Business Institutions Program Business Bootcamp Session 1

Transcription

1 Summer 2015 Business Institutions Program Business Bootcamp Session 1 Student Alumni Engagement Program

2 Introduction Professor Mark Witte and I developed the BIP Bootcamp to offer undergrads a better understanding of the fundamentals of business, so that you can better explore different career paths and position you to succeed in pursuing these paths During our discussions, we will endeavor to stay high-level so as to ensure everyone walks away with the big-picture Some of these concepts are complex enough that you may need to review them on your own in the future, but the key takeaways should be clear We will try to balance theory and practice throughout these sessions Above everything else, let s have some fun with this! 1

3 Bootcamp Core Agenda Video Sessions: Session 1 Understanding the Landscape of Business Session 2 Fundamentals of Accounting - Financial Statements - Start and Run a Company Session 3 Intro to Valuation Session 4 Basics of Finance Saturday Bootcamp: Module 1 Prepare Your Company for Sale Module 2 Bid on Company as a Private Equity Investor Module 3 Add Value as a Strategic Consultant 2

4 Session 1 Understanding the Landscape of Business

5 Dan Shedivy Northwestern B.A. Economics (1997) Accenture Strategic Services Business Analyst William Blair Investment Banking Analyst Kellogg M.B.A. (2002) McKinsey Engagement Manager Many great career paths to chose from there is no right or wrong, it s about figuring out what is right for you, and that is what the Bootcamp is all about! JP Morgan Vice President / Portfolio Manager William Blair Investment Banking, Managing Director 3

6 Understanding the Landscape Operator (Principal) Lifecycle of a Business Start-up Growth Mature Conceptual business plan, in need of capital to prove concept Proven concept, looking to grow (capital for growth or liquidity?) Execute Strategic Plan (Operational Excellence / Organic and M&A Growth) Go public? Investor (Principal) Friends & Family / Angels Early Stage Venture Capital (Non-Control) Private Equity (Control Sale) Adding value : Financial Engineering or Operational Oversight? Lenders (Senior through Sub-Debt) Fund of Funds / Endowments etc. Private Wealth Management / Investment Advisors Buy Side Institutions Public Debt & Equity (Mutual Funds / Hedge Funds) I-Sales & Trading I-Banker (Agent) Raise Private Capital (Debt and Equity) Run Sell-Side Processes Raise Debt Financing (Acquisitions or Recaps) Sell-Side Equity Research Analyst Capital Market Execution Consultants (Agent) Other Agents Strategy: Development, White Space Studies, Opportunity Evaluation, Competitive Dynamics Process / Change Management: Operational Excellence; Org Dev; Reorg; Integration Technology: Deploying technology for clients Lawyers, Accountants, PR/Marketing, etc. 4

7 How Do You Impact ROIC? Little Capital Invested Where do you want to be? think ROIC (Return on Invested Capital) Investment decisions are driven by expected returns for the risk taken Lots of Capital Invested Generates Little Cash Generates Lots Of Cash 5

8 What is YOUR Value Proposition? The Mouse Trap The Lower Cost / Mass Produced Mouse Trap The Better Mouse Trap??????? Cost Benefit Value Lower Cost Benefit Higher Value Cost Greater Beneft Higher Value Higher Cost Greatest Beneft? Higher Value The more value you create, the more sustainable your ability to do so is, and the greater your ability to scale your model, the more valuable your business/role is 6

9 Accounting A Necessary Evil In order to understand each player s role in adding value we must first understand what it really means to add value in the economic sense This requires an understanding of how we think about both: Invested Capital (Is this just dollars invested, or is this affected by who is putting what dollars in?) AND Returns (profit? Cash flow?...how are these different?) Only then do we know how to evaluate ROIC and how any player can affect it Operators: efficiently deploy capital and execute against a strategic plan Investors: determine who governs/operates, and in many ways provides capital for growth (if warranted) Bankers: provide options to access capital markets through competitive processes, positioning, tight diligence Consultants: answering big picture strategic questions and/or enhancing operational effectiveness (doing the right things vs doing things right) Other service providers: Drive Growth (PR/Mktg), Minimize Costs (Other Vendors), Mitigate Risks (Lawyers) this also lets us begin to understand what are acceptable returns and how that affects valuation in the broader sense (risk and reward go hand in hand) 7

10 Session 2 Fundamentals of Accounting

11 Agenda What is accounting, and why do we care? Introduction to the three key Financial Statements: Balance Sheet, Income Statement, and Cashflow Statement Let s start a company and run it for a few years What does this all mean, and why should I care? 10

12 What is Accounting, and Why Do We Care? Accounting is the language of business, allowing different parties to communicate effectively by speaking the same language Utilizing standard accounting will allow a management team to monitor and assess the financial state of their business through various financial metrics Proper accounting also allows individuals removed from the daily operations of a business to have visibility into the financial health and historic performance of a company Board of Directors charged with monitoring the state of its business Investors evaluating the state of their investment Research analysts who are asked to evaluate a business s prospects Allows management teams to improve their businesses and more efficiently deploy their scarce resources to worthy projects Supports effective monitoring of those entrusted with running businesses Gives third parties the faith needed to invest in companies they are far removed from 11

13 Agenda What is accounting, and why do we care? Introduction to the three key Financial Statements: Balance Sheet, Income Statement, and Cashflow Statement Let s start a company and run it for a few years What does this all mean, and why should I care? 12

14 Accounting Monitors The Cash That Is Invested In A Business and the Subsequent Generation or Utilization of that Cash Balance Sheet A snapshot of a company s assets and obligations at a specific point in time Shows who has invested cash into our business (equity investors, lenders, and creditors); and what form that cash exists in our operations (inventories, equipment, etc.) Income Statement The revenues generated and expenses incurred by a company over a specific length of time Allows us to compare growth and profitability against previous periods as well as against competitors Cashflow Statement The sources and uses of cash for a specific period of time, broken into three categories: Operating cashflows: the day to day operations Investing cashflows: major purchases or sales of equipment Financing cashflows: whether debt and equity investors are putting cash into the business or getting cash out 13

15 The Balance Sheet s Line Items May Vary, But Basic Presentation is Always the Same Balance Sheet ($MM) as of Dec. 31, 2004 In order of liquidity (ease of converting to cash) Assets Liabilities and Equity Cash 10 Current Debt 10 Accounts Receivables 20 Accounts Payables 30 Inventories 20 Total Current Liabilities 40 Total Current Assets 50 Long-term Debt 30 Net PP&E 50 Total Liabilities 70 Stockholders Equity 30 Grand Total Assets 100 Total Liabilities and Equity 100 Cash: Cash Accounts Receivables (A/R): Cash owed from customers for sales already made Inventories (Inv): Raw materials to be made into finished goods, works of goods in progress or finished goods waiting to be sold Current Assets (CA): Assets which should be turned into cash over the next operating cycle (1yr) Net Property Plant and Equip (PP&E): Current fair value of tangible fixed assets Current Debt (ST Debt): Debt due in the next year Accounts Payables (A/P): Cash owed to suppliers for goods/services already received Current Liabilities (CL): Cash that must be paid out over the next operating cycle (1yr) Long Term Debt (LT Debt): Debt due after one year Equity: Retained book value of equity investments to date 14

16 A Graphic Depiction of the Balance Sheet Portrays Where Cash Resides and How the Business was Funded Equity 70 Inv Debt Cap. suppliers fund your operations 10 0 Cash A/R Inv Curr Assets PP&E Total Assets A/P ST Debt Curr Liabs LT Debt Equity L + E Cap Sources Just like you fund your customers operations Where is my cash: in cash, in current assets, or in less liquid tangible assets? Who has funded my balance sheet: suppliers, creditors, or equity investors? Ultimately, we will need other metrics and other companies financials to gauge whether this is a healthy or less than optimal balance sheet for this company 15

17 Net Working Capital (Current Assets Current Liabilities) Net Cash Tied Up In Short Term Capital to Run Business Op Cash A/R Inv C.A. A/P NWC T=0 T=1 Change Cash Impact Cash Use of Cash A/R Use of Cash Inv Use of Cash CA Use of Cash A/P Source of Cash CL Source of Cash NWC Use of Cash To get more assets, we use up cash Reducing assets frees up cash To reduce our liabilities, we need to use cash When we increase liabilities, it s like getting a loan and is a source of cash Where is my cash: in cash, in current assets, or in less liquid tangible assets? Who has funded my balance sheet: suppliers, creditors, or equity investors? Ultimately, we will need other metrics and other companies financials to gauge whether this is a healthy or less than optimal balance sheet for this company 16

18 Invested Capital What Funds NWC and PP&E and Requires a Return Translating the Balance Sheet Into Invested Capital Terms is Critical for Valuation Work CA CL NWC PP&E Debt Equity Inv. Capital How much invested capital (cash) is tied up in this business? How is this invested capital split up between NWC, in PP&E, etc? Where is our funding coming from, debt or equity investors? Translating the Balance Sheet into Invested Capital terms is critical for valuation work, as this helps us answer the first of three critical questions: How much have investors (debt and equity) put into this business? What type of return do they receive for these investments? Should they be happy with this investment given the risks of this investment and potential alternatives? 17

19 Income Statement The Income Statement s Line Items May Vary, But the Basic Presentation is Always the Same Income Statement ($MM) Jan 1, 2014 to Dec. 31, 2014 Sales 100 Cost of Goods Sold (COGS) 70 Gross Profit 30 Selling, General & Admin (SG&A) 15 Depreciation & Amortization (D&A) 5 Operating Profit (EBIT*) 10 Interest Expense 3 Pretax Income 7 Taxes 2 Net Income 5 Sales: Value of goods and services given to customers in this operating period (rule of thumb: you only recognize sales once the goods are shipped or the invoice for services sent) COGS: Economic value of the goods or services for which you are booking revenues SG&A: Expenses associated with running the day to day business (utilities, salaries, etc) D&A: Non-cash charges** to recognize the erosion of value of longer term assets on the Balance Sheet (depreciate PP&E; amortize intangible assets) Interest Expense: Payment made to debt-holders only to compensate them for their investment Taxes: Self explanatory Net Income: Residual profits equity-holders have claim to *EBIT = Earnings Before Interest and Taxes **Non-cash charges: expenses I recognize to reflect true destruction of economic value associated with generating these sales (conform to the spirit of the matching principle ) but I don t actually have to send a check out to anyone to pay, in a way I already paid for these longer term assets up front and simply recognize a portion of that payment over time 18

20 Cash is King The Income Statement May Reflect Long-Term Economics, But is Limited in Revealing True Cash Flow for a Period of Time Sales may be paid for by your customers on credit, so you did not necessarily receive any cash for those sales yet You may have already paid cash for the inventories you just sold Depreciation and amortization are non-cash charges in which you are capturing the erosion of economic value for an asset that allowed you to generate the period s sales in the first place Even taxes stated on the income statement may not be the true cash amount a company actually pays So, we need a statement that reflects the reality of a company s cash flows to understand how cash is being generated and used this is where the Cashflow Statement comes in 19

21 Cashflow Statement The Cashflow Statement Shows a Company s True Sources and Uses of Cash for a Given Period Cashflow Statement ($MM) Jan 1, 2014 to Dec. 31, Net Income 5 + Non-cash charges (e.g., D&A) 5 - Increase in Current Assets 40 + Increase in Current Liabilities 30 Operating Cashflow 0 - Capital Expenditures (PP&E) 55 + Sale of PP&E 0 Investing Cashflow Additional Equity Issued to Inv Debt Issued 40 - Dividends to Equity Holders 0 Financing Cashflow 65 Total Cashflow 10 Operating Cashflows: Reflects not just the true cash in-flows/out-flows from the income statement, but also whether the period required an increase or decrease in Net Working Capital (CA-CL) - Remember, if current assets have to rise in a given period, this increase in assets would require cash; an increase in current liabilities would provide a source of cash; we need to reflect this net change in our operating cashflow statement to reflect the true cash generation for the business as a whole Investing Cashflows: Did we have to use cash to increase our fixed assets, buying new equipment etc.; Did we sell certain fixed assets and get cash in the process for liquidating this PP&E Financing Cashflows: Are we receiving cash from debt and/or equity investors, or are we paying cash out to them? Would you be happier if Total Cashflow was 5MM, but it was all from Operating Cashflow? I hope so! 20

22 We Can Now See How the Three Statements Interact at a High-Level Total cashflow reflects the change in Cash line item Balance Sheet Increase in assets is a cash outflow; increase in liabilities/equity is a cash inflow Net Income increases equity (less any dividends paid) Cashflow Statement Income Statement Net Income + non-cash charges is the basis for operating cashflows 21

23 Session 2 Fundamentals of Accounting (continued)

24 Agenda What is accounting, and why do we care? Introduction to the three key Financial Statements: Balance Sheet, Income Statement, and Cashflow Statement Let s start a company and run it for a few years What does this all mean, and why should I care? 22

25 Accounting is a Language of Debits and Credits Every line item on the Balance Sheet and Income Statement can be represented in terms of a T- Account that can have $$ added to or taken from T-Accounts allow us to track the simultaneous in-flows and out-flows of business in a way that guarantees we accurately track every dollar (e.g., double entry accounting) To increase assets we must use cash To get cash we must have investors, debtors or creditors To generate sales, we must incur expenses and/or give up assets The T-Account always has Debit Entries (also depicted by Dr.) on the left side; and Credit Entries (also depicted by Cr.) on the right DEBITS ALWAYS EQUAL CREDITS Dr. Cr. There are two types of T-Accounts: Balance Sheet and Income Statement For Balance Sheet Accounts, Asset T-Accounts are increased by Debits (left side) and decreased by Credits (right side); whereas Liabilities/Equity T-Accounts are increased by Credits (right side) and decreased by Debits (left side) For Income Statement T-Accounts, Sales are Credits (right side), whereas expenses are Debits (left side); this is because, ultimately the net income resulting from the sum of these transactions will flow into shareholders equity on the balance sheet, so if an Income Statement line item helps to increase equity, it should follow the same nature as the Equity Account on the Balance Sheet 23

26 A Visual Depiction of T-Accounts will Reinforce the Mechanics of Double-Entry Accounting Dr. Cr. Dr. Cr ASSETS LIABS + EQUITY Dr. Cr. Dr. Cr. We get cash We borrow money We get more inventory We spend cash We get cash We sell a factory We spend cash We pay back debt We spend cash We pay expenses 24

27 Selling Our Goods: 2 Separate But Related Entries Dr. Cr. Dr. Cr ASSETS LIABS + EQUITY Dr. Cr. Dr. Cr. Increase Cash or A/R Recognizing Revenue Inventory reduced to reflect Goods we are selling Capture the Costs Of the goods sold 25

28 First Year s Operations: Raise Funds, Build a Plant, and Run the Business Transactions in Year 1 1 We raise $25MM from equity investors 2 We issue $40MM in long-term debt 3 We use $50MM to build a factory that will last 10 yrs 4 We buy $90MM in raw materials held as imentor inventoryon on credit 5 We sell $70MM of finished inventory for $100MM on credit 6 We pay $15MM for utilities, etc. for the year 7 We recognize $5MM of depreciation of our factory 8 We collect $80MM of Accounts Receivables from customers 9 We reinvest an additional $5MM to replace some equipment 10 We pay off $60MM of the Accounts Payable we owe our suppliers 11 We pay $3MM in interest expense 12 We pay $2MM in taxes 13 Close out Income Statement T-Accounts to Equity's Retained Earnings ASSETS CASH INVENTORY LIABILITIES & EQUITY ACCT S PAYABLE DEBT EQUITY INC. STATEMENT* SALES COGS SG&A EXPENSE DEPREC. EXPENSE t=0 t=1 ASSETS Cash 0 Inv 0 A/R 0 Net PP&E 0 0 LIABILITIES A/P 0 Debt 0 EQUITY 0 ACCT S RECEIVABLE GROSS PP&E ACCUM. DEPREC. INTEREST EXPENSE TAX EXPENSE * Hits Equity at Close L + EQUITY 0 26

29 First Year s Operations: Raise Funds, Build a Plant, and Run the Business Transactions in Year 1 ASSETS LIABILITIES & EQUITY INC. STATEMENT* 1 We raise $25MM from equity investors 2 We issue $40MM in long-term debt 3 We use $50MM to build a factory that will last 10 yrs 4 We buy $90MM in raw materials held as inventory on credit 5 We sell $70MM of finished inventory for $100MM on credit 6 We pay $15MM for utilities, etc. for the year 7 We recognize $5MM of depreciation of our factory 8 We collect $80MM of Accounts Receivables from customers 9 We reinvest an additional $5MM to replace some equipment 10 We pay off $60MM of the Accounts Payable we owe our suppliers 11 We pay $3MM in interest expense 12 We pay $2MM in taxes 13 Close out Income Statement T-Accounts to Equity's Retained Earnings CASH INVENTORY ACCT S PAYABLE DEBT 40 2 EQUITY SALES COGS SG&A EXPENSE DEPREC. EXPENSE t=0 t=1 ASSETS Cash 0 10 Inv 0 20 A/R 0 20 ACCT S RECEIVABLE INTEREST EXPENSE Net PP&E GROSS PP&E 3 50 TAX EXPENSE LIABILITIES A/P Debt 0 40 * Hits Equity at Close EQUITY 0 30 ACCUM. DEPREC. 5 7 L + EQUITY

30 Second Year s Operations: Run the Business Transactions in Year 2 ASSETS LIABILITIES & EQUITY INC. STATEMENT* * Starting balances equal ending balances of last period 1 We purchase $150MM more in inventory on credit 2 We sell $140MM of Inventory for $220MM, half for credit 3 We pay $15MM for utilities, etc. over the year 4 We recognize $5MM of depreciation of our factory 5 We collect $60MM of Accounts Receivables 6 We pay back $100MM to our suppliers for Accounts Payable 7 We pay $3MM in interest expense 8 We pay $20MM in taxes 9 we pay a $25MM dividend to equity shareholders 10 Close out Income Statement T-Accounts to Equity's Retained Earnings CASH * 10 INVENTORY * 20 ACCT S PAYABLE 30 * DEBT 40 * EQUITY 30 * SALES Change t=0 t=1 t=2 t2-t1 ASSETS Cash Inv A/R Net PP&E ACCT S RECEIVABLE * 20 GROSS PP&E * 55 LIABILITIES A/P Debt ACCUM. DEPREC. * Hits Equity at Close EQUITY * L + EQUITY

31 Second Year s Operations: Run the Business Transactions in Year 2 ASSETS LIABILITIES & EQUITY INC. STATEMENT* * Starting balances equal ending balances of last period 1 We purchase $150MM more in inventory on credit 2 We sell $140MM of Inventory for $220MM, half for credit 3 We pay $15MM for utilities, etc. over the year 4 We recognize $5MM of depreciation of our factory 5 We collect $60MM of Accounts Receivables 6 We pay back $100MM to our suppliers for Accounts Payable 7 We pay $3MM in interest expense 8 We pay $20MM in taxes 9 we pay a $25MM dividend to equity shareholders 10 Close out Income Statement T-Accounts to Equity's Retained Earnings CASH * INVENTORY * ACCT S PAYABLE * DEBT 40 * EQUITY * SALES COGS SG&A EXPENSE DEPREC. EXPENSE Change t=0 t=1 t=2 t2-t1 ASSETS Cash Inv A/R Net PP&E ACCT S RECEIVABLE * GROSS PP&E * INTEREST EXPENSE TAX EXPENSE LIABILITIES A/P Debt ACCUM. DEPREC. * Hits Equity at Close EQUITY * 5 4 L + EQUITY

32 Should We Be Happy with Year 2 s Performance? Income Statement T=1 T=2 Sales COGS Gross Profit SG&A D&A 5 5 EBIT Interest 3 3 Pretax Income 7 57 Taxes 2 20 Net Income 5 37 Gross Margin 30.0% 36.4% Did we achieve growth? While growing, did our profitability improve? Improved pricing relative to COGS? Operating economies of scale? Change in interest expense? Paying more or less of profits in taxes? Note: of course, all of this can only be judged relative to what other companies of similar size in the same industry achieve; everything is relative! Op Margin 10.0% 27.3% Net Margin 5.0% 16.8% 30

33 What Should Year 2 s Cashflow Statement Look Like? Cashflow Statement ($MM) + Net Income? + Non-cash charges (e.g., D&A)? - Increase in Current Assets? + Increase in Current Liabilities? Operating Cashflow? - Capital Expenditures (PP&E)? + Sale of PP&E? Investing Cashflow? + Additional Equity Issued to Inv.? Have you accounted for every line item on the balance sheet? Does the total cashflow match the change in the Balance Sheet s cash line item? Would you be happy with this cashflow statement, relative to last period s; why or why not? + Debt Issued? - Dividends to Equity Holders? Financing Cashflow? Total Cashflow? 31

34 How do we Know That These Statements Make Sense? Equity increases by net income less dividends Balance Sheet Income Statement t=1 t=2 ASSETS Change Cash Inv A/R Net PP&E LIABILITIES A/P Debt EQUITY LIABS + EQUITY t=1 t=2 Sales COGS Gross Profit SG&A D&A 5 5 EBIT Cashflow Statement Operating Activities t=1 t=2 + Net Income Non-Cash (D&A) Increase in CA Increase in CL Operating CF 0 32 Investing Activities - Capex 55 0 Investing CF Financing Activities + Issue Equity Issue Debt Dividends Paid 0 25 Financing CF TOTAL CASHFLOW 10 7 Total cashflow reflects the change in Cash line item Interest 3 3 Pretax Income 7 57 Taxes 2 20 Net Income 5 37 Gross Margin 30% 36.4% Op Margin 10.0% 27.3% Net margin 5.0% 16.8% 32

35 Working Capital Needs $ $ $ $120.0 $24.0 What is the ratio of Inventory I need to keep on hand relative to the Goods I sell in a year? 24 / 4 = 6 I turn my inventory 6x a year 365 Days / 6 turns = ~61 Days of Inventory it looks like I have on hand. DO I WANT HIGHER OR LOWER TURNS? DO I WANT HIGHER OR LOWER DAYS INVENTORY? $ 80.0 $ 60.0 Similarly how much in Payables can I keep relative to the Goods I sell in a year? 24 / 8 = 3 3x 365 Days / 3 turns = ~122 Days to Pay A/P. DO I WANT HIGHER OR LOWER DAYS PAYABLE (i.e. DPOs)? $ 40.0 $ 20.0 $30.0 $4.0 ($8.0) $26.0 I want a business that requires very little Working Capital it requires less cash to grow and means I have less capital invested and, ceteris peribus, better returns!!! - Sales COGS GB AR Inv A/P NWC We would connect Sales to A/R though; 120 / 30 = 4x 365 Days / 4 turns = ~91 Days before I collect my receivables DO I WANT HIGHER OR LOWER DAYS (i.e. DSOs)? 33

36 Net Working Capital / Days Cash Conversion If it takes 61days for inventory to be sold Days Inv 61 and another 122 before we get to collect cash from sales DSOs DPOs 122 (91) but we don t pay for the inventory for 91days then on average we turn goods into cash in 92 days Cash Conversion What if I held inventory for <2 days, collected my receivables in 7 days but didn t pay my payables for 30 days*? * In its early years of operations, Dell ran with a negative NWC balance 34

37 Projecting PP&E $ $ $30.0 $129.0 $18.0 $134.0 $ $ $ 80.0 $100.0 $10.0 $20.0 $110.0 $11.0 $13.0 $ 60.0 $ 40.0 $ PP&E 2011 Depr 2011 Capex 2011 PP&E 2012 Depr 2012 Capex 2013 PP&E 2014 Depr 2014 Capex 2014 PP&E Look at Sales/PP&E to understand how many $s of sales every $ of PP&E is invested for capital intensive businesses; note - this can be affected by capacity utilization Depreciation as a % of PP&E provides an implied life of PP&E Capex vs Depreciation provides insight into a company s position for growth 35

38 What about Cash on a Balance Sheet? Every business needs to hold some cash, how much depends on the business model General rule of thumb would suggest that no company should have more than 1-5% of sales equivalent in cash anything beyond that is excess cash That excess cash has nothing to do with the company s value you look at that excess cash on a stand-alone basis (if you could buy a car worth $20K that had $1million of cash in the glove compartment, shouldn t you just pay $1,020,000?...Yes!) We typically don t project out cash (even though you theoretically should project out operating cash as another component of NWC this is not typically done in practice) it is the plug for all of the operating and financing assumptions within a projection model 36

39 Simple Excel Projection Example 37

40 Use Historical Performance to Inform Projections (1 of 2) PROJECT TRAINING Base Case Income Statement ($ in millions) Historical Financials Projected Financials FY (8) FY (7) FY (6) FY (5) FY (4) FY (3) FY (2) FY (1) FY 1 FY 2 FY 3 FY 4 FY 5 FY 6 Sales $3,489 $3,812 $4,116 $3,991 $4,443 $5,301 $6,144 $6,205 $6,391 $6,583 $6,780 $6,984 $7,193 $7,409 Cost of Goods Sold 2,575 2,816 3,128 3,097 3,410 4,040 4,646 4,644 4,793 4,937 5,085 5,238 5,395 5,557 Gross Profit ,033 1,261 1,498 1,561 1,598 1,646 1,695 1,746 1,798 1,852 SG&A EBITDA Depreciation EBIT Interest Expense (Interest Income) (1) (1) (2) (2) (2) (3) (5) (5) (4) (4) (5) (5) (5) (5) Net Interest Expense/(Income) Other Expenses/(Income) Pre-tax Income Income Taxes Net Income Available to Common $173 $181 $160 $43 $167 $255 $318 $288 $308 $322 $336 $342 $346 $347 Avg. Shares Out. (in millions) Net Income Per Share $1.73 $1.81 $1.60 $0.43 $1.67 $2.55 $3.18 $2.88 $3.08 $3.22 $3.36 $3.42 $3.46 $3.47 Margins & Growth Rates Projected Financials FY (3) FY (3) FY (3) FY (3) FY (3) FY (3) FY (2) FY (1) FY 1 FY 2 FY 3 FY 4 FY 5 FY 6 Growth Rates Sales 9.3% 8.0% (3.0%) 11.3% 19.3% 15.9% 1.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% EBITDA 6.9% (2.3%) (20.1%) 17.7% 23.6% 14.8% 1.3% 1.1% 3.0% 3.0% 3.0% 3.0% 3.0% EBIT 4.2% (8.1%) (46.3%) 77.5% 32.5% 19.9% (0.1%) 6.2% 4.4% 4.2% 2.1% 1.5% 0.9% Pre-tax Income 5.4% (11.5%) (61.7%) 144.3% 44.6% 24.6% (1.1%) 6.8% 4.7% 4.1% 1.8% 1.2% 0.4% Net Income 4.6% (11.6%) (73.1%) 288.4% 52.4% 24.8% (9.2%) 6.8% 4.7% 4.1% 1.8% 1.2% 0.4% Margins Cost of Goods Sold 73.8% 73.9% 76.0% 77.6% 76.7% 76.2% 75.6% 74.8% 75.0% 75.0% 75.0% 75.0% 75.0% 75.0% Gross Profit 26.2% 26.1% 24.0% 22.4% 23.3% 23.8% 24.4% 25.2% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% SG&A 9.5% 9.8% 9.2% 10.2% 10.4% 10.5% 11.2% 11.9% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% EBITDA 16.7% 16.3% 14.8% 12.2% 12.9% 13.3% 13.2% 13.2% 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% EBIT 10.1% 9.7% 8.2% 4.6% 7.3% 8.1% 8.4% 8.3% 8.5% 8.6% 8.7% 8.7% 8.5% 8.4% Other Expenses (% of Sales) 0.1% 0.1% 0.1% 0.3% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% Interest Rate 10.7% 11.0% 11.3% 9.3% 8.0% 6.6% 7.2% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% Interest Income Rate (0.9%) (2.1%) (2.4%) (2.1%) (2.6%) (3.1%) (2.3%) (2.3%) (2.3%) (2.3%) (2.3%) (2.3%) (2.3%) Pre-tax Income 8.5% 8.2% 6.7% 2.7% 5.8% 7.1% 7.6% 7.4% 7.7% 7.8% 7.9% 7.8% 7.7% 7.5% Tax Rate 41.8% 42.2% 42.2% 59.4% 35.5% 32.0% 31.9% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% Net Income 5.0% 4.7% 3.9% 1.1% 3.8% 4.8% 5.2% 4.6% 4.8% 4.9% 5.0% 4.9% 4.8% 4.7% 38

41 Use Historical Performance to Inform Projections (2 of 2) Balance Sheet ($ in millions) Projected Financials FY (3) FY (3) FY (3) FY (3) FY (3) FY (3) FY (2) FY (1) FY 1 FY 2 FY 3 FY 4 FY 5 FY 6 Assets Cash $120 $110 $80 $85 $102 $94 $229 $200 $192 $197 $203 $210 $216 $222 Accounts Receivable ,027 1,227 1,303 1,256 1,313 1,371 1,430 1,473 1,517 1,563 Inventory Prepaids/Other Total Current Assets 1,133 1,173 1,347 1,366 1,556 1,916 2,191 2,163 2,151 2,239 2,331 2,413 2,498 2,573 Property, Plant & Equipment 1,140 1,148 1,124 1,089 1,068 1,047 1,073 1,081 1,121 1,175 1,233 1,293 1,383 1,482 Total Assets $2,273 $2,321 $2,471 $2,455 $2,624 $2,963 $3,264 $3,243 $3,272 $3,415 $3,563 $3,706 $3,881 $4,055 Liabilities & Shareholders' Equity Accounts Payable $457 $453 $540 $481 $619 $721 $799 $683 $722 $744 $766 $789 $813 $837 Accrued Expenses Total Current Liabilities ,066 1,287 1,486 1,256 1,234 1,271 1,309 1,348 1,388 1,430 Total Debt Shareholders' Equity ,004 1, ,061 1,179 1,362 1,427 1,501 1,578 1,651 1,745 1,837 Total Liabilities & Shareholders' Equ $2,272 $2,321 $2,471 $2,455 $2,624 $2,963 $3,264 $3,243 $3,272 $3,415 $3,563 $3,706 $3,881 $4,055 check Balance Sheet Cash as % of Sales 3.4% 2.9% 1.9% 2.1% 2.3% 1.8% 3.7% 3.2% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% Days Receivable Inventory Turns 9.7x 10.3x 9.4x 9.4x 8.9x 8.9x 9.1x 9.6x 9.6x 9.5x 9.4x 9.2x 9.0x 9.0x Days Inventory Days Payable Days to Cash Contribution Prepaid Expenses as % of Sales 1.2% 1.1% 1.3% 1.7% 1.0% 2.7% 2.4% 3.6% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% Accrued Expenses as % of Sales 11.8% 10.7% 8.8% 9.1% 10.1% 10.7% 11.2% 9.2% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% PP&E Metrics PP&E Turnover 3.1x 3.3x 3.7x 3.7x 4.2x 5.1x 5.7x 5.7x 5.7x 5.6x 5.5x 5.4x 5.2x 5.0x BoY PP&E $1,140 $1,148 $1,124 $1,089 $1,068 $1,047 $1,073 $1,081 $1,121 $1,175 $1,233 $1,293 $1,383 less Depr ($253) ($269) ($304) ($249) ($279) ($298) ($309) ($286) ($287) ($289) ($303) ($321) ($344) plus Other /(Divestitures) $0 $0 $0 $0 $0 $0 $0 Capital Expenditures EoY PP&E $1,140 $1,148 $1,124 $1,089 $1,068 $1,047 $1,073 $1,081 $1,121 $1,175 $1,233 $1,293 $1,383 $1,482 Capital Expenditures Growth Rate (8.4%) (6.1%) 9.8% (15.2%) 13.2% 25.7% (2.4%) 3.3% 4.5% 1.4% 5.0% 13.1% 7.6% Depreciation as % of Net PP&E 22.1% 23.7% 27.5% 23.1% 26.4% 28.1% 28.7% 26.0% 25.0% 24.0% 24.0% 24.0% 24.0% Capex as % of Depreciation 103.2% 91.1% 88.5% 91.6% 92.5% 108.7% 102.4% 114.2% 118.9% 119.8% 120.0% 128.0% 128.6% Debt/Capitalization 35.7% 36.1% 36.0% 37.2% 37.2% 36.7% 33.7% 31.4% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 39

42 Agenda What is accounting, and why do we care? Introduction to the three key Financial Statements: Balance Sheet, Income Statement, and Cashflow Statement Let s start a company and run it for a few years What does this all mean, and why should I care? 40

43 Accounting Fundamentals Help Answer Critical Business Questions How much cash is invested in my business, and for what (NWC vs PP&E)? How am I funding my business: debt, equity, or from my operations? Is my business performing favorably? Growth? Profitability? Cashflow positive? Efficiency? Days to cash PP&E Turnover Do I have too much debt? Is this a good business, from a financial perspective? Can it improve, and if so, how? What is this company worth, to me or to someone else? Based on my assessment of the past and what I believe about the business future operations, what type of cash will be required/generated going forward? 41

44 and Our Understanding of Accounting Lets Us Boil Everything Down to Cash Flow for Valuation Purposes Cash Flows from Operations AND Financing Decisions Free Cash Flow EXCLUDING Financing Decisions Balance Sheet ASSETS Income Statement t=1 t=2 Change Cash Inv A/R Net PP&E LIABILITIES A/P Debt EQUITY L + EQUITY t=1 t=2 Sales COGS Gross Profit SG&A D&A 5 5 EBIT Interest 3 3 Pretax Income 7 57 Taxes 2 20 Net Income 5 37 Gross Margin 30.0% 36.4% Op Margin 10.0% 27.3% Net margin 5.0% 16.8% Cashflow Statement t=1 t=2 Operating Activities + Net Income Non-Cash (D&A) Increase in CA Increase in CL Operating CF 0 32 Investing Activities - Capex 55 0 Investing CF Financing Activities + Issue Equity Issue Debt Dividends Paid 0 25 Financing CF TOTAL CASHFLOW 10 7 Basis of a DCF Model: Free Cash Flow t=1 t=2 Revenue COGS Gross Profit Total Operating Expenses Operating Income (EBIT) Provision fo Income Taxes (40%) Tax Affected EBIT Add back D&A Unlevered Operating Cash Flow Capital Expenditures (55.0) 0.0 Change in NWC: (Increase) / Decrease (10.0) (10.0) Change in Other Net Operating Assets Free Cash Flow (54.0) 31.0 We will compensate for financing decisions in how we discount the value of these future cashflows 42

45 Session 3 Intro to Valuation

46 Discounting Cashflows to Today (i.e. Present Value) We Should Now Be in a Position to Project Out Future Cashflows and Place a Value On Them By Discounting at the Weighted Average Cost of Capital (WACC) 2. Free cash flows 1. Understand historical performance Free cash flow during explicit forecast period Revenue growth Cost behavior Working capital requirements Operating liability requirements 4. Continuing value Free cash flow past explicit forecast period Returns on existing capital Returns on new capital Rate of reinvestment Continuing value (in 2024) 5. Discount Net present value (NPV) 3. Cost of capital Free cash flow past explicit forecast period Opportunity cost of invested capital Time value of money Inflation expectations Relevant risk 43

47 Discount Rate = Required Rate of Return The Return Investors Require for Investments is Used to Discount Expected Payoffs and Judge The Merits of Investing The concept of return can be demonstrated in two ways: We could ask, what would a promise of $110 in a year be worth today, if I require a 10% return? here if I discount $110 by 10%, 110/1.1, I am left with $100; Alternatively, we could ask what we would require as a payoff in a year for an investment of $100 if the risk merits a 10% return; here the math is reversed to 100 x 1.1 = $110 In this case, receiving $110 in one year for investing $100, when the risk merits a 10% return, the investor is not better off (I.e., no value has been created), we are technically indifferent In other words, you would be indifferent between this and a $100 investment that yields $120 if you required a 20% return; neither is technically superior This calculation of adding up the discounted future cashflows is called the Net Present Value (NPV) it allows us to compare the values of different investment opportunities Cashflows from Investor s Perspective t=0 t=1 t=2 t=3 t=4 Discounted Cashflows from Investor s Perspective _0_ + _0_ + (1+10%) (1+10%)^2 (1+10%)^3 Σ = $0 Net Present Value _0_ (1+10%)^4 Discounted Cashflows; $120 payout with 20% required return (1+20%) _0_ + + _0_ + (1+20%)^2 (1+20%)^3 _0_ (1+20%)^4 Σ = $0 Net Present Value 44

48 Net Present Value (NPV): Putting Future Cashflows into Today s Dollars Any Stream of Cashflows, Coupled With a Discount Rate (i.e. Required Return), Can Yield Equivalent Present Value Discounting future cashflows allows us to value that stream of promised cash We should be willing to pay up to the present value of those future cashflows, at which point the overall project would, by definition, yield NPV=0 In this case, if we can pay anything less than $300, then we have the opportunity to create value (I.e., invest in an NPV Positive Project) Of course the tough questions are: What are those expected cashflows in the future?; and What is the right discount rate to use in calculating the PV of the cashflows? Cashflows from Investor s Perspective ? t=0 t=1 t=2 t=3 t=4 Discounted Cashflows from Investor s Perspective ( r = 10%) 110 (1+10%) _0 66.6_ (1+10%)^2 (1+10%)^3 _219.6_ (1+10%)^ Σ = $300 Present Value 45

49 Taking The Present Value of Cashflows That Never Stop Seems Impossible Future cashflows in future dollars Present value of future cashflows (r=10%) 60 What are these perpetual cashflows worth today??

50 Shortcuts Exist to Value Perpetual Future Payments Value of C Received Forever Discounted by r PV = Σ PV = Σ C 1 + r + C (1 + r) a a r a (1 + r) Define X = Define a = 1 (1 + r) C (1 + r) X (PV) = Σ (a(1 + X + X ))X Define Eq.1 X (PV) = Σ a(x + X 2 + X ) Define Eq.2 Eq.1 - Eq.2 = a(1+x+x 2 + ) - a(x+x 2 +X 3 + ) PV X(PV) = a[(1+x+x 2 + ) - (X+X 2 +X 3 + )] = a PV (1 X) = a PV = a / (1 X) PV = _C_ r Substitute earlier terms back in and simplify Adding perpetual growth g of the C payments would result in: PV = _C_ r - g 47

51 Enterprise and Equity Value A DCF Generates the Value of the Total Operating Enterprise; Equity Holders Have a Claim on This and Other Non-Op Assets After Debt Holders Have Been Made Whole Value of Operations Value of Non Operating Assets Value of Entity (or Enterprise) Value of Debt Value of Equity # Shares x Share Price (Mkt Cap) 48

52 Terminal Value Apart From Projecting Explicit Cashflows, We Must Value the Entity on a Continuing Basis (e.g. Terminal Value) PV = _C_ r - g 1) Recall how we value a perpetual stream of cashflows that grows at a certain rate forever 2) This allows us to take our last year of explicit cashflows, and (provided it is a good proxy for future cashflows), apply this perpetuity formula 3) It s important to remember to do 2 things, in terms of mechanics to get to today s PV: Grow last explicit year s cashflows to generate C Treat this as a cashflow in your last explicit projection period WACC = 10%; Perp Growth= 3% Year CF PV TV 1, Calculating Terminal Value C = $100 x (1 + 3%) = $103 Value of TV = 103 / ( 10% - 3%) = $1,471 Note: this is a Year 2010 Cashflow PV of TV = $1,471/(1.1)^5 = $914 Enterprise Value: $1,181 49

53 Investment Bankers Will Often Use Multiples to Assess Terminal Values (or Values in General) If we know that a perpetual $10, with no growth and a discount rate is worth $10/.1 = $100, then other opportunities of similar growth and risks should also be worth 10x; this is the basic concept behind multiples (e.g., valuation ratios should hold for similar companies) We can use several operating metrics as multiples to derive a value estimate: Sales, EBITDA, EBIT, Net Income; However, be careful about which metric applies to what capital s value Net Income only applies to the Equity Value of a Company (Debt Capital has already been compensated through interest payments) Sales, EBITDA, and EBIT can all be applied to the Total Value Multiples are only right if the underlying DCF drivers justify the multiples (the devil is in the details, and applying multiples is a lazy approximation for valuation) Total Value Sales Total Value EBITDA Total Value EBIT Enterprise Value Or Total Value Total Value Firm Value Enterprise Value Net Debt Equity Value Equity Value Net Income Equivalent to a P/E Multiple 50

54 Quick Concept Check on Multiples The entire capital structure allows for (has rights to) Sales, EBITDA, and EBIT; however, once interest expense is paid, the debt component of the capital structure is satisfied and does not have a claim on the remaining stream of earnings that period. (thousands except per share) Net Sales $15,000 Debt & Equity Cash = $2,000 COGS 10,000 Total Debt = $8,000 Gross Profit 5,000 D&A = $500 Share Price = $10 Operating Expenses 2,500 Shares = 2,000 EBIT 2,500 Debt & Equity Net Debt = $6,000 Interest Income 100 Equity Value = $20,000 Interest Expense 200 Debt Total Value = $26,000 Pretax Income 2,400 TV / Sales = Taxes 800 TV / EBITDA = Net Income 1,600 Equity TV / EBIT = EPS $0.80 EV / Net Income = Shares Outstanding 2,000 Share Price / EPS = 51

55 Your Mission Step 1 Project out free cash flow for ($ in millions) Revenues $57 $74 $85 GP $24 $32 $36 Operating Profit $12 $17 $20 From the CFO: We should be able to grow at 10% for the next 3-5yrs Our GP will improve by 1%/yr for the next 5 years Our G&A expenses are a combination of variable and fixed there is a little depreciation within Opex This is a software service company, so our WC needs are pretty straightforward no inventory, get paid in 30 days on average and handle payables in 20 days Capex is fairly steady we have averaged $4MM in capex/yr for last couple years should stay at that pace for next couple years I depreciate all capex over 2 years Step 2 Develop a perspective on what this Company is worth if sold at the end of

56 Session 4 Basics of Finance

57 So How Did it Go???? Step 1 Project out free cash flow for ($ in millions) Revenues $57 $74 $85 GP $24 $32 $36 Operating Profit $12 $17 $20 From the CFO: There is NO crystal ball the only thing we know for certain is that any set of projections will be WRONG We should be able to grow at 10% for the next 3-5yrs Our GP will improve by 1%/yr for the next 5 years Our G&A expenses are a combination of variable and fixed there is a little depreciation within Opex This is a software service company, so our WC needs are pretty straightforward no inventory, get paid in 30 days on average and handle payables in 20 days Capex is fairly steady we have averaged $4MM in capex/yr for last couple years should stay at that pace for next couple years I depreciate all capex over 2 years Step 2 Develop a perspective on what this Company is worth if sold at the end of 2014 Lots of subjectivity in valuation but it is grounded in finance theory let s go there now 53

58 What is Finance, and Why Do We Care? Finance addresses the way individuals and organizations raise, allocate, and use monetary resources over time while considering the risks and rewards of their available options Throughout this section, we must remember that there are two sides of the investment coin : the Investor and the Investee I need to raise capital to invest I have money to invest, in my business. What is the but where am I going to optimal way to finance my get the best return for the activities, given the returns risks I can take? investors will want for the risks I can ask them to take? Investor Investee I-Bankers at the Nexus of Finance Both parties must find the arrangement compelling to proceed with this investee/investor relationship Finance will help us understand how both sides assess their situations and come to that win-win arrangement Cash is given and cash is ultimately paid back and then some (hopefully) so clearly we are focused on CASH FLOW (or proxies for cash flow) 54

59 Key Questions for Investors Risk and Reward Go Hand in Hand What are you being promised? Where will the cash come from to live up to that promise (cashflows? assets/collateral?) When and how can I get my money back? Where am I in priority for being repaid.in good and bad times? DEBT EQUITY Senior Junior Preferred Common Which is Better? A or B A B 55

60 Company s Needing Capital Have Decisions Cheap Debt Financing Capital Sources Equity Financing Expensive Investment Grade Non-Investment Grade Preferred Common Investment Grade Bank Market Investment Grade Bond Market Private Placement Market Leveraged Loan Market Mezzanine / 2nd Lien Market High Yield Bond Market Convertible Debt Market Paid before common, typically has a dividend, often times liquidation preferences and sometimes other rights Paid last, with least amount of protection so with the greatest risk, this is the most expensive financing Those in need of capital want to finance their operations with a capital that requires the lowest overall return requirements that required return is the Company s Cost of Capital 56

61 Credit Ratings Dictate Access to Debt Markets For high yield and leveraged loan transactions, investors will require that credit ratings be assigned by Moody s and S&P Investors in leveraged loans typically make investment decisions based on a corporate credit rating which isn t tied to a single tranche of debt High Yield investors focus on the rating of a specific tranche Banks and other private lenders do not require ratings, but many institutional investors will not lend to non-rated companies Should consider whether rating will be beneficial for companies with EBITDA of approximately $35-$40 million or more Ratings Spectrum High Grade (Investment Grade) Moody s Aaa Aa A Baa Ba B Caa Ca C C S&P AAA AA A BBB BB B CCC CC C D Typically have full access to unsecured debt capital markets: Commercial paper available to strongest credits Bank market capacity in excess of $10 billion for some borrowers High grade bonds with long term maturities (up to 30+ years) Leveraged or Non-Investment Grade Market access is highly variable depending on size and rating: Four B credits (Ba3 / BB- or better) generally have deep access to bank, institutional term loan and high yield bond markets Around the B1 / B+ area, bank market become limited and institutional term loans begin to play a much larger role New issues rated below Caa1/CCC+ are not common in the debt markets 57

62 What is the Right Discount Rate? You discount future cash-flows to reflect your required rate of return If I need to make 20%, then you promising me $100 is worth $100/(1+20%) = $83.3 if I pay any more that future promise of cash, then I don t make that return As we just saw, not all investments bear the same risk, so each source of capital will have its own cost of capital Required rate of return should be based on i) time value of money to some extent, but primarily on ii) the risk you can t diversify away that is where CAPM comes in 58

63 Capital Asset Pricing Model (CAPM) Determining the Required Rate of Return aka the Cost of Capital Review on your own or look up on the internet CAPM is a systematic method that tries to calculate the return you should require for a given amount of market risk From an investee s perspective (i.e., the company raising capital), this is the cost of the capital invested in their business, or what they are expected to give to investors from a return standpoint This Hurdle Rate will determine whether a company is creating or destroying value for shareholders; remember, if a company fails to return at least its cost of capital, it is destroying value for shareholders CAPM allows us to identify the required return (aka cost of capital) for securities of different undiversifiable risk profiles Once we know the cost of debt and cost of equity that is funding an entity, we can understand what a company s Weighted Average Cost of Capital (WACC) is we discount an entity s cashflows to present value using the WACC WACC = (D/(D+E))*Kd*(1 taxrate) + (E/(D+E))*Kel % Debt Interest is tax % Equity deductible Where does this come from?!?! Note: Kd stands for the Cost of Debt and Kel stands for the Cost of Levered Equity (these are derived by market rates of interest and CAPM) 59

64 CAPM and BETA Help Calculate Cost of Equity (Kel) Review on your own or look up on the internet CAPM Equation Kel = Rf + β i (Rm-Rf) RETURN 7.0% Beta = 0.7 Use 30yr Treasury, Mkt Risk Prem (additional return required for risk); Practitioners use anywhere from 3-7% Market Risk Premium Rm Rf 2.5% Require Rf + 70% of the Market Risk Premium RISK σ Example: Beta = 0.7 Exp Return = 2.5% +.7 x (7% - 2.5%) = 5.7% This is the return an equity investor requires for investing in an entity with this type of risk 60

65 Refresher Course on Multiples If we know that a perpetual $10, with no growth and a discount rate is worth $10/.1 = $100, then other opportunities of similar growth and risks should also be worth 10x; this is the basic concept behind multiples (e.g., valuation ratios should hold for similar companies) We can use several operating metrics as multiples to derive a value estimate: Sales, EBITDA, EBIT, Net Income; However, be careful about which metric applies to what capital s value Net Income only applies to the Equity Value of a Company (Debt Capital has already been compensated through interest payments) Sales, EBITDA, and EBIT can all be applied to the Total Value Multiples are only right if the underlying DCF drivers justify the multiples (the devil is in the details, and applying multiples is a lazy approximation for valuation) Total Value Sales Total Value EBITDA Total Value EBIT Enterprise Value Or Total Value Total Value Firm Value Enterprise Value Net Debt Equity Value Equity Value Net Income Equivalent to a P/E Multiple 61

66 Consumer Packaged Goods Retailers What are the right set of comparable companies for Whole Foods? 62