Financial Model Training

Different Valuation Techniques

Jul 24, 2011

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There are a number of different valuation techniques that can be used to assess the value of a company, and each have their own strengths and weaknesses. We are going to run through a few common valuation techniques and examine their differences:

DCF Techniques: there are a number of discounted cash flow techniques, all sharing the basic premise that the value of a company is the sume of the cash flows a company will produce, discounted at an appropriate cost of capital.

Dividend Discount Model: The dividend discount model uses the dividends paid by the company to assess value. The underlying concept that supports the use of the dividend discount model is that an investor who does not have control of the company will generally receive cash from the company in the form of dividends, which may or may not represent all the cash flow the company generates. Given the investor cannot control the internal cash flows of the company if it does not have control of the company, an investor should only value the cash flows it receives. In this instance, the investor has supplied equity capital into the company, and as such the appropriate discount rate is the cost of equity.

Free Cash Flow to Equity Model: This model discounts all the free cash flow that ends up in the control of the equity holders after paying all expenses and superior capital claims (generally debt, hybrids). This model is appropriate for valuing companies when the capital structure that is in place is expected to remain in place or be changed by existing equity holders over a longer period of time whereby the cost of equity and other capital claims are relatively predictable. One weakness of this model is that it does not look at what the source of the equity cash flows is, and can therefore potentially misvalue cash flows that include debt drawdowns or repayments. The appropriate discount rate again is the cost of equity.

Unlevered Free Cash Flow Model: This model is also often referred to as the Free Cash Flow to the Firm model. This model involves taking the cash flow available to pay all capital providers, assuming the company has an optimal capital structure in place. This model is used in order to value the assets or enterprise of the company instead of a particular tranche of the company's capital structure. It is particularly useful for acquisition valuation, and for distressed situations where the value of the company may be less than the value of debt the company is carrying. The discount rate used in this valuation technique is the weighted average cost of capital (WACC), assuming an optimal capital structure for the company.

Residual Income Model: The residual income model discounts economic profits that the company generates (which is different from cash flows), and again assumes an optimal capital structure. The model uses NOPAT, which is calculated as EBIT x (1 - tax rate) as the 'cash flow' to be discounted, but also deducts a capital charge each year to determine what profit was generated above the cost of capital each year. Again this model uses the WACC as the discount rate.

Financial Modelling fundamental accounting principal

Jun 01, 2011

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In financial modelling and in accounting there is a fundamental rule that must be satisfied in order for financial statements to balance and make sense, which is Double Entry. This means that any financial event that occurs for a company must impact two of the financial statements in order for them to make sense, and also that if something happens on the asset side of the balance sheet that there must be a corresponding effect on the liabilities and equity side of the balance sheet. Sometimes a financial event can impact all three financial statements simultaneously, however these events can be analysed as two seperate events (or more) impacting two financial statements each. A summary of some different types of financial events and the financial statements they must impact in order for a financial model to balance are listed below:

• Income received: This will always impact the Income Statement (P&L) and will always impact the balance sheet as well. It can impact the balance sheet by increasing an asset or decreasing a liability, and also by increasing equity. It may or may not affect the cash flow statement as income can be recognised prior to cash being received;
• Expense incurred: This will always impact the Income statement, and will always impact the balance sheet, but in the opposite manner to income. It can impact the balance sheet by decreasing an asset or increasing a liability, and will also reduce equity. As with income, expenses may or may not affect the cash flow statement as expenses can be recognised prior to cash being paid;
• Capital raised: This will impact the cash flow statement by increasing cash flows from financing activities, and will affect the balance sheet by increasing the relevant balance sheet item (either debt or equity), as well as increasing the cash balance;
• Capital expenditure: This will reduce cash flow on the cash flow statement in the cash flow from investing activities section, and will reduce cash on the balance sheet and correspondingly increase a fixed asset balance.

Cash Collection Cycle

Feb 27, 2011

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Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation

In the last post we discussed the concept of Working Capital and intoduced the cash collection cycle. The cash collection cycle is an important driver of profitability for a company. When building a financial model of a company or performing a valuation it is important to understand the impact of a company's cash collection cycle. Companies can temporarily bolster cash reserves by manipulating their cash collection cycle around their end of financial year to appear more profitable and efficient, and can end up going insolvent from not managing their cash collection cycle effectively.

Recapping the last post, the cash collection cycle is composed of the following: Receivables days + Inventory days - Creditor days.

Each item is important, and there are different consequences for managing working capital to have a cash collection cycle of different lengths:

• Receivables Days: If receivables days are long, this means that a company is taking a long time to collect money for its customers after providing them with a product. The advantage of running a long receivables days policy is that more customers are able to make a purchase immediately and this allows customers to manage their own cash flow better so they can pay their bill for the sale when they are ready and able to. The disadvantages of running a long receivables days policy is that this means that the company is taking credit risk against its customers, and therefore needs to allocate more resources/systems to manage the eventual collection of cash. Additionally this means that the company needs to find an alternate source of cash to fund the inventory or costs it has incurred in making the sale. If a company has a short cash collection cycle then this reduces credit risk for a company and means it generates cash from sales more quickly, but it can be counter-productive as it means that competitors may be able to lure customers away with more attractive sales terms.
• Inventory Days: If a company has a long inventory days period, this means that it keeps a substantial amount of stock compared to the amount it sells in a year. The advantage of this policy is that when a customer wants to make a purchase then it is highly likely the company will have the products available to sell to the customer. Additionally, as a general rule numerous businesses (in particular retail) achieve a higher rate of sales if customers come to the opinion that your point of stale (retail shop front, warehouse etc) is a good place to go in order to find the product they are looking for. Having a higher inventory level helps this effect. An additional benefit of running high inventory levels is that your suppliers are more likely to want to continue doing business with you and may also become more stable suppliers because they are able to depend on regular larger orders. Numerous companies try to run very low inventory days policies in order to optimise cash collection. An inventory management model called 'just in time' inventory management involves obtaining inventory from suppliers only at the point in time that it is needed for a sale or for part of a manufacturing process. This sort of model is more common when a company has substantial market influence or is the biggest player in its supply chain, and can therefore dictate terms. Disadvantages of running a low inventory days policy include the risk of not having inventory available when it is needed and stressing your suppliers' businesses.
• Creditor Days: If a company runs a long creditor days policy this means that it takes a long time for the company to pay its suppliers. This helps in the cash collection process as it delays the payment of costs. Creditors can therefore be viewed as a form of interest free funding, and therefore from a pure capital allocation perspective it is generally viewed as positive to have a longer creditor days policy. Detriments of having a long creditor days policy include stressing suppliers or potentially being forced to come up with a substantial amount of cash if suppliers refuse to continue offering the same creditor terms. Suppliers may even just not want to deal with a company anymore if it won't pay its bills on time. A further detrimental effect of running a very long creditor days policy is that banks view a very stretched creditor day cycle as a sign that a company is stressed, which can lead to more restrictive banking covenants or even withdrawal of bank funding. The primary disadvantage of running a short creditor days period is that it has a detrimental effect on cash generation.

Working Capital

Feb 10, 2011

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Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation

Working Capital is an important concept to understand in Financial Modelling, as it can often be the main driver of cash flow for a company. We are going to run through the three most common components of Working Capital that drive cash flow for a substantial proportion of companies.

First, what is working capital?

Working Capital is strictly defined as Current Assets - Current Liabilities. However, current assets often includes an amount of cash, and current liabilities often include an amount of short term debt, which are both parts of the capital structure of a company. As such when analysing the Working Capital of a company we adjust Working Capital by subtracting cash from current assets, and subtracting short term debt from current liabilities, to get adjusted Working Capital.

Working Capital is basically the capital invested in the company that is "put to work". This is the opposite of fixed capital, which is invested in long-term assets such as buildings that stay in the same form of investment for a long period.

The three major components of working capital that show up in a lot of financial statements are:

1. Receivables,
2. Inventory, and
3. Creditors

Receivables: Receivables literally means amounts of cash owed to the company in question that have not been received yet. The most common type of receivable for industrial companies is a Trade Receivable, which is created when a company sells a product to a customer and gives them a credit term that means they can delay cash payment. For a company that records 200 in sales in a period, but only collects 140 in cash from sales in that period, the company will record a Trade Receivable for the difference (60), representing the amount owed to it in sales revenue that it did not collect.

Inventory: Is a store of the goods that the company intends to sell. Inventory can be in various forms, including Raw Materials, Work in Progress, Finished Goods, or goods in transit. Raw Materials are generally things such as raw steel or iron or another commodity input that the company intends to use to create a good. Work in Progress is generally goods that are in the process of being manufactured for sale (for a company like Ford Motor Co this could represent half-finished cars still on the production line). Finished Goods are goods that are ready for sale and do not require any further work done. Goods in transit are generally finished goods on their way to a point of sale.

Creditors: Creditors represent a liability, whereas Receivables and Inventory represent assets for a company. A Trade Creditor balance is recorded on the balance sheet of a company when it has purchased goods for its inventory (or to on-sell to its own customers) for which it has not paid cash yet.

There are two other Working Capital items that are noteworthy but less common. Prepayments represent the opposite of a creditor, when the company has paid for inventory or some other product without having received it yet, and is recorded as an asset on the balance sheet. Deposits are the opposite of a receivable, when the company receives cash for a sale prior to providing the goods it is selling to its own customers. Deposits are recorded as a liability on the balance sheet of the company.

The three items Receivables, Inventory and Creditors combine to form what is known as the Cash Collection Cycle of the Company. The Cash Collection Cycle of a company looks at how long a dollar has to be invested in the working capital of a company prior to recording a sale (and hopefully some gross profit!).

The Cash Collection Cycle works as follows:

• A company provides 60 day payment terms to its customers, meaning that once it provides goods to a customer it takes 60 days to get cash from them. This increases the cash collection cycle by 60 daysas money is invested in the sold product by the company for the 60 days until it is received from the customer;
• A company carries inventory on its shelves for 40 days. For the entire 40 days the company has therefore invested cash in a product on its shelves. This is added to the days receivable (60 days from the point above) to mean our cash collection cycle is at 100 days.
• A company gets creditor terms of 30 days from its inventory supplier, meaning that for the first 30 days that the inventory sits on its shelves, its supplier actually has its money invested in the inventory instead of the company. This reduces the cash collection cycle by 30 days as the company does not need to use its own cash during this period to fund the inventory. This -30 days combines with +60 from Receivables and +40 from inventory holding period to provide a total cash collection cycle of 70 days.
• The 70 days represents the amount of time that the company has to use its own money to fund inventory prior to receiving cash for the sale of the product.

In part two of this we will discuss the pros and cons of having different cash collection cycle structures.

Return on Invested Capital ROIC part 2

Feb 07, 2011

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Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation

In the last post we discussed the concept of return on invested capital, how to calculate invested capital and ROIC. In this post we are going to discuss an important consideration in financial modelling, which is future capital investment requirements and how this affects ROIC.

Invested Capital was defined in the last post as the sum of invested debt and invested equity capital, minus cash. These values were derived from the balance sheet of the company we were looking at. This is one method of looking at invested capital but it hides the actual return that a company has earned on its capital base, and can earn in the future.

Let's run through an example which shows a 5 year life-cycle of a company and its return on invested capital:

This is a simple example set of financial statements, but let's run through what is happening with the company.

• The company has purchased some fixed assets (its invested capital) for 2000, financed via a 50/50 mixture of debt and equity. For the sake of example assume this fixed asset is a large building. The large building is depreciated in a straight line over the 5 year period. You should notice that the sum of all the depreciation recorded is -2000, exactly depreciating the fixed assets to 0.
• The company pays its interest on time, and pays out all NPAT in dividends to equity holders. We can see that the company is accumulating cash of 400 per year, this is because the depreciation expense is a non-cash expense that is deductible for tax purposes, so whatever the company depreciates is turned into a cash balance. For simplicity we have assumed the company earns no interest on its cash (just like is the case in a lot of the western world at the moment with 0% government interest rates...).
• Since Invested Capital is Debt + Equity - Cash, we see that the invested capital of the company gradually declines over the 5 years, and as a result the return on invested capital increases to the point where the company is returning more than 100% of invested capital to its capital providers. In other words this company appears to be phenomenally profitable!
• Note that for simplicity we have also assumed no capex over the 5 year period.

So what is wrong with the picture of this company appearing so amazingly profitable? The gap here is that the balance sheet is not a good reflection of the actual invested capital of the company.

In the real world (not accounting world), fixed assets can either decline in value or increase in value over time (or both). In this case the fixed assets are helping this company to generate EBITDA that has grown at a 5% per annum rate since inception of the company in year 0, so in reality the value of that property has probably risen (assuming capitalisation rates are the same or higher - capitalisation rate is basically the earnings yield required for an asset, so 6% capitalisation rate means the value is 1/0.06 x earnings).

So what is the implication of this? The implication for this relates to future investment in fixed assets. Can this company invest in its fixed assets and generate a 100.17% return on invest capital on a sustainable basis? Probably not, otherwise everyone would be doing it and interest rates would be much higher.

So what was the ROIC that the company earned on the investment? To calculate this we will use the Gordon Growth Model with NOPAT set to equal the same as year 5 NOPAT, and a 9% WACC with a 0% terminal growth rate to determine the terminal value:

The IRR from this set of cash flows is 46%, still a phenomenal ROIC given interest rates on debt are 7%, but less lofty than the 100.17% ROIC indicated on the balance sheet in the last year of the financial statements above.

If we were comparing this company to a new company based on ROIC, we need to understand what the current ROIC of this company is. Let's say for example that the fixed assets have grown in line with EBITDA, that is 5% per annum. Their current value = 2000 x (1.05)^5 =2552. The company will no longer be able to claim depreciation expense so next year's NOPAT will equal EBITDA x (1- tax rate) = 972.41 x 0.7 = 680.68. This yields a current ROIC of 680.68/2552 = 26.7%.

So if I were choosing one of two investments, either a new project with a 30% ROIC or potentially the purchase of the example company, I need to compare the 30% ROIC to the 26.7% ROIC, not the 100.17% ROIC calculated from the balance sheet or the 46% ROIC calculated from the IRR.

The moral from this is:

• Financial statements tell you about the past, not the present or future;
• Financial statements reflect values in the accounting world, which can and do differ from the real price world we actually experience;
• Incremental costs are important in assessing the value of a company, not historical costs.

Certain businesses will hide deteriorating ROIC more-so than others. For example, often airlines appear to be generating strong ROIC, but they tend to have capex costs that increase at a rate well above inflation due to tight supply of large aircraft. So the ability of an airline company to re-invest profitably is not accurately reflected in their financial statements, and their current and future ROIC can be very different from their current balance sheet ROIC depending on how long it has been since they re-invested in their fixed assets.

 

Return on Invested Capital ROIC

Jan 19, 2011

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Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation

Return on Invested Capital is an important concept in understanding the value of a company, but one that most people starting out in finance (and a lot of experienced people) don't fully appreciate (or understand at all).

Let's take a look at two companies that appear to be performing quite differently at first glance:

Company A is generating a substantially higher return on equity than Company B, so at first glance it could be tempting to think that Company A is a better investment or should justify a higher share price. If we assumed that the Cost of Equity of each company is 10% and that neither company will grow any further (stagnant), then the equity of Company A is worth 44.1%/10% x 400m = $1764m and has an Enterprise Value (debt + equity) of $2364m, and Company B has an equity value of 24.9%/10% x 800m = $1992m and an Enterprise Value of $2192m. So apparently Company A is worth $172m more than Company B.

On examination we can also see a few things that are very similar about these two companies: The same asset levels, the same sales and EBIT (earnings before interest and tax). The things that differ about the two companies are related to the capital structure of the companies. Company A has higher debt and lower equity invested, which means that it pays a higher level of interest (which is tax deductible), leading to a lower level of tax paid. So through higher gearing it has achieved a higher Return on Equity.

ROIC (Return on Invested Capital) attempts to assess companies based on their operating performance, independent of their capital structure. ROIC is a measure that removes the effect of leverage, and allows you to compare companies based on the performance of their assets, independent of any additional financial risk the management have taken in running their companies.

The trick with ROIC is to ignore the effects of the capital structure on the financial statements. As such on the balance sheet instead of differentiating between Debt and Equity, we add them together to get Invested Capital. On the profit & loss statement we ignore the effects of debt, so below the EBIT line we ignore interest and recalculate tax as if no interest was charged. The resulting version of NPAT that we arrive at is referred to as Net Operating Profit After Tax (NOPAT). To get ROIC, we then divide NOPAT by Invested Capital. Let's re-examine the two companies we looked at before on this basis:

We can see from the above table that the ROIC of companies A and B are identical at 21%. What this tells us is that, assuming all else equal, the assets of each company are worth the same amount as they provide the same return to their capital providers. So, if the assets are worth the same amount under this analysis, but Company A was worth more when we ran through a quick valuation above, how do we reconcile the difference? The way to reconcile the difference is by recognising that the additional financial leverage that Company A is using has increased the riskiness of that company compared to compay B, and therefore a higher cost of equity should be used in measuring the value of the equity of company A than company B. In practice it is also likely that company A would be charged a higher interest rate than company B as well.

Note that this methodology is great for valuing assets, however in practice management can add value to equity providers by managing for lower interest costs (in % terms), so ROIC is not the only thing to consider when valuing a company, but it should be a tool in any good analyst's analytical methods.

 

 

Valuing High Growth Companies - some basics

Jan 04, 2011

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Tags: corporate finance, financial modelling, financial modeling, company valuation

Valuing and comparing High Growth companies requires a different approach than those generally used by investors to value and compare more stable and established companies.

In the last blog post we discussed calculating the justified PE ratio of a company based on the gordon growth model. Using the gordon growth model is inappropriate for high growth companies though, as high growth companies may have a terminal growth rate that is approaching or even exceeding the cost of equity of the company. Additionally, high growth companies may not be able to make a profit. In either case, this renders the PE ratio and the gordon growth model quite useless in determining the fair value of stock in the company.

In valuing high growth companies there is more guess work than with established companies, especially companies that produce a new product that will form a new market.

When I am trying to put a value on a high growth company I use the following framework as a reference point (although it is by no means the only way or the definitive way of determining the value of such a company):

1. Estimate the potential size of the market for the product the company is producing;

2. Estimate the potential market share that a firm could expect to control in such a market;

3. Estimate a cost structure for the industry;

4. Estimate the size the company needs to be in order to be self-funding;

5. Estimate a sales growth profile for the company;

6. Estimate the amount of capital the company requires in order to reach it's self-sustaining point;

7. Construct a simple DCF.

8. Estimate a probability that a market will be successfully established for the product, then probability weight the DCF.

Justified PE Ratio

Dec 18, 2010

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Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation

Lots of investors and finance professionals use the PE ratio to assess whether a stock is good value or not, however lots of investors and finance professionals do not know how to assess a PE ratio in an absolute sense, and therefore only derive a benefit by comparing PE ratios among different companies. The justified PE ratio can be estimated using an adjusted version of the Gordon Growth Model. This can help investors assess whether or not a stock represents good absolute value as well as good relative value.

The Gordon Growth Model states that the justified share price of a stock can be calculated as:

Where:

Po is the justified share price at the present time

Do is the most recent dividend (full year dividend)

g is the sustainable dividend growth rate of the company

k is the cost of equity of the company

So if the company had a 10% cost of equity, a sustainable growth rate of 5%, and a dividend of $2 per share last year, the justified share price is calculated as:

2 x (1.05)/(0.1 - 0.05) = $42 per share.

We can get a justified PE ratio by ensuring that the Do is set to 1, or by dividing both sides of the equation by earnings:

So, if the company again has a cost of equity of 10%, a sustainable growth rate of 5%, a dividend of $2 per share last year and earnings of $3 per share last year, the justified PE ratio would be:

(2/3) x (1.05)/(0.1 - 0.05) = 14

Now we can cross check this. Previously we calculated using the Gordon Growth Model that the justified share price of the company was $42. We know from the last example that the earnings per share were $3 per share. 42/3 = 14, so both our equations agree with eachother.