Introduction to Financial Analysis
This article is an effort to provide a short review of the most important financial statements, their most common metrics, and their role in strategy, to serve as a common language that helps us all start on the same page when discussing a financial analysis or the financial side of the strategy of any business.
While we will try to stick to the Generally Accepted Accounting Principles (GAAP) with which all public companies must report their financials, bear in mind that both public and private companies are also free to present their numbers in non-GAAP statements.
This review is broken down into multiple parts each covering an important piece of the strategist’s financial toolkit:
- Introduction to the Balance Sheet
- Introduction to the Income Statement
- Introduction to the Cash Flow Statement
- Other Important Financial Metrics
- The Cash Conversion Cycle
- Understanding Time Value of Money
- Calculating Return on Investment
- Using Enterprise Value for a Comps Valuation Analysis
- The Only Strategy Book You’ll Ever Need
- References
This review is by no means an attempt to serve as a replacement for a more thorough source on financial analysis. You can check the references at the end of this page or read our Capital Allocation section for more information on specific subjects.
To get the most out of this review, we recommend that you head over to Google Finance, pick a company of your choice, and do a financial analysis of that company as you go through the next sections.
Now Let’s dive in.
Financial Analysis: Why the Balance Sheet is the gatekeeper
A company’s balance sheet is a financial report that provides a view of the company’s assets, its liabilities and stakeholders’ equity at a given point in time, and is critical to any financial analysis.
Shareholders’ equity, which is the value of investors’ stake in the business, is calculated as the difference between what the business owns (its assets) and what it owes (its liabilities) at that particular time.
A balance sheet therefore always adheres to the basic formula:
Assets = Liabilities + Shareholders’ Equity
Or put in other words:
Shareholders’ Equity = Assets – Liabilities
The general rule of the Balance Sheet is that the company’s Assets must always match its Liabilities plus Shareholders’ equity. The balance sheet always balances is what any accountant, veteran or not, will tell you.
Financial Analysis: Why does the Balance Sheet always balance?
Simple, because it does. Let us give you an example. Let’s say that a company starts out with a capital injection of $10 million from its investors. At that point, the balance sheet of the startup will show $10 million in Cash as assets, and $10 million in the equity section.
That means that at that moment the total equity of the shareholders is $10 million in cash.
Now let’s say that executives spend $2 million in cash buying a truck. As soon as the transaction is recorded, the balance sheet will show only $8 million on the cash line, while $2 million will go to Fixed Assets.
Total Assets are still $10 million ($8 million in cash plus $2 million in Fixed Assets), and match the $10 million we have in equity at the other side of the balance sheet.
Now let’s say that the company borrows $2 million through a commercial loan. Since the loan is received in the form of cash, the Cash line in the balance sheet goes up to $10 million again which, added to the $2 million we already had in Fixed Assets, totals $12 million.
At the same time, the loan creates a Liability (in this case an Account Payable) which along with the $10 million we had in common stock adds up $12 million, equalizing the asset side.
Now let’s say that the company borrows $2 million through a commercial loan. Since the loan is received in the form of cash, the Cash line in the balance sheet goes up to $10 million again which, added to the $2 million we already had in Fixed Assets, totals $12 million.
At the same time, the loan creates a Liability (in this case an Account Payable) which along with the $10 million we had in common stock adds up $12 million, equalizing the asset side.
Make sure you understand these concepts as they are very important in any real-life financial analysis.
Now, for the sake of the example, let’s say that the company decides to pay its lenders $1 million to cut its debt in half. Now its Cash line will go down $1 million (to $9 million) and its Debt line will also go down by the same amount (to $1 million) to reflect the payment made.
Every transaction that’s recorded will move things around but in the end, both sides must always balance out in your financial analysis.
Breaking down the balance sheet in your financial analysis
The Assets side of the Balance Sheet is usually divided into Current Assets, which are those that can be converted into cash within a year, and Non-Current or Long-term Assets which would take longer than Current Assets to be “cashed” or liquidated.
The most common categories to break down the Current Assets section include:
- Cash and Cash Equivalents: This includes money at hand (in bank accounts) and other “liquid assets” that could be turned into cash in a short time, something like a day or so.
- Marketable Securities: Sometimes referred to as Short-Term Investments, this line includes equity securities that can be traded in a liquid market such as common stock, commercial papers and treasury bills.
- Accounts Receivable (A/R): Money that customers owe the company. This is in most cases related to products that have been sold but haven’t been paid for yet.
- Prepaid Expenses: Expenses that have been paid in advance but are being spread over a period of time, for example an insurance plan or rent that’s paid upfront, or an advertising campaign that will benefit the company for multiple years.
- Inventory: Goods ready to be sold, or in the process of production.
Long-term Assets on the other hand include those assets that would take more than a year to liquidate and are usually classified as:
- Property, Plant and Equipment (also PPE or Fixed Assets): All physical assets the company owns including buildings, vehicles, land, computers and others.
- Long-term Investments: Securities that can’t be or that are not expected to be liquidated within a year.
- Intangible Assets: Non-physical items such as intellectual property, research and development costs and “goodwill” (excess money paid to buy an asset or a company).
- Accumulated Depreciation: This is usually a negative number on the Assets side of the balance sheet, to account for the loss of value that buildings and equipment accumulate because of their use in the business operations.
At the other side of the Balance Sheet, the Liabilities section is usually split into Current and Long-term Liabilities in your financial analysis.
Current Liabilities are those that need to be taken care of within a year, and include some of the following items:
- Current Portion of Long-term Debt: The part of the long-term debt that is due within the current year.
- Accounts Payable: Money that the company owes to its vendors that hasn’t been paid yet.
- Short-term Liabilities: This line includes other short-term payments the company has to make, but that hasn’t yet, for example payroll.
- Deferred Revenues or Customer Prepayments: Money received from the sale of products or services that have not yet been delivered to customers.
Long-term Liabilities on the other hand are usually broken down into:
- Long-term Debt: This includes the portion of the long-term debt (loans) that is not due within the current year.
- Long-term Liabilities: Long-term liabilities other than loans such as deferred bonuses, taxes and pension funds.
Finally, the Owner or Shareholder equity section is usually broken down as:
- Retained Earnings: After-tax profits that have been earned but not paid to shareholders because they have been reinvested in the business or used to pay off debt (in short, this is money that could have otherwise been paid out as dividends to shareholders).
- Preferred Stock: Shares that received special payment schedules, usually of higher priority (or seniority) than Common Stock.
- Common Stock: These are the shares that represent common ownership of the company, and usually the voting rights.
Example: Amazon’s Financial Statements
Just as a reference, the next figure shows Amazon’s simplified Balance Sheet for the year ending December 31st, 2017 (source: NASDAQ).
The Balance Sheet is considered by most experts as the most important financial analysis statement as it presents a snapshot of a company’s ability to pay its duties and make money.
It is very important that you read any footnotes when reviewing the balance sheet of publicly traded companies as they may reveal information that is critical for a good understanding of the numbers.
Financial Analysis: Common Balance Sheet Financial Metrics
From the information shown in a company’s balance sheet, we can calculate important metrics that can help us analyze its financial health. One of these metrics is the Current Ratio, calculated as Current Assets divided by Current Liabilities.
The Current Ratio is a quick indication of the liquidity of the company at a given point in time as it measures whether the company could get enough cash within a year to pay for long term liabilities.
A Current Ratio that’s lower than one indicates that the company could run out of cash to cover its obligations within the next 12 months, and for many its optimal value is somewhere between 1.2 and 2.0 but it varies across industries and companies. Something to have in mind when analyzing the finances of any company.
Nevertheless, this metric only provides a quick indication of liquidity and should not replace a more thorough financial analysis if evaluating a company’s real ability to pay its bills.
A more conservative measure of the company liquidity is the Quick Ratio, which subtracts Inventory from the Current Ratio calculation:
The Quick Ratio may be a better indicator for some companies who may not be able to realize the full value of their inventory within the short term.
Financial Analysis: Working Capital
Another important metric that can be calculated from a company’s Balance Sheet is its Working Capital, or the amount of money it needs to finance its operation in the short term. It is calculated as the difference between Current Assets and Current Liabilities.
Working Capital = Current Assets – Current Liabilities
A low or positive Working Capital is usually preferable, but just like most metrics it varies across industries and the particular preferences of a company.
As you may guess, Working Capital is directly influenced by the payment terms negotiated with vendors and buyers, where the sooner we get money from buyers and the later we pay vendors the less money we need in the form of Working Capital to finance operations.
One company that created a whole business model by challenging the way Working Capital was used in its industry was Dell Computers.
When it first came out with its build-on-demand business model, where customers would pay for computers before they were made, it put Dell in a favorable position against its competitors who had to spend a lot in Working Capital to make their computers that would later be placed on the shelves of their distribution channels.
Under that model, manufacturers wouldn’t get their money back until 30 or even 90 days after the computers were sold to final customers, which meant they had to finance the whole operation during the time it took to manufacture, distribute and sell the computers.
But by getting the money before the computers were made and the parts ordered, Dell flipped the conventional use of Working Capital from negative to positive, providing the company with a strong financial advantage to quickly grow and expand its operations.
As you may have noticed, the formula used to calculate Working Capital in a financial analysis is similar to how we calculated the Current Ratio in that they both use Current Assets and Current Liabilities. For that reason, the Current Ratio is also commonly referred to as the Working Capital Ratio.
Finally, one of the most utilized balance sheet metrics in any financial analysis is the Debt-to-Equity ratio, which compares a company’s Total Liabilities to Shareholder’s Equity to measure how much of the value that the owners have invested in the company is being financed by vendors, lenders and creditors.
Although a low debt-to-equity ratio may be preferable, it may flag an inefficient capital allocation practice.
Financial Analysis: How the Income Statement shows where profitability comes from
In a nutshell, the Income Statement estimates the profit that a business makes during a particular period. It provides a summary of the business’s revenues and its costs, breaking these down into those related to the actual goods sold and the costs related to running the business.
An Income Statement calculates three types of profit:
- Gross Profit: This represents the gross margin made by the business from selling its products and services. It is calculated as the difference between sales (revenues) and the cost of the goods or services being sold (also known as COGS for Cost of Goods Sold).
- Operating Profit: Also known as EBIT (Earnings Before Interests and Taxes), this is calculated as Gross Profit minus operating expenses, which is a major category including all direct and indirect Selling, General and Administrative expenses or SG&A (some people call it overhead), amortization and depreciation.
- Net Profit (also known as “Net Earnings”): This is what is left after taxes, interest expenses and one-time charges are deducted from the Operating Profit (EBIT). This is the “bottom line” of the income statement and is used to calculate key company metrics such as Price to Earnings (P/E) and Earnings per Share (EPS) which we explore later in this appendix.
Through the Income Statement we can measure the profitability of a business unit or product division. Gross Profit for example measures the margins that the business makes from selling its products, while Operating Profit measures how much the company earns from running the business.
In the same way, we can also argue that since Net Earnings account for taxes and interest payments they are a measure of the financial management of the business. This financial management is super important when it comes to analyzing a business because taxes and debt, if not optimized, can become a burden to growth.
When Toys R Us filed for bankruptcy in September 2017, it disclosed that the company had around $5 billion in debt and was spending somewhere around $400 million a year servicing that debt, which prevented the company from investing in innovation and the improvement of their facilities.
You must sometimes go an extra mile in order to optimize these costs. One of the reasons Amazon located its headquarters in Seattle was that because of the relatively low population it would only have to collect taxes from a minor percentage of customers (as merchants in the US are not required to collect taxes from out-of-state sales).
Financial Analysis Example: Amazon’s Income Statement
For illustration purposes, the next figure shows a simplified version of Amazon’s Income Statement for the year ending December 31st, 2017 (Source: NASDAQ).
Important Income Statement Metrics in your Financial Analysis
The income statement provides a lot of insights into the profitability of a business unit or organization, and there are a few metrics that we can calculate from it that can help us extract even more useful information.
One of these metrics is Gross Margin, which calculates the percentage of sales that is retained in the form of profit from the sales of products and services.
A similarly important metric is the Operating Margin, which calculates the profit that a company makes from running the business measured as a percentage of sales.
Following the same approach, we can also calculate the Profit Margin ratio, to measure the percentage of sales that the business is producing after accounting for interests, taxes and one-time charges.
We could argue that the difference between the Operating Margin and the Profit Margin has a lot to do with the financial management of the business and how well this is optimized to minimize the impact of taxes and debt in the value created for shareholders.
From a company’s income statement we can also calculate the business’s EBITDA (Earnings Before Interests, Taxes, Depreciation and Amortization), a non-GAAP investors’ favorite metric that provides a general view of the performance of the business by itself, before accounting for its financing.
The formula to calculate EBITDA from an income statement is fairly simple:
EBITDA = Net Income + Depreciation + Amortization + Interest
As you can see, a company’s EBITDA adjusts Net Income for non-cash expenses such as depreciation and amortization, and for other expenses related to how the business finances its operations (by adding back interests and taxes), making the metric neutral in terms of capital structure choices.
Finally, two metrics that are very popular among investors in public companies are the Earnings Per Share and Price to Earnings ratios.
Earnings per Share (EPS) measures the amount of money that each shareholder would receive if the company paid all of its earnings during a given period as dividends and is calculated as the Net Income minus preferred dividends divided by the number of outstanding shares of the company.
Preferred dividends are a special type of stock which grants dividend rights for the holders, so to measure the earnings that would be available to common shareholders, they must be subtracted from the total Net Income when analyzing the financial information of a company.
The Price-to-Earnings or P/E ratio on the other hand calculates the relative value of a company stock at a given point in time, with respect to its EPS.
This ratio is also commonly known as the price or earnings “multiple”. As you may expect, the P/E ratio is calculated by dividing the stock price by the company’s EPS.
Both EPS and P/E are used by investors and market analysts to assess the value of a stock, as they benchmark the ability of a business to produce earnings with the price of its stock at a given time.
Financial Analysis: Your Cash Flow is the “real” reality check
The Cash Flow Statement has been part of the official financial reports that public corporations must make available since 1987. In short, a cash flow statement summarizes a company’s inflows and outflows of cash during a given period, so in a sense, when you look at it and analyze it you’re basically taking a peek at the company’s bank accounts.
A cash flow statement is different from the income statement in that it only accounts for cash transactions, so credit or non-cash expenses such as depreciation and amortization are not accounted for.
Financial Strategy tips: How the Cash Flow is broken down
A cash flow statement is broken down into three sections in the following order: Cash Flow from Operations, Cash Flow from Investment Activities and Cash Flow from Financing Activities.
All three sections have critical information for any financial analysis.
The first part of the statement, Cash Flow from Operating Activities, includes the cash the business received from customers or any other sources, and the cash payments the business made during that period.
There are two ways to calculate cash flows from operating activities. A direct approach records all major cash transactions, both in and out of the business, such as cash sales, debt collections, and cash spent paying vendors, payroll, utilities, rent and others during the period.
An indirect approach begins with the bottom line of the income statement (Net Earnings) and adds and subtracts differences in key accounts such as accounts receivable, inventory and accounts payable, and in non-cash transactions like depreciation and amortization, to reflect the real movement of money.
Most publicly listed companies prefer to use the indirect approach to report their cash flow statements as it is easier to analyze.
A healthy operating cash flow means that the company can finance its growth with minimum or no need for loans and cash injections. Remember how “low capital needs” is one of the metrics that Warren Buffett likes to see when looking at a company, and this can be measured from the operating cash flow.
The second part of statement, Cash Flow from Investment Activities, reports all the cash investments made by the company during the reporting period, including any purchases and sales of equipment, land or financial securities.
A company with a low balance of investment activities relative to similar peers suggests that management might not be re-investing enough in the future of the company. They might be either struggling to find growth opportunities, or just “milking it while it lasts” which is typical in declining industries.
In a growing industry, however, this number usually needs to be high and growing (see Amazon’s simplified cash flow statement at the end of this section).
Finally, the third section of a cash flow statement that you must analyze, Cash Flow from Financing Activities, includes cash that moves in and out of the business in relation to debt, loans and transactions with shareholders such as dividend payouts.
Good capital allocators use debt strategically (for example to finance opportunistic acquisitions and share repurchases), avoid paying dividends and decrease the number of outstanding shares over time through opportunistic buybacks, activities that are reflected in this section of the cash flow statement.
As an example, the figure below shows Amazon’s simplified cash flow statement for the period ending December 31st, 2017 (Source: NASDAQ).
Cash Flow Metrics you need in your financial analysis
Just as with the other statements, the statement of Cash Flows can produce powerful indicators to help us analyze and understand the real financial health of a business unit.
One metric that has become increasingly popular with Wall Street analysts is Free Cash Flow or FCF, which measures the cash a company is able to generate after accounting for all capital expenses needed to maintain its asset base.
FCF can be calculated from the cash flow statement by subtracting capital expenditures (also known as CAPEX) from the company’s operations cash flow.
FCF = Cash Flow From Operations – Capital Expenditures
A longer version would work its way from the Operating Profit (EBIT) in the Income Statement and make the proper adjustments to correct for cash and non-cash transactions, for example:
For analysts, FCF represents the cash that a company can use to enhance shareholder value and is used to provide a measure of the true profitability of a business. In the end, you can’t pay your bills with Net Earnings.
Another popular ratio when it comes to cash flows is the Operating Cash Flow to Sales or CFO/Sales which measures the ability of a business to convert sales into cash.
An obviously important ratio that can be calculated from the cash flow statement is the Free Cash Flow to Operating Cash Flow which measures the amount of free cash that the business produces that could be used to boost its own growth.
These are both important indicators not only from an investor’s point of view to value the
Other Important Metrics in your Financial Analysis
Let’s review a few important financial analysis metrics that use information from more than one statement.
Let’s start with Coverage Ratios, which measure the ability to serve debt and other liabilities with the cash the business produces. The two most used are the Current Liability and Long-term Debt coverage ratios.
To calculate the Current Liability Coverage Ratio, we divide the cash flow from operations by Current Liabilities.
Alternatively, you could use only short-term debt as the denominator to get a measure of the business’s ability to pay its debt within the next year.
Similarly, to calculate the Long-term Debt Coverage Ratio, we divide our Cash Flow from Operations by the total Long-term Debt.
To get a measure of how a business manages its assets to produce cash we can calculate the Asset Efficiency Ratio as Cash Flow from Operations divided by Total Assets.
Similarly, we can calculate the Return on Assets (ROA) by using Net Earnings instead of Cash Flow From Operations as in the previous formula.
Another metric that is very popular among investors and market analysts is the Return on Invested Capital or ROIC which measures the return that investors are making on their investment in the company.
ROIC is best calculated by dividing the Net Operating Profit After Taxes (NOPAT) by the Total Invested Capital.
NOPAT is calculated from the income statement by subtracting taxes from the operating income (also known as EBIT):
NOPAT = EBIT x (1 – Tax Rate)
There are multiple ways to calculate and analyze the invested capital from the balance sheet but probably the most direct approach is by subtracting Current Liabilities and Cash from the company’s Current Assets, then adding Long-Term or “fixed” assets:
Key Financial Analysis Concept: Cash Conversion Cycle
Finally, let’s review a business metric that can tell us a lot about a business’s operations: the Cash Conversion Cycle or CCC. In short, CCC measures the amount of time it takes a company to convert its investment in raw materials into cash.
In essence, the CCC can be calculated as the sum of the days to convert raw materials into sales plus the number of days it takes customers to pay, minus the number of days that the business gets from vendors to pay for raw materials.
CCC is most well known by its formula:
CCC = DIO + DSO – DPO
Where:
DIO: Days of Inventory Outstanding
DSO: Days of Sales Outstanding
DPO: Days Payable Outstanding
For example, if we say that on average it takes the company 15 days to convert raw materials into sales, and that vendors require payment within 30 days after delivery of raw materials while customers have 60 days to pay for final products, then the CCC can be calculated as:
CCC = 15 + 60 – 30 = 45 days
That is the number of days that this operation must finance its operations. In other words, the company has to pay vendors for raw materials 45 days before it receives the money from the products made with those raw materials.
If the company makes $10 million a year in sales, which on average means sales of around $27,000 per day, it means that the business would need around $1.2 million (or 12 percent of sales) in working capital to finance customers.
When information about Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO) as these metrics are formally known is not available, they can be approximated from the information in the business’s financial statements.
To estimate DIO (inventory), we can take the average inventory from the balance sheet and divide by the average cost of goods sold (COGS) per day which can be obtained from the income statement.
To calculate the DSO (Days Sales Outstanding), we can use the average Accounts Receivable from the balance sheet and divide by the average sales per day (which are obtained from the Income Statement).
Following a very similar approach we can calculate the DPO as:
A higher CCC means that a larger amount of money will be trapped in the business financing customers, while a negative CCC means that the business holds onto customer cash before serving the products, which in a way is like saying that customers are financing other customers.
Financial Analysis: Time Value of Money
A final concept we want to briefly refresh here is the Time Value of Money, the idea that one dollar today is worth more than a dollar tomorrow, and that consequently one dollar tomorrow is worth less than a dollar today.
To understand how this works, let’s assume that you make an investment today that yields a certain percentage return rate “r” per year. At the end of the first year, that investment would have gained some interest, and it would be worth:
I1 = I0 x (1+r)
Where 0 and 1 represent the beginning and the end of the investment period respectively. That means that the investment at the end of the period (I1) is higher than the initial investment (I0) by a factor of (1+r).
If we leave the money in that investment for another period, the money will gain interest again and now the amount of money at the end of the second period will be:
I2 = I0 x (1+r) x (1+r), which can also be represented as I2 = I0 x (1+r)2
Following the same logic, we can then say that the value of the investment at the end of any period n in the future, can be calculated as:
In = I0 x (1+r)n
In is what in finance we call the Future Value of I0 and is the basis of many interest-based investment calculations. From the same formula, we can deduce that the Present Value I0 of a given amount of money in the future In is then:
That’s how financial analysts calculate how much
Where I1, I2 and I3 represent the cash flow generated by an investment during periods 1, 2 and 3 respectively.
The factor (1+r)n is the basis of introducing Time Value of Money into any financial calculation, and is used several times in this appendix.
Calculating Return on Investment (ROI) in your Financial Analysis
When evaluating capital allocation decisions, the decisive factor to analyze is the Return on Investment also known as ROI. In practice, there are multiple ways to calculate the ROI of new projects but the most widely used is a combination of Net Present Value, Internal Rate of Return, and Payback.
Each one provides a unique view of returns that can be used to determine overall financial feasibility, but none is by itself a replacement for the other two.
Important Financial Analysis Concept: Net Present Value
The Net Present Value (NPV) of an investment calculates how much the future cash flow produced by an investment is worth today, and discounts from that value the investment itself, hence the word Net in NPV.
In other words, the NPV is the cash excess or deficit measured in today’s money that a project creates after paying off all of the costs associated with it, including its initial investments, and after yielding investors their expected rate of return.
A positive NPV means that the value of the projected cash flow exceeds the anticipated costs and expected returns in terms of today’s money, therefore it indicates a feasible investment.
A negative NPV on the other hand measures the cash loss that the project would produce to investors (again, in terms of today’s money), indicating that the investment is not financially feasible.
As with any other financial indicator, the accuracy of the NPV is only as good as the information used to estimate the project’s cash flows, but the metric is a good indication of the net volume of money created by an investment based on the information available at the time.
As implied above, the NPV is also affected by the return required by investors, also known as the discount or “hurdle” rate r in the Time Value of Money formula that we reviewed earlier.
Because the NPV measures the leftover cash after paying off initial investments and returning investors their desired rate of return, the higher the rate that investors demand the lower the NPV (the leftover) will be.
If you increase the hurdle rate enough you will get to an inflection point where the NPV becomes negative, indicating that the project will no longer produce what investors require.
Important Financial Analysis Metric: The Internal rate of Return
The hurdle rate exactly at the inflection point is the Internal Rate of Return of the investment, or IRR. Unlike the NPV, the Internal Rate of Return provides a percentage metric of returns. It is the hurdle rate that makes the NPV zero.
Not understanding how these metrics complement each other can bias your financial analysis.
In a nutshell, the IRR tells investors how much they would have to increase their desired return rate before the project becomes unprofitable, meaning that the higher the IRR the more attractive an investment is for investors.
Our final metric, the Payback period, is different to both the NPV and the IRR in that it only measures the time that it would take investors to get their money back. In its most popular version, the Payback time is calculated by determining how many periods of free cash flow are needed to accumulate enough cash to pay the original investment back.
For example, an investment of $2.5 million that produces $500,000 a year in free cash flow will have a 5-year simple Payback period. That calculation however, although frequently used among investors, does not take into account the Time Value of Money.
A time-adjusted version (which is the one I use and recommend) considers the Time Value of Money formula to calculate the Payback period in terms of today’s money. That of course increases the Payback period but is a more precise calculation as it takes into consideration the “opportunity costs” of the investment.
In either case however, the Payback period should never be used in isolation to make investment decisions as it doesn’t provide any indication of critical investment parameters such as return rate and the ability to create cash.
With that being said, NPV, IRR and Payback are best used in combination to evaluate a potential investment, since together they produce a more rounded view of the quality of the investment and its return to investors.
Success in the evaluation of capital allocation decisions is due in part to a good understanding of how these return metrics work, what they mean and their limitations.
The rest relies on the shoulders of the evaluators and financial analysts, who must ensure that the information used to make these estimates presents a good representation of what could actually happen.
Even the best metrics can’t be accurate if the projections are wrong, or if the project is not properly structured. To use a principle from computing science: “Garbage in, garbage out”.
Using Enterprise Value (EV) for a Comparable Company Financial Analysis (Comps)
In the book, we explain that there is a preference around the use of “multiples” to evaluate entrepreneurial companies by relating them to a group of similar publicly-traded companies.
In short, the methodology looks to calculate a few specific financial parameters in comparable public companies that investors can use as proxies to estimate the value of private ones.
In a nutshell, this method, which many refer to as Comparable Company Analysis or “comps” is based on the assumption that similar businesses of about the same size within the same industry will have similar valuation multiples.
To start, evaluators and financial analysts must define a peer group that will serve as a reference for the analysis, which consists of a sample of companies they consider to have similarities with the private company.
The sample will normally include companies of similar size, operating in the same industry and when relevant, within the same geography as the target.
The next step is to calculate the factors that will be used to compare the companies. One of the most commonly used methodologies uses ratios that take into account the Enterprise Value (EV) of the companies, since its calculation is usually very straightforward for both private and public companies.
The EV is a metric that estimates the purchase price of an organization and provides a more comprehensive view on what a company is worth to an investor than market capitalization or other metrics.
To calculate the EV of publicly traded companies, we start with the company’s market capitalization at the moment of evaluation, then add and subtract some items to reflect the true value that an investor would have to pay for the company.
The easiest way to calculate the EV for a private company (which in this case is an entrepreneurial company) is through the present value (PV) of the company’s projected financials. These financials represent our view (not necessarily the company’s) of the company’s future performance.
The general formula to calculate the EV of a private company is through the sum of the present value of the company’s cash flows over a given period, normally three to five years, plus what is called the Terminal Value (TV) of the company, which is an indication of the cash flows the company generates beyond the evaluation period.
EV = PV(CF1-n) + TVn
Terminal Value is usually calculated as the present value of a “perpetual” annuity that grows at certain rate, based on the company’s sales forecast.
Besides the estimation of the actual cash flows that we expect the target company to produce, there are two variables we need to pay close attention to when doing a financial analysis that involves calculating EV: the discount rate by which we will discount its cash flows, and the growth rate at which we consider its sales will grow.
These two numbers have critical implications for the final valuation and investment decision. The peer group that we compare the target company against is also of great importance as it sets the reference for the benchmark.
The EV is used to calculate the ratios with which we will determine whether the pre-money valuation (before we invest) is appropriate, with respect to what we see in the market. The most used ratios are EV/Sales, EV/EBITDA and EV/EBIT.
If we know for example, that similar public companies trade at an EV to Sales of three to four, we would expect the valuation of the private target to be within that range. If not, there have to be clear, provable reasons that explain the difference.
The Only Strategy Book You’ll Ever Need
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References
Wu, Sun. Strategy for Executives, this book can now be downloaded for free here.
Investopedia. Free Cash Flow. URL: https://www.investopedia.com/terms/f/freecashflow.asp
Investopedia. Comparable Company Analysis – CCA. URL: https://www.investopedia.com/terms/c/comparable-company-analysis-cca.asp