revenue
is gained by performing non-core business activities such as installation, operation, or
maintenance of a system.
Cost of goods sold (COGS): This is the total cost of sales or services, also referred to as the
cost incurred to manufacture goods or services. Keep in mind that it only includes the cost of
products which you sell. COGS does not usually include indirect costs, like overhead.
Gross profit: Gross profit is defined as net sales minus the total cost of goods sold in your
business. Net sales is the amount of money you brought in for the goods sold, while COGS is
the money you spent to produce those goods.
Gains: Gain is a result of a positive event that causes an organization’s income to increase.
Gains indicate the amount of money realized by the company from various business activities
like the sale of an operating segment. Likewise, the profits from one time non-business
activities are also included as gains for the business. For example, company selling off old
vehicles or unused lands etc. Although gain is considered secondary type of revenue, the two
terms are different. Revenue is the money received by a company regularly while gain can be
accounted for the sale of fixed assets, which is counted as a rare activity for a company.
Expenses: Expenses are the costs that the company has to pay in order to generate revenue.
Some examples of common expenses are equipment depreciation, employee wages, and
supplier payments. There are two main categories for business expenses: operating and
non-operating expenses. Expenses generated by company’s core business activities are
operating expenses, while the ones which are not generated by core business activities are
known as non-operating expenses. Sales commission, pension contributions, payroll account
for operating expenses while examples of non operating expenses include obsolete inventory
charges or settlement of lawsuit.
Advertising expenses: These expenses are simply the marketing costs required to expand the
client base. They include advertisements in print and online media as well as radio and video
ads. Advertising costs are generally considered part of Sales, General & Administrative
(SG&A) expenses.
Depreciation: Depreciation refers to the practice of distributing the cost of a long-term asset
over its life span. It is a management accord to write off a company’s asset value but it is
considered a non-cash transaction. Depreciation mainly shows the asset value used up by the
business over a period of time.
Earnings before tax (EBT): This is a measure of a company’s financial performance. EBT is
calculated by subtracting expenses from income, before taxes. It is one of the line items on a
multi-step income statement.
Net income: Net profit can be defined as the amount of money you earn after deducting
allowable business expenses. It is calculated by subtracting total expenses from total revenue.
While net income is a company’s earnings, gross profit can be defined as the money earned by
a company after deducting the cost of goods sold.
An income statement is a rich source of information about the key factors responsible for a
company’s profitability. It gives you timely updates because it is generated much more
frequently than any other statement. The income statement shows a company’s expense,
income, gains, and losses, which can be put into a mathematical equation to arrive at the net
profit or loss for that time period. This information helps you make timely decisions to make
sure that your business is on a good financial footing.
The balance sheet adheres to the following accounting equation, where assets on one side, and
liabilities plus shareholders' equity on the other, balance out:
This formula is intuitive: a company has to pay for all the things it owns (assets) by either
borrowing money (taking on liabilities) or taking it from investors (issuing shareholders'
equity). For example, if a company takes out a five-year, $4,000 loan from a bank, its assets
(specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the
long-term debt account) will also increase by $4,000, balancing the two sides of the equation. If
the company takes $8,000 from investors, its assets will increase by that amount, as will its
shareholders' equity. All revenues the company generates in excess of its expenses will go into
the shareholders' equity account. These revenues will be balanced on the assets side, appearing
as cash, investments, inventory, or some other asset.
Assets, liabilities and shareholders' equity each consist of several smaller accounts that break
down the specifics of a company's finances. These accounts vary widely by industry, and the
same terms can have different implications depending on the nature of the business. Broadly,
however, there are a few common components investors are likely to come across.
The balance sheet is a snapshot representing the state of a company's finances at a moment in
time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For
this reason, the balance sheet should be compared with those of previous periods. It should also
be compared with those of other businesses in the same industry since different industries have
unique approaches to financing.
A number of ratios can be derived from the balance sheet, helping investors get a sense of how
healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with
many others. The income statement and statement of cash flows also provide valuable context
for assessing a company's finances, as do any notes or addenda in an earnings report that might
refer back to the balance sheet.
Assets: Within the assets segment, accounts are listed from top to bottom in order of their
liquidity – that is, the ease with which they can be converted into cash. They are divided into
current assets, which can be converted to cash in one year or less; and non-current or long-term
assets, which cannot.
• Cash and cash equivalents are the most liquid assets and can include Treasury bills and
short-term certificates of deposit, as well as hard currency.
• Marketable securities are equity and debt securities for which there is a liquid market.
• Accounts receivable refers to money that customers owe the company, perhaps
including an allowance for doubtful accounts since a certain proportion of customers
can be expected not to pay.
• Inventory is goods available for sale, valued at the lower of the cost or market price.
• Prepaid expenses represent the value that has already been paid for, such as insurance,
advertising contracts or rent.
• Long-term investments are securities that will not or cannot be liquidated in the next
year.
• Fixed assets include land, machinery, equipment, buildings and other durable,
generally capital-intensive assets.
• Intangible assets include non-physical (but still valuable) assets such as intellectual
property and goodwill. In general, intangible assets are only listed on the balance sheet
if they are acquired, rather than developed in-house. Their value may thus be wildly
understated – by not including a globally recognized logo, for example – or just as
wildly overstated.
Liabilities: Liabilities are the money that a company owes to outside parties, from bills it has to
pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries.
Current liabilities are those that are due within one year and are listed in order of their due date.
Long-term liabilities are due at any point after one year.
Some liabilities are considered off the balance sheet, meaning that they will not appear on the
balance sheet.
Retained earnings are the net earnings a company either reinvests in the business or use to pay
off debt; the rest is distributed to shareholders in the form of dividends. Treasury stock is the
stock a company has repurchased. It can be sold at a later date to raise cash or reserved to repel
a hostile takeover. Some companies issue preferred stock, which will be listed separately from
common stock under shareholders' equity. Preferred stock is assigned an arbitrary par value –
as is common stock, in some cases – that has no bearing on the market value of the shares
(often, par value is just $0.01). The "common stock" and "preferred stock" accounts are
calculated by multiplying the par value by the number of shares issued.
Additional paid-in capital or capital surplus represents the amount shareholders have invested
in excess of the "common stock" or "preferred stock" accounts, which are based on par value
rather than market price. Shareholders' equity is not directly related to a company's market
capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum
of the equity that has been purchased at any price.
Figure 3 Balance Sheet Example
The balance sheet is an invaluable piece of information for investors and analysts; however, it
does have some drawbacks. Since it is just a snapshot in time, it can only use the difference
between this point in time and another single point in time in the past. Because it is static, many
financial ratios draw on data included in both the balance sheet and the more dynamic income
statement and statement of cash flows to paint a fuller picture of what's going on with a
company's business.
Different accounting systems and ways of dealing with depreciation and inventories will also
change the figures posted to a balance sheet. Because of this, managers have some ability to
game the numbers to look more favorable. Pay attention to the balance sheet's footnotes in
order to determine which systems are being used in their accounting and to look out for red
flags.
The cash flow statement includes all cash inflows a company receives from its ongoing
operations and external investment sources, as well as all cash outflows that pay for business
activities and investments during a given quarter. These include cash flows from operating
activities (CFO), but also cash flows from financing (CFO) and investing (CFI) activities.
There are two forms of accounting that determine how cash moves within a company's
financial statements. They are accrual accounting and cash accounting. Accrual accounting is
used by most public companies and is the accounting method where revenue is reported as
income when it's earned rather than when the company receives payment. Expenses are
reported when incurred, even though no cash payments have been made.
For example, if a company records a sale, the revenue is recognized on the income statement,
but the company may not receive cash until a later date. From an accounting standpoint, the
company would be earning a profit on the income statement and be paying income taxes on it.
However, no cash would have been exchanged.
Also, the transaction would likely be an outflow of cash initially, since it costs money for the
company to buy inventory and manufacture the product to be sold. It's common for businesses
to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be
an accounts receivable with no impact on cash until collected.
Cash accounting is an accounting method in which payment receipts are recorded during the
period they are received, and expenses are recorded in the period in which they are paid. In
other words, revenues and expenses are recorded when cash is received and paid, respectively.
Important: Earnings and cash are two completely different terms. Earnings happen in the
present when a sale and expense are made, but cash inflows and outflows can occur at a later
date. It is important to understand this difference when managing any business payments.
A company's profit is shown as net income on the income statement. Net income is the bottom
line for the company. However, because of accrual accounting, net income doesn't necessarily
mean that all receivables were collected from their customers.
From an accounting standpoint, the company might be profitable, but if the receivables become
past due or uncollected, the company could run into financial problems. Even profitable
companies can fail to adequately manage their cash flow, which is why a cash flow statement is
a critical tool for analysts and investors.
Cash Flow Statement: A cash flow statement has three distinct sections, each of which relates
to a particular component—operations, investing, and financing—of a company's business
activities. Below is the typical format of a cash flow statement.
If a client pays a receivable, it would be recorded as cash from operations. Changes in current
assets or current liabilities (items due in one year or less) are recorded as cash flow from
operations.
Typically, investing transactions generate cash outflows, such as capital expenditures for plant,
property, and equipment; business acquisitions; and the purchase of investment securities.
Cash inflows come from the sale of assets, businesses, and securities. Investors typically
monitor capital expenditures used for the maintenance of, and additions to, a company's
physical assets to support the company's operation and competitiveness. In short, investors can
see how a company is investing in itself.
For investors who prefer dividend-paying companies, this section is important since it shows
cash dividends paid since cash, not net income, is used to pay dividends to shareholders.
Cash Flow Analysis: A company's cash flow can be defined as the number that appears in the
cash flow statement as net cash provided by operating activities, or "net operating cash flow."
However, there is no universally accepted definition. For instance, many financial
professionals consider a company's cash flow to be the sum of its net income, depreciation, and
amortization (non-cash charges in the income statement). While often coming close to net
operating cash flow, the shortcut can be inaccurate, and investors should stick with using the
net operating cash flow figure. While cash flow analysis can include several ratios, the
following indicators provide a starting point for an investor to measure the investment quality
of a company's cash flow.
Note: If your cash flow analysis shows that you are about to be low on cash and not able to
make your payments, you can adapt by obtaining financing, cutting costs, or trying to increase
income. This is why cash flow analysis is important.
There is no exact percentage to look for, but the higher the percentage, the better. It should also
be noted that industry and company ratios will vary widely. Investors should track this
indicator's performance historically to detect significant variances from the company's average
cash flow/sales relationship along with how the company's ratio compares to its peers. It is also
essential to monitor how cash flow increases as sales increase since it's important that they
move at a similar rate over time.
To calculate FCF from the cash flow statement, find the item cash flow from operations—also
referred to as "operating cash" or "net cash from operating activities"—and subtract capital
expenditures required for current operations from it.
You can go one step further by expanding what's included in the free cash flow number. For
example, in addition to capital expenditures, you could also include dividends for the amount
to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow
figure. This figure could then be compared to sales, as shown earlier.
As a practical matter, if a company has a history of dividend payments, it cannot easily suspend
or eliminate them without causing shareholders some real pain. Even dividend payout
reductions, while less injurious, are problematic for many shareholders. For some industries,
investors consider dividend payments to be necessary cash outlays similar to capital
expenditures.
It's important to monitor free cash flow over multiple periods and compare the figures to
companies within the same industry. If free cash flow is positive, it should indicate the
company can meet its obligations, including funding its operating activities and paying
dividends.
Free cash flow is an important evaluative indicator for investors. It captures all the positive
qualities of internally produced cash from a company's operations and monitors the use of cash
for capital expenditures.
3. Financial Modelling
3.1 Introduction and Best Practices
Financial modeling is the process of creating a summary of a company's expenses and earnings
in the form of a spreadsheet that can be used to calculate the impact of a future event or
decision.
A financial model has many uses for company executives. Financial analysts most often use it
to analyze and anticipate how a company's stock performance might be affected by future
events or executive decisions.
Financial analysts use them to explain or anticipate the impact of events on a company's stock,
from internal factors, such as a change of strategy or business model to external factors such as
a change in economic policy or regulation.
Financial models are used to estimate the valuation of a business or to compare businesses to
their peers in the industry. They also are used in strategic planning to test various scenarios,
calculate the cost of new projects, decide on budgets, and allocate corporate resources.
Examples of financial models may include discounted cash flow analysis, sensitivity analysis,
or in-depth appraisal.
The financial modeler creates one cell for the prior year's sales, cell A, and one cell for the
current year's sales, cell B. The third cell, cell C, is used for a formula that divides the
difference between cell A and B by cell A. This is the growth formula. Cell C, the formula, is
hard coded into the model. Cells A and B are input cells that can be changed by the user.
In this case, the purpose of the model is to estimate sales growth if a certain action is taken, or
a possible event occurs. Of course, this is just one real-world example of financial modeling.
Ultimately, a stock analyst is interested in potential growth. Any factor that affects, or might
affect, that growth can be modeled. Also, comparisons among companies are important in
concluding a stock. Multiple models help an investor decide among various competitors in an
industry.
3.2 Historical Data
Bloomberg: Energy and Agriculture
Investors can find a quick view of the markets at Bloomberg.com/markets. A market snapshot
appears at the top of the page showing U.S., European, and Asian market data. Indexes from
the Americas, Europe, Africa, the Middle East, and Asia-Pacific regions can be readily
accessed.
Data for certain futures, commodities, bonds, and currencies are also available. By selecting
"Economic Calendar" under the "Market Data" heading, investors can view current and
upcoming economic announcements such as the EIA Petroleum Status Report. Delayed price
quotes and historical price charts are also provided.
Based on Phase 1, a project cannot be separated from things like defining a project scope,
project time-line and / or a project goals. To define project goal we will use a example from
mobile application project for the public transportation in the city of Brussels. The mobile
application has to allowed the users to:
Investors can find company-specific information regarding annual and quarterly financials,
key statistics and ratios, external links for analyst estimates, SEC filings (EDGAR Online), and
transcripts.
Under the "Charts & Data" tab on the home page, investors can find live, historical, and
technical charts for precious metals. In addition to news and usable market data, Kitco has an
online precious metals store called Kitco Metals Inc.
It is a retailer of precious metals including gold, silver, platinum, palladium, and rhodium.
Kitco is also a leading supplier of refining services, labware for mineral analysis, and
precision-crafted devices for manufacturing processes.
Investors can also find information regarding recent corporate events including preliminary
earnings announcements that have been reported on Form 8-K. Users can access the EDGAR
database at www.sec.gov/edgar to search by companies and filings, by all SEC-registered
companies in a particular state or country, or with a specific Standard Industrial Classification
(SIC) code. Current and historical EDGAR archives can be researched.
From here, investors can select from a variety of historical price charts ranging from one day to
several decades, with the option to include splits, dividends, and a modest assortment of
popular technical indicators. Investors can also compare historical data for two or more stocks
by using the "Compare" feature.
Financial models are essentially just tools to help people make business decisions. These
decisions often include: whether or not to invest in a company, asset, or security; whether or
not to invest in a project (project finance); whether or not to do a merger or acquisition (M&A),
and whether or not to raise money (e.g., do an IPO); and other corporate finance transactions.
The financial model allows decision makers to test scenarios, observe potential outcomes, and,
hopefully, make an informed decision. There is a lot of talk about software programs that can
be used, but the truth is that the vast majority of financial modeling takes place in Excel.
Here are some of the most important Excel tips for financial modeling:
• Use as many keyboard shortcuts as possible
• Keep formulas and calculations simple – break them down into smaller steps
• Use the grouping function to organize sections of the financial model
• Use F5 (go to special) to quickly locate all hardcoded numbers or formulas
• Use Trace Precedents and Trace Dependents to audit the model
• Use XNPV and XIRR to apply specific dates to cash flows
• Use INDEX MATCH over VLOOKUP for looking up information
• Use a combination of date functions (EOMONTH) and IF statements to make dates
dynamic
• Remove gridlines when presenting or sharing the financial model
• Memorize all the most important Excel formulas for financial modeling
• Use color-coding to distinguish between inputs and formulas (e.g., blue and black)
• Build a standalone 3 statement model on one worksheet (don’t separate the statements
onto different sheets)
• Clearly separate the assumptions or drivers from the rest of the model (one section at
the top)
• Use clear headers and subheads (with bold shading) to clearly distinguish sections
• Use the cell comments function (shift + F2) to describe calculations or assumptions that
need explaining
• Build in error checks such as ensuring the balance sheet balances (without a “plug”)
• Pull forward (or repeat) information where it helps users follow the logic of the model
(e.g., pull forward EBITDA from the income statement to the cash flow valuation
section)
• Avoid linking to other Excel workbooks unless absolutely necessary (and if so, clearly
indicate those links exist)
• Avoid circular references unless necessary (and use an iterative calculation to solve
them)
• Use tables, charts, and graphs to summarize important information
Figure 5 Amazon Valuation Modelling Course (corporatefinanceinstitute.com)
• Top-down analysis. In this approach, you start with the total addressable market TAM
and then work down from there based on market share and segments such as
geography, products, customers, etc., until you arrive at revenue.
• Bottom-up analysis. In this method, you start with the most basic drivers of the
business such as website traffic, then conversion rate, then order value, and finally
revenue, in the case of an e-commerce business.
• Regression analysis. With this type of forecast, you analyze the relationship between
the revenue of the business and other factors, such as marketing spend and product
price, by performing regression analysis in Excel.
• Year-over-year growth rate. This is the most basic form of forecasting. Simply use a
year-over-year (YoY) percentage growth rate.
From a financial modeling perspective, this is the least subjective part of the process. With the
assumptions clearly stated, an analyst more-or-less multiplies, divides, adds, or subtracts to
produce the statements. This is the step-by-step part of the financial modeling guide.
Step #1 – Begin by calculating revenue, based on the forecasting approach used from the above
section. From there, fill in the cost of goods sold (COGS), gross profit, and operating expenses,
and arrive at earnings before interest taxes depreciation and amortization (EBITDA).
Step #2 – Create supporting schedules for (i) capital assets (PP&E, depreciation, and capital
expenditures), (ii) working capital balances (accounts receivable, accounts payable, and
inventory), and (iii) financing schedules for equity capital, debt balances, and interest expense.
Step #3 – Finish the Income Statement (depreciation, interest, taxes, net income) and fill in the
Balance Sheet items except for cash, which will be the last part of the financial model to be
completed.
Step #4 – Build the Cash Flow Statement, consisting of cash from operating activities, cash
used in investing activities, and cash from financing activities. Combined, these three sections
will determine the closing cash balance, which links to the balance sheet to complete the
financial model.
Further Analysis
With the baseline financial model in place, it’s time to layer on whatever type of financial
modeling exercise suits the situation.
• DCF analysis – discounted cash flow analysis (DCF model) to value a business
• M&A analysis – evaluate the attractiveness of a potential merger, acquisition, or
divestiture (M&A model course)
• Capital raising – analyze the pro forma impact of raising debt or equity, or other
capital events
• LBO analysis – determine how much leverage (debt) can be used to purchase the
company (LBO model course)
• Sensitivity analysis – layering on a section that evaluates how sensitive the business or
the investment is to changes in assumptions or drivers (sensitivity analysis course)
It’s one thing to build a complex model that only you understand, but it’s another thing to
effectively communicate the risks, rewards, and critical factors to all audiences.
As the capstone for your financial modeling training, we recommend either an advanced Excel
course to learn how to build all the best charts and graphs for a presentation, dashboard, or any
other document you’re producing.
Figure 6 Financial Model (corporatefinanceinstitute.com)
4. Valuation
4.1 Introduction and Best Practices
Investment banks perform two basic, critical functions for the global marketplace. First,
investment banks act as intermediaries between those entities that demand capital (e.g.,
corporations) and those that supply it (e.g. investor). This is mainly facilitated through debt and
equity offerings by companies. Second, investment banks advise corporations on mergers &
acquisitions (M&A), restructurings, and other major corporate actions. The majority of
investment banks perform these two functions, although there are boutique investment banks
that specialize in only one of the two areas (usually advisory services for corporate actions like
M&A).
In providing these services, an investment bank must determine the value of a company. How
does an investment bank determine what a company is worth? In this guide you will find a
detailed overview of the valuation techniques used by investment bankers to facilitate these
services that they provide. While there are many different possible techniques to arrive at the
value of a company—a lot of which are company, industry, or situation-specific—there is a
relatively small subset of generally accepted valuation techniques that come into play quite
frequently, in many different scenarios.
These valuation techniques are easily the most commonly used, other than in valuations for
specific, niche industries such as oil & gas or metal mining (and even in those industries, the
aforementioned valuation techniques frequently come into play). Different parts of the
investment bank will use these core techniques for different needs in different circumstances.
Frequently, however, more than one technique will be used in a given situation to provide
different valuation estimates, with the concept being to triangulate a company’s value by
looking at it from multiple angels.
For example, M&A bankers are typically most interested in Transaction and Comparables
valuation for acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite
company shares in the public equity markets in advance of an initial public offering (IPO) or
secondary offering, and thus rely heavily on Comparables valuation. Financial sponsors and
leveraged finance groups will almost always value a company based upon leveraged buyout
(LBO) transaction assumptions, but will also look at others. Also, in many cases, all of these
groups will employ some degree of DCF valuation analysis. These different divisions of an
investment bank may come up with similar valuation ranges using some subset of the
techniques given, but will approach this process often with entirely different goals in mind.
Thus all of these techniques are used routinely by investment banks, and for a banking analyst,
at least some degree of familiarity with all of these techniques must be achieved in order for
that analyst to be considered proficient at his or her job.
However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact
estimate based on theory and computation), they often lose in accuracy (giving a true indicator
of the exact value of the company). DCFs are exceedingly difficult to get right in practice,
because they involve predicting future cash flows (and the value of them, as determined by the
discount rate), and all such predictions require assumptions. The farther into the future we
predict, the more difficult these projections become. Any number of assumptions made in a
DCF valuation can swing the value of the company—sometimes quite significantly. Therefore,
DCF valuations are typically most useful and reliable in a company with highly stable and
predictable cash flows, such as an established Utility company.
Because DCFs are so difficult to “get perfect,” they are typically used to supplement
Comparable Companies Analysis and Precedent Transaction Analysis.
Discounted Cash Flow Price Target Model
$ Values are in $'000s
Cost of Debt:
=
Cost of Debt * (1-0.3) Assume Debt Cost= 5%
What is the Cost of Debt?
=
Please calculate first and
5% * (1-0.30)
then remove this box for the
=
3,4%
answer. Thanks
Step 3: Calculate Net Present Value. What is the Net Present Value? Please
NPV = calculate first and then remove this box
$5.443
for the answer. Thanks
P/E ratios are used by investors and analysts to determine the relative value of a company's
shares in an apples-to-apples comparison. It can also be used to compare a company against its
own historical record or to compare aggregate markets against one another or over time.
To determine the P/E value, one must simply divide the current stock price by the earnings per
share (EPS).
The current stock price (P) can be found simply by plugging a stock’s ticker symbol into any
finance website, and although this concrete value reflects what investors must currently pay for
a stock, the EPS is a slightly more nebulous figure.
EPS comes in two main varieties. TTM is a Wall Street acronym for trailing 12 months. This
number signals the company's performance over the past 12 months. The second type of EPS is
found in a company's earnings release, which often provides EPS guidance. This is the
company's best-educated guess of what it expects to earn in the future. These different versions
of EPS form the basis of trailing and forward P/E, respectively.
The price-to-earnings ratio (P/E) is one of the most widely used tools by which investors and
analysts determine a stock's relative valuation. The P/E ratio helps one determine whether a
stock is overvalued or undervalued. A company's P/E can also be benchmarked against other
stocks in the same industry or against the broader market, such as the S&P 500 Index.
Sometimes, analysts are interested in long-term valuation trends and consider the P/E 10 or P/E
30 measures, which average the past 10 or past 30 years of earnings, respectively. These
measures are often used when trying to gauge the overall value of a stock index, such as the
S&P 500, because these longer-term measures can compensate for changes in the business
cycle.
The P/E ratio of the S&P 500 has fluctuated from a low of around 5x (in 1917) to over 120x (in
2009 right before the financial crisis). The long-term average P/E for the S&P 500 is around
16x, meaning that the stocks that make up the index collectively command a premium 16 times
greater than their weighted average earnings.
These two types of EPS metrics factor into the most common types of P/E ratios: the forward
P/E and the trailing P/E. A third and less common variation uses the sum of the last two actual
quarters and the estimates of the next two quarters.
The forward (or leading) P/E uses future earnings guidance rather than trailing figures.
Sometimes called "estimated price to earnings," this forward-looking indicator is useful for
comparing current earnings to future earnings and helps provide a clearer picture of what
earnings will look like—without changes and other accounting adjustments.
However, there are inherent problems with the forward P/E metric—namely, companies could
underestimate earnings in order to beat the estimated P/E when the next quarter's earnings are
announced. Other companies may overstate the estimate and later adjust it going into their next
earnings announcement. Furthermore, external analysts may also provide estimates, which
may diverge from the company estimates, creating confusion.
As a historical example, let's calculate the P/E ratio for Walmart Inc. (WMT) as of Nov. 14,
2017, when the company's stock price closed at $91.09.2 The company's profit for the fiscal
year ending Jan. 31, 2017, was $13.64 billion, and its number of shares outstanding was 3.1
billion. Its EPS can be calculated as $13.64 billion / 3.1 billion = $4.40.3
Bank of America Corporation (BAC) closed out the year 2017 with the following stats:4
In other words, Bank of America traded at roughly 19x trailing earnings. However, the 18.92
P/E multiple by itself isn't helpful unless you have something to compare it with, such as the
stock's industry group, a benchmark index, or Bank of America's historical P/E range.
Bank of America's P/E at 19x was slightly higher than the S&P 500, which over time trades at
about 15x trailing earnings.
To compare Bank of America's P/E to a peer's, we calculate the P/E for JPMorgan Chase & Co.
(JPM) as of the end of 2017:4
When you compare Bank of America's P/E of almost 19x to JP Morgan's P/E of roughly 17x,
Bank of America stock does not appear as overvalued as it did when compared with the
average P/E of 15 for the S&P 500. Bank of America's higher P/E ratio might mean investors
expected higher earnings growth in the future compared to JPMorgan and the overall market.
However, no single ratio can tell you all you need to know about a stock. Before investing, it is
wise to use a variety of financial ratios to determine whether a stock is fairly valued and
whether a company's financial health justifies its stock valuation.
In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. A low P/E can indicate either that a company may
currently be undervalued or that the company is doing exceptionally well relative to its past
trends. When a company has no earnings or is posting losses, in both cases, the P/E will be
expressed as N/A. Though it is possible to calculate a negative P/E, this is not the common
convention.
Important Note: A P/E ratio of N/A means the ratio is not available or not applicable for that
company's stock. A company can have a P/E ratio of N/A if it's newly listed on the stock
exchange and has not yet reported earnings, such as in the case of an initial public offering
(IPO), but it also means a company has zero or negative earnings, Investors can thus interpret
seeing N/A as a company reporting a net loss.
The price-to-earnings ratio can also be seen as a means of standardizing the value of $1 of
earnings throughout the stock market. In theory, by taking the median of P/E ratios over a
period of several years, one could formulate something of a standardized P/E ratio, which
could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.
The concept of total addressable market is important for startups and existing businesses
because the estimates of effort and funding required allow them to prioritize specific products,
customer segments, and business opportunities. Where there are potential investors and buyers
of the business, company executives can use TAM to provide a viable value proposition.
Figure 10 Total Addressable Market (TAM) Illustration
Creating a viable value proposition involves estimating the market size, size of the overall
investment, competition, growth expected, and the available market size. All this can be
achieved through TAM. For example, when a private equity firm intends to acquire a startup
company, it can use TAM to estimate the revenue generation potential of a product or service
offered by that company.
TAM takes into account the products and customer segments that remain untapped by the
startup. The assessment helps to determine the actual size of the available market and the
prevailing competition for the products offered by the startup.
There are three methods used to calculate the total addressable market. They include:
#1 Top Down
The top-down analysis follows a process of elimination that starts by taking a large population
of a known size that comprises the target market and using it to narrow down to a specific
market segment. Top-down analysis can be represented by an inverted pyramid that shows the
large population of a known segment at the top and the narrowed down segment at the bottom.
The method uses industry research and reports to get the estimates of the population.
An example is a start-up technology company that offers an app targeting small businesses that
cannot afford premium accounting software. The company relies on industry research that
shows that there are 1 billion businesses around the world, out of which 30% lack access to
premium accounting software (30% x 1 billion customers = 300,000,000 potential customers).
Research shows that 90% of businesses that do not use a premium accounting application
employ an in-house full-time accountant. This brings the number of potential businesses to
10% x 300,000,000= 30,000,000. If the business is offering the application for free but with
subscriptions of $100 per year, the estimated total addressable market is $3 billion (30,000,000
x 100). (All the figures used are based on assumptions).
#2 Bottom Up
Bottom-up analysis is a more reliable method because it relies on primary market research to
calculate the TAM estimates. It uses more reliable data on the current pricing and usage of a
product. For example, for a startup company with a free accounting mobile app and annual
subscriptions worth $100, it can take a reasonable estimate of the number of businesses in its
target market to obtain the TAM.
The advantage of using a bottom-up approach is that the company can explain why it selected
certain customer segments and left out others. The company relies on data from its research or
survey and, therefore, the addressable market would be more relevant and accurate rather than
when relying on inarguable data.
#3 Value Theory
Value theory relies on an estimate of the value provided to customers by the product and how
much of that value can be reflected in the product pricing. A company estimates how much
value it can add and why it should capture this value through the product pricing. Value theory
is used to calculate TAM when a company is introducing new products into the market or
cross-selling certain products to existing customers.
The value theory approach can be used to estimate Uber’s addressable value. Users opting to
use Uber taxis enjoy the option of driving themselves, using public means, or taking the
competitor’s taxis. Since users are willing to forego all these alternatives and take an Uber taxi,
the company can estimate the value that these users derive from using the Uber taxis and
determine how to capture the value in its pricing.
TAM, SAM, and SOM represent the various subsets of a market. TAM refers to the total
demand for a product or service that is calculated in annual revenue. SAM stands for
Serviceable Available Market, and it is the target addressable market that is served by a
company’s products or services.
SOM, on the other hand, is an acronym for Serviceable Obtainable Market, which is the
percentage of SAM that can be realistically achieved. Identifying these subsets within an
industry requires some market research to understand the proportions of each area.
An example is consumer expenditure on food in the UK. In 2014, the value of this market was
estimated to be 200 billion euros, which represents the total addressable market. The consumer
food market entails fresh food, and alcoholic and non-alcoholic drinks.
The alcoholic drinks industry, which served 49 billion euros, is the serviceable available
market (SAM). The industry contains several large manufacturers and suppliers who service
the market. A section of the alcoholic drinks industry that is served by one manufacturer is the
serviceable obtainable market (SOM).
The Total Addressable Market is one of the essential metrics that startups and existing
companies use to estimate the potential scale of the market in terms of total sales and revenues.
When a company is in the process of releasing a new product, a new customer segment, or plan
to cross-sell an existing product to existing customers, TAM helps in breaking down these
numbers into manageable levels. An investor should be objective in estimating the available
market because an exaggerated value may lead to markets with less potential for growth. The
ideal market for any entrepreneur is one with potential growth capacity.
One way to analyze your financial health and identify how it might be improved is by looking
closely at your financial ratios. Ratios are used to make comparisons between different aspects
of a company's performance or how the company stacks up within a particular industry or
region. They reveal very basic information such as whether you have accumulated too much
debt, stockpiled too much inventory or are not collecting receivables fast enough.
A common use of financial ratios is when a lender determines the stability and health of your
business by looking at your balance sheet. The balance sheet provides a portrait of what your
company owns or is owed (assets) and what it owes (liabilities). Bankers will often make
financial ratios a part of your business loan agreement. For instance, you may have to keep
your equity above a certain percentage of your debt, or your current assets above a certain
percentage of your current liabilities.
But ratios should not be evaluated only when visiting your banker. Ideally, you should review
your ratios on a monthly basis to keep on top of changing trends in your company. Although
there are different terms for different ratios, they fall into 4 basic categories.
Liquidity Ratios
These measure the amount of liquidity (cash and easily converted assets) that you have to cover
your debts, and provide a broad overview of your financial health.
The current ratio measures your company's ability to generate cash to meet your short-term
financial commitments. Also called the working capital ratio, it is calculated by dividing your
current assets—such as cash, inventory and receivables—by your current liabilities, such as
line of credit balance, payables and current portion of long-term debts.
The quick ratio measures your ability to access cash quickly to support immediate demands.
Also known as the acid test, the quick ratio divides current assets (excluding inventory) by
current liabilities (excluding current portion of long-term debts). A ratio of 1.0 or greater is
generally acceptable, but this can vary depending on your industry.
A comparatively low ratio can mean that your company might have difficulty meeting your
obligations and may not be able to take advantage of opportunities that require quick cash.
Paying off your liabilities can improve this ratio; you may want to delay purchases or consider
long-term borrowing to repay short-term debt. You may also want to review your credit
policies with clients and possibly adjust them to collect receivables more quickly.
A higher ratio may mean that your capital is being underutilized and could prompt you to invest
more of your capital in projects that drive growth, such as innovation, product or service
development, R&D or international marketing.
But what constitutes a healthy ratio varies from industry to industry. For example, a clothing
store will have goods that quickly lose value because of changing fashion trends. Still, these
goods are easily liquidated and have high turnover. As a result, small amounts of money
continuously come in and go out, and in a worst-case scenario liquidation is relatively simple.
This company could easily function with a current ratio close to 1.0.
On the other hand, an airplane manufacturer has high-value, non-perishable assets such as
work-in-progress inventory, as well as extended receivable terms. Businesses like these need
carefully planned payment terms with customers; the current ratio should be much higher to
allow for coverage of short-term liabilities.
Efficiency Ratios
Often measured over a 3- to 5-year period, these give additional insight into areas of your
business such as collections, cash flow and operational results.
Inventory turnover looks at how long it takes for inventory to be sold and replaced during the
year. It is calculated by dividing total purchases by average inventory in a given period. For
most inventory-reliant companies, this can be a make-or-break factor for success. After all, the
longer the inventory sits on your shelves, the more it costs.
Assessing your inventory turnover is important because gross profit is earned each time such
turnover occurs. This ratio can enable you to see where you might improve your buying
practices and inventory management. For example, you could analyze your purchasing patterns
as well as your clients to determine ways to minimize the amount of inventory on hand. You
might want to turn some of the obsolete inventory into cash by selling it off at a discount to
specific clients. This ratio can also help you see if your levels are too low and you're missing
out on sales opportunities.
Inventory to net working capital ratio can determine if you have too much of your working
capital tied up in inventory. It is calculated by dividing inventory by total current assets. In
general, the lower the ratio, the better. Improving this ratio will allow you to invest more
working capital in growth-driven projects such as export development, R&D and marketing.
Evaluating inventory ratios depends a great deal on your industry and the quality of your
inventory. Ask yourself: Are your goods seasonal (such as ski equipment), perishable (food) or
prone to becoming obsolete (fashion)? Depending on the answer, these ratios will vary a great
deal. Still, regardless of the industry, inventory ratios can you help you improve your business
efficiency.
Average collection period looks at the average number of days customers take to pay for your
products or services. It is calculated by dividing receivables by total sales and multiplying by
365. To improve how quickly you collect payments, you may want to establish clearer credit
policies and set collection procedures. For example, to encourage your clients to pay on time,
you can give them incentives or discounts. You should also compare your policies to those of
your industry to ensure you remain competitive.
Profitability ratios
These ratios are used not only to evaluate the financial viability of your business, but are
essential in comparing your business to others in your industry. You can also look for trends in
your company by comparing the ratios over a certain number of years.
Net profit margin measures how much a company earns (usually after taxes) relative to its
sales. A company with a higher profit margin than its competitor is usually more efficient,
flexible and able to take on new opportunities.
Operating profit margin, also known as coverage ratio, measures earnings before interest and
taxes. The results can be quite different from the net profit margin due to the impact of interest
and tax expenses. By analyzing this margin, you can better assess your ability to expand your
business through additional debt or other investments.
Return on assets (ROA) ratio tells how well management is utilizing the company's various
resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The
number will vary widely across different industries. Capital-intensive industries such as
railways will yield a low return on assets, since they need expensive infrastructure to do
business. Service-based operations such as consulting firms will have a high ROA, as they
require minimal hard assets to operate.
Return on equity (ROE) measures how well the business is doing in relation to the investment
made by its shareholders. It tells the shareholders how much the company is earning for each of
their invested dollars. It is calculated by dividing a company’s earnings after taxes (EAT) by
the total shareholders’ equity, and multiplying the result by 100%.
A common analysis tool for profitability ratios is cross-sectional analysis, which compares
ratios of several companies from the same industry. For instance, your business may have
experienced a downturn in its net profit margin of 10% over the last 3 years, which may seem
worrying. However, if your competitors have experienced an average downturn of 21%, your
business is performing relatively well. Nonetheless, you will still need to analyze the
underlying data to establish the cause of the downturn and create solutions for improvement.
Leverage ratios
These ratios provide an indication of the long-term solvency of a company and to what extent
you are using long-term debt to support your business.
Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed,
whether it comes from creditors or your own investments, for example. In general, a bank will
consider a lower ratio to be a good indicator of your ability to repay your debts or take on
additional debt to support new opportunities.
For a fee, industry-standard data is available from a variety of sources, both printed and online,
including Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual
Statement Studies and Statistics Canada (search for Financial Performance Indicators for
Canadian Business). Industry Canada's SME Benchmarking Tool offers basic financial ratios
by industry, based on Statistics Canada small business profiles.
6. Conclusion
In conclusion, accounting and finance can be differentiate by education, job, skills, tools and
ethics. First of all, the jobs scope of accounting is to record the transactions and provide a
financial report. Nonetheless, financier are to do analysis base on the financial report which
provided by the company. Not only that, financier also have to do decision making regarding
on the financial reports. In additional, accounting professionals is to see how the company is
performing and to make sure that the day to day accounting is in good operations. For finance,
they have to forecast how is the company performance in the future. In my opinion, accounting
and finance both are totally different because base on the proofs above we know that
accounting and finance have different skills
*END OF REPORT*