Mercurio Capital - Financial System, Economic Strategy, Capital Budgeting, Quantitative Methods

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Horace Barrett
5 years ago
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2 Main Objective: Growth in Shareholder Value Increase the general valuation of the company Increase the share premium Reduce Risk Integrate Financial Strategy in the Business Strategy (as an extra layer in the Internal Business Cycles (market, BP, BM, Ops, Financial) Increase Financial Efficiency 2

3 Financial Engineering Terminal Values Strategic Finance Optimal Capital Structures Risk Frontiers 3

4 Difference between nominal (par) value of share and Premium Positive financial differences in capital budgeting Increase in market multiples Perceived Value 4

5 Increase Cashflows Reduce Equity Risk Increase share price (if public company) Net Income higher than Nominal Cost of Equity 5

6 Cash/accounting-based Higher EBITDA Higher Net Income Non-cash-based (intangible) Lower Risk Higher efficiency Client base Market position Technology/BP/BM Disruption Return Speed Good management Sustainability Good Governance IP Brand 6

7 Non-Cash-based (Risk) Cash/accountingbased (ex, DCF) 7

8 Cash-based comparison some examples EUA 3 largestcompanies by 460 billion USD (Market Capitalization in billion USD) Wal-Mart 248 Royal Dutch Shell 132 Exxon Mobil 406 Net Income versus Market Capitalization (in billion USD) 2012* Net Income Market Cap ICBC Bershire Hathaway General Motors 6 38 Toyota

9 Cash-based comparison more examples EBITDA multiples * Intel 19 5 Cisco 85 5 Pfizer 28 7 EMC * 9

10 Cash-based dynamics need for interpretation Sales Depends on profitability, type of contracts, size and client s credit worthiness EBITDA Asset-heavy balance sheets can look healthier than reality Depends on market type B2B B2C, geography Ignores Working Capital needs and structured Debt arrangements Net Profit Too much NI can destroy future Value for shareholders (no investment) Ignores liquidity management Assets Ignores Value for Shareholders and Financial metrics (because of accounting rules logic) Valuations can be extreme deviation 10

11 Revenue increases in large cap companies Revenue increase Revenue increase Apple 45% Samsung 29% Lloyds Bank 20% Toyota 13% 11

12 Risk (more than 17% NPV difference with 10% exponential increase in Risk)* Good Business Decisions (Cost of Lost Opportunity) Strategic orientation Integration between Risk and Business Risk, 100 cashflow increasing 5 years 12

13 Cash ways to make money on/from equity: Capital appreciation (in a sale) Dividends distribution Monetization of capital increase (if a public company) Lending on margin Non-cash ways to increase equity value: NPV higer than 0 IRR, ROI higher than WACC ROE higher than Cost of Equity Lower Equity risk Positive change in Valuation Model (ex, Asset-based to Cash flow-based) Terminal Valuation Multiple higher than Initial Valuation Multiple Reinvestment Policy Net Income higher than Nominal Cost of Equity Increase share price (if public company) Increase in the share premium Increase multiplier Asset ownership/control Perceived value 13

14 Equity = Money (cash) Base of market economy Shareholders, investors, partners sole objective is increase Value - multiply their initial and ongoing investments What the shareholders contribute with cash/assets/debt, plus Net Income Can be Increased Substituted Diluted Premium or Loss 14

15 Current Sales Ebitda Proposed Value for Shareholders Equity Strategy Net Income Value for shareholders Financial Strategy Capital Budgeting Capital Structure Increase in Sales Increase in EBITDA/NI 15

16 Choice Unlimited resources Rationality 16

17 Derivatives: ~USD 700 trillion Bonds: ~ USD 97 trillion Stocks: ~USD 50 trillion Commercial real estate: ~USD 10 trillion Pivate Equity (investment funds): ~USD 2 trillion 17

18 18

19 GDP= Private consumption + Private investment + Government ( consumption & investment) + Trade Balance ( exports imports) Average government weight on GDP ~20%* World GDP 2012: USD 72 trillion (nominal) 72 t 20% = 58 trillion Assume private companies could have valuation = 1 year sales Private Equity funds USD 2 trillion Therefore World value of private companies ~USD 56 trillion or 40 trillion, or ~7% of world financial system * 19

20 Return needed to keep the equity in the company Opportunity Cost of invest in another company, assets, country, products, etc Cost of Equity = Risk = Opportunity Cost = Rate of Return = Equity Discount Rate Many variables can affect rates Can be partly market, partly sector-specific Intrinsic Risk is controlled by management Can be affected by external non-controllable variables (ex, Country Risk) For private companies, only way to find out Effective Rates is by dealing 100% Dealing contracts can have cash and non-cash components, ex, shares in a listed company and clawback provisions Main challenges with Equity: Not visible (not cash/accounting cost) Measured indirectly (Mkt multiples, Quantitative Methods) 20

21 Return needed to keep equity + Debt in the company Opportunity Cost of invest in another company, assets, country, products, etc Cost of Capital = WACC = Capital Discount Rate = Company Risk Main challenges with Cost of Capital: Parly not visible Quants can be challenging 21

22 Required Rate of Return Event driven Seed Build Startup TIO Early Growth Late Expansion T - Technology I - Implementation O - Operation IPO Mature Time Present value Future value 20% 20% 20% 20% % 8.00% 6.00% 4.00%

23 Required Rate of Return Seed Equity Cheaper Equity Less Equity 50 Debt Cheaper Debt Higher Debt Startup 20 Early Growth 10 Late Expansion IPO Mature Time 23

24 Required Rate of Return Return Risk Time 24

25 Sales Cashflows Net Income Nº Clients Nº Units sold Market penetration Market Assets 25

26 Markets are made of millions of investments Choice of thousands different investments Choice lower Risk, lower Return (lower Required Rate of Return) higher Risk, higher Return (higher Required Rate of Return) 26

27 Size (ex, Sales) Risk 27

28 Adapt to market (Systematic Risk) Control Intrinsec (Non-systematic)Risk Reduce Uncertaintity (Uncertainty Avoidance) 28

29 Usually sectorspecialists Own Capital (Retained Earnings) 4F s Founders, Friends, Family, Fools Boutiques Family Offices Venture Capital Residual Private Equity funds Secondaries ~2 trillion Funding (Equity) Sector agnostic Pension Funds Mutual Funds Insurance Companies ~70 trillion 29

30 Investors (Shareholders) Clients Creditors Employees Suppliers State Stakeholders ICCESS 30

31 Organic (growth speed lower) R&D New Products New clients New markets Acquisitions/Merger (growth speed higher) Synergies Business combinations Horizontal versus Vertical Types of Business Growth 31

32 Capital Structure Capital Budgeting Internal Portfolio rebalancing Synergies 32

33 Hardware Design Hardware assembly Software Development Product Development Intelectual Property licensing Direct Sale versus sale through distributors/resellers Product maintenance 33

34 Market (what does the market want, where is it, how much is it willing to pay, etc) Business Plan (product/service being sold) Business Model (the way it s sold) Operations (assets, equipment, people, cash) Financial (basic modeling P&L and Balance Sheet) 34

35 The higher the Risk, the higher the Required Return High risk Equity (can be lost) Low risk Debt (needs a guarantee, cannot be lost) Growth (as capital appreciation) Value (dividends as cashflows) Sustainability & Good Governance 35

36 Positive correlation in world markets 36

37 Tech Sector Exponential Growth Expectancy 37

38 Private Public Liquidity None High Price formation None Market Historical prices None Ongoing Investors type 4 F s, Boutique, Business Angel Pension funds, institutional Information to market None/little Regular Value formation Market Market Risk High Lower Dealing speed Months Milliseconds Regulation & Governance None High Pricing abnormalities Huge Small 38

39 Net Income result is higher than nominal share capital plus Premium in a sustained market rates Private Equity valuation covers Cost of Capital in a sustained market rates 39

40 CashFlow Type of valuation Method Seed None Non-cash Last Historical Value Startup 0-0,5 m Cash & market Asset-based Early Expansion 0,5m-10 m Cash & market Risk-based Late Expansion 10 m-50 m Cash & market DCF IPO 50 m + Cash & market DDM Entry Value Cash flows Reinvestment policy Exit Value Lowest risk Highest cash flow and/or multiplier 40

41 Enterprise Value Discounted Cash Flows EBITDA multiple Net Income multiples Sales/other ratios Market multiple Asset-based Contract/client-based 41

42 Market Business combination Business Plans Feasibility Business Models Competition Operations Financial 42

43 Management team overarching objective should be to create Value for Investors Management team should then balance the interests: Clients Creditors Employees Suppliers State 43

44 Economic and Financial valuation of a project or an asset. Measured in NPV, ROI, IRR, Payback, Breakeven Starts with an idea. Cost/Benefit analysis Sensitivity analysis Contraction/expansion Substitution versus new Speed (do more, do less) Cost/rewards of Not-doing Real Options Binomial Trees (decision logic) Probability and statistics 44

45 Synergies capture Diversification effect due to Negative Correlation (sum of parts may not be the same) Weightings Contagion 45

46 Distress Factors remove Value from Shareholders sistematically (different from Weaknesses and Threats) Two types: Light Consolidated Can be invisbible and latent for years Are under management control (unlike Weaknesses and Threats) 46

47 Cash Values Non-cash Values Entry Value Cashflows Exit Value 47

(20 minutes presentation) Intro What is money? Equity, what is it, how does it work, where to find it, how much does it cost? Funding Where to find

1 (20 minutes presentation) Intro What is money? Equity, what is it, how does it work, where to find it, how much does it cost? Funding Where to find equity and debt? Tips for start ups How to use equity