Quiz 3 (Financial ratios - Valuation) Questions and Answers

Quiz 3 (Financial ratios - Valuation) Questions and Answers Define Activity Ratios these ratios measure how efficiently a company operates. How well does the company use its resources to generate sales? The Activity Ratios are 1. Inventory turnover 2. A/R turnover 3. A/P turnover 4. Working Capital turnover 5. Fixed asset turnover 6. Total asset turnover 7. Days Sales Outstanding (DSO) 8. Days Payable Outstanding (DPO) There are many, many more. Some Activity Ratio Formulas are: Inventory Turnover Ratio = COGS / Average Inventory (low ratio indicates company is struggling to move its inventory) Accounts Receivable Turnover = Total Sales on Credit / Average A/R Balance in the period (low ratio indicates a company is struggling to collect) Total Assets Turnover = Total Sales / Total Assets (low ratio indicates company is struggling to move product) Return on Equity (ROE) = Net Income / All outstanding Shares in the market(low ROE ((10% or less)) indicates a company does not generate profitefficiently Which liquidity ratio is the most liquid? Cash ratio Which liquidity ratio is the least liquid? Quick ratio What does a low ratio in inventory turnover mean? The company is struggling to move its inventory What does a low ratio in A/R turnover mean? The company is struggling to collect What does a low ratio in total asset turnover mean? The company is struggling to move their product What does a low ROE mean for a company? It means that the company doesn't generate profit efficiently What are leverage ratios? Ratios that measure a company's ability to pay its long-term debt Define a Performance (Profit) Ratios --these ratios measure a company's ability to generate net income/profit Performance (Profit) Ratios examples Gross Profit Margin (GPM) = Gross Profit / Total Sales Operating Profit Margin (OPM) = Operating Profit / Total Sales Net Profit Margin (NPM) = Net Profit or Net Income / Total Sales Return on Equity (ROE) = Net Income / All outstanding Shares in the market(low ROE ((10% or less)) indicates a company does not generate profit efficiently. What are some leverage ratios? (1)Debt-ratio: Total Debt to Total Assets; typically expressed as a decimal or % (2)Debt-equity: Total Debt / Total Equity (3)interest coverage: EBIT / Interest Expense All of these ratios are attempting to measure the company's ability to meet it's long-term debt obligations. What are market/valuation ratios? Ratios that measure a company against its peers and the broader market What are some market/valuation ratios? (1) Price to Earnings (P/E) = Current Market Price of a share / Net Income (2) Price to cash flow (P/CF) = Current Market Price of a share / Cash Flow (3) price to sales (P/S) = Current Market Price of a Share / Total Sales (4) enterprise value to EBITDA = Enterprise value (EV) is market capitalization + preferred shares + minority interest + debt - total cash. Essentially, the ratio tells you how many multiples of EBITDA (generally considered to be an easy-to-obtain proxy for cash flow) What does the enterprise value to EBITDA ratio tell you? The number of multiples of EBITDA What is the idea behind "Present Value"? The idea is that a dollar today, is "worth more" than a dollar tomorrow What is tomorrow's dollar? Future value (FV) Why is today's dollar or (PV) "worth more"? Because of inflation and risk What is inflation? The general rising of prices of the macro economy Give some examples of inflation: Wages, raw materials, energy, housing, commercial rents, foodstuffs Why does inflation make today's dollar worth more than tomorrow's dollar? Present value future value (the present value of the dollar is worth more than the future value) What are the types of financial risk? 1. Default risk (credit risk) 2. Liquidity risk (lack of a market to trade private company shares) 3. Market risk 4. Operational risk 5. Geopolitical risk 6. Reputational risk (traditionally less important; more important in age of social media) There are several additional types of risk that are beyond the scope of this course What is default risk (credit risk)? The risk associated with a firm not paying its debts; the firm defaults on its obligations What is liquidity risk(a lack of a market to trade private company shares)? small, privately held companies do not have a ready market to trade their shares. If a shareholder wants to exit his or her position, they cannot sell the shares on a public exchange. They have to follow a proscribed process from the Company's operating and/or shareholder agreements What are the 4 risk factors in market risk? 1. Equity risk—broader markets begin to decline systematically 2. Interest rate risk—interest rates change dramatically thereby affecting underlying valuation models. 3. Currency risk- values of the currency that assets are denominated in change dramatically (Brexit as an example) 4. Commodity risk—prices of commodities change dramatically. What is operational risk? the Company fails to execute on its strategic goals and objectives, has a failure in people or processes, is hit by exogenous shocks (outside the firm), legal risk, fraud, privacy protection, etc. What is geopolitical risk? a Company is exposed to geopolitical factors beyond its reasonable control. 1. Terrorism (travel, financial services, airlines) 2. Tariffs (The company finds itself in an industry that becomes subject to traded disputes with little notice (Orange Juice, Levis, Harley Davidson). What is reputational risk? losses resulting from damage done to a Company's reputation 1. Delta and the puppy dog. 2. Tylenol and arsenic 3. Uber and a culture of sexism Why do we care about risks? The higher the risk, the higher the interest becomes, and they inform our thinking on the likelihood a company can deliver its financial forecast for future revenues, earnings, and cash flow. These risks also allow us to compare the riskiness of different industries, companies, assets, or investments. What do we need to know for understanding ROI (return on investment)? Cost of capital, and hurdle rate for investment (Required Rate of Return in your book) What is cost of capital? The minimum return that investors expect for providing capital to the company. This then sets the benchmark for the required rate of return for any new projects or acquisitions. If a Company's Cost of Capital is 8.0%, what must the return rate be? Higher than 8.0% What are the 3 steps to calculate ROI? Determine the initial cash outlay of the project Project the future cash inflows 1. Critical—you are forecasting cash inflows from the project...NOT PROFITS! Evaluate the future cash inflows 1. Are they substantial enough to make the investment? How do you know? 2. There are 3 methods to evaluate the future cash flows What are the 3 steps for calculating future cash flows? Payback method, net present value method(NPV), and internal revenue method (IRR) When should we reject a project? When the payback period is longer than the life of the project What does payback period analysis tell us? That we should continue on in our investigation because we still don't know what the return of the project is What does the payback method calculate? How long it will take to recoup the investment with future cash flows What do we need to use the payback method? Life of the project, total cost of the project, and future cash flows generated by the project What do we need to calculate NPV? Net Present Value (NPV) is the method of choice for financial analysts to evaluate any project, investment or acquisition. NPV is more complex, but it is far more accurate in assessing the present value of the future cash flows of a project. NPV is used in Capital Budgeting, valuation and M&A analysis. In order to perform NPV calculation, we need to first calculate the... Discount Rate What is discount rate? The interest rate used to calculate present value using discounted cash flow analysis What are we looking for when calculating NPV? The present value of the future cash flow How do you calculate NPV? capture all of the future cash flow values and subtract the initial cost of the project What is the relationship between Discount Rate/Hurdle Rate/Cost of Capital and NPV? Inverse. CC/HR/DR goes up = NPV goes down. CC/HR/DR goes down = NPV goes up. What is capital expenditure? The purchase of assets that have expected useful lives greater than 1 year When is an asset considered a capital expenditure? When it is subject to depreciation What are some examples of capex? Vehicles, Computer, Land, Buildings, Machines. Note Capex The process of performing the ROI analyses, AND looking at our cash flow forecast results in the Capital Budgeting function of the firm. Therefore, we must consider the following when deciding WHEN, not if, to undertake a CapEx project: 1. Do we have sufficient Cash Flow in this period (month, quarter, year) to put the asset into service now? 2. Is there an ongoing use of cash that is required to allow the asset to generate the cash flow we estimated in our ROI calculations? For example, if it's a vehicle, what about fuel, repairs, insurance, licensed driver(s), etc? 3. Does the Capital Expenditure materially alter our cash flow forecast beyond the period in which we are looking to put it into service? Types of financial risk 1. Default risk (credit risk) 2. Liquidity risk (lack of a market to trade private company shares) 3. Market risk 4. Operational risk 5. Geopolitical risk 6. Reputational risk (traditionally less important; more important in age of social media) 1. default risk Default risk (credit risk):-- the risk associated with a firm not paying its debts; the firm defaults on its obligations 2. liquidity risk Liquidity risk (lack of a market to trade private company shares)--small, privately held companies do not have a ready market to trade their shares. If a shareholder wants to exit his or her position, they cannot sell the shares on a public exchange. They have to follow a proscribed process from the Company's operating and/or shareholder agreements. 3. market risk --Comprised of 4 different risk factors 1. Equity risk—broader markets begin to decline systematically 2. Interest rate risk—interest rates change dramatically thereby affecting underlying valuation models. 3. Currency risk- values of the currency that assets are denominated in change dramatically (Brexit as an example) 4. Commodity risk—prices of commodities change dramatically. 4. operational risk - the Company fails to execute on its strategic goals and objectives, has a failure in people or processes, is hit by exogenous shocks (outside the firm), legal risk, fraud,privacy protection, etc. 5. geopolitical risk - a Company is exposed to geopolitical factors beyond its reasonable control. 1. Terrorism (travel, financial services, airlines) 2. Tariffs (Company finds itself in an industry that becomes subject to traded disputes with little notice (Orange Juice, Levis, Harley Davidson). 6. reputational risk -- losses resulting from damage done to a Company's reputation Why do we care about risk? 1. The higher these "buckets of risk" the higher the cost of the money becomes (interest) 2. They help inform our thinking on the likelihood a Company can deliver on its financial forecast for future revenues, earnings and cash flow. 3. These risk also allow us to compare the riskiness of different industries, companies, assets, or investments. What is valuation? The process of a third party providing me with the economic value of my business vs what my business is actually worth What are 2 primary ways to consider what a business valuation is? 1. A qualified, independent (not conflicted), 3rd party performs research and analysis and provides you with the "economic value" of your business 2. Market forces tell you what your business is worth Why would a company need a valuation? Angel/seed round of investment, as a condition of your companies operating agreement, , buy/sell agreement, estate planning, litigation, M&A purposes, and upon exit What is valuation trying to determine? What the business is worth as of the valuation date What are the three methods used in valuation? The income approach, market approach, and asset approach What does the income approach use? The company's future earnings capacity to indicate the company's value What finance method does the income approach use? Discounted Cash flow What does the market approach use? Comparable transaction data to arrive at an implied multiple for the subject company What does the asset approach use? The Net Asset Value method (NAV) method What does the NAV do? It sums the value of the company's total assets and substracts its total liabilities and arrives at a "net asset" valuation What is the NAV method used for? Bankruptcies, orderly liquidations and firms going out of business What is NAV Method NOT TYPICALLY used for? for going concern entities outside of investment funds, and real estate trusts Why would private companies perform valuations? Another major reason private companies perform valuations is to value interests in companies. What are valuation multiples? Multiples of several metrics used in valuation a company • Analysts will convey value regarding a company in terms of its valuation multiples—i.e.Company X is trading at 2x or 3x or 10x • Multiples of "what" you may ask? • In valuation we use several metrics when discussing multiples • The most common are: • Sales • EBIT • EBITDA • Enterprise Value What metrics are used as valuation metrics? Sales, EBIT, EBITDA, and enterprise value In terms of rigor, valuation analysts are most inclined to use... most inclined to use EBITDA and EBIT, followed by Sales and lastly Enterprise Value. • Typically, we would present all 4 values in our report • So, a Company might have the following combination of: • Sales 2.5x • EBIT 5.0X • EBITDA 7.5x • EV 1.89x What is a premium? An increase in value above the calculated share price of the company as a whole What is the most common valuation premium? Control premium