How Finance Works

Summary Notes

Weihan Huang

January 1, 2024
Contents

1 Financial Analysis 4
1.1 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.1 Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.2 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.3 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.4 Property, plant, and equipment (PP&E) . . . . . . . . . . . . . . . . . . . . . 5
1.1.5 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.1 Accounts payable and notes payable . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.2 Accrued items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.3 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.4 Preferred and common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3 Understanding Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.1 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.2 Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3.3 Financing and Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.3.4 Productivity or Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.3.5 The DuPont Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2 The Finance Perspective 13

2.1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.1 EBIT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.2 EBITDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.1.3 Operating Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.1.4 Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.1.5 The Cash Conversion Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.1.6 Free Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.2 The Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.2.1 Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.2.2 Sunk Costs and Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . 21

3 The Financial Ecosystem 23

3.1 The Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2 The Buy Side - Institutional Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2.1 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2.2 Pension Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.2.3 Foundation and Endowment Funds . . . . . . . . . . . . . . . . . . . . . . . . 25
3.2.4 Sovereign Wealth Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.2.5 Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.3 The Sell Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.3.1 Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2
 3.3.2 Salespeople . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.3.3 Investment Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.4 The Media . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.5 Incentives for Equity Analysts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.6 The Problem at the Heart of Capital Markets . . . . . . . . . . . . . . . . . . . . . . 28
3.6.1 The Principal-Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

4 Sources of Value Creation 30

4.1 Market-To-Book Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.1.1 Influencing Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.1.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
4.2 The Weight Average Cost of Capital (WACC) . . . . . . . . . . . . . . . . . . . . . . 33
4.2.1 The cost of debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.2.2 Optimal capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.2.3 The cost of equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.3 Common Mistakes with WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.3.1 Using the same cost of capital for all investments . . . . . . . . . . . . . . . . 39
4.3.2 Lowering WACC using more debt . . . . . . . . . . . . . . . . . . . . . . . . . 40
4.3.3 Exporting WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

5 The Art and Science of Valuation 42

5.1 Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.1.1 Pros and cons of multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.2 Problematic Methods for Assessing Value . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.2.1 Payback periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.2.2 Internal rates of return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.3 Discounted Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.3.1 Free cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.3.2 Laboratory investment valuation exercise . . . . . . . . . . . . . . . . . . . . . 45
5.4 Valuation Mistakes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
5.4.1 Ignoring incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
5.4.2 Exaggerating synergies and ignoring integration costs . . . . . . . . . . . . . . 51
5.4.3 Underestimating capital intensity . . . . . . . . . . . . . . . . . . . . . . . . . 51

6 Capital Allocation 52
6.1 Capital Allocation Decision Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
6.2 Retaining Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
6.2.1 The perils of inorganic growth . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
6.2.2 Conglomerates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
6.3 Distributing Cash to Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
6.3.1 The decision to distribute cash . . . . . . . . . . . . . . . . . . . . . . . . . . 57
6.4 Myths and Realities in Financing Decisions . . . . . . . . . . . . . . . . . . . . . . . . 58
6.4.1 Equity issuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
6.4.2 Stock splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
6.4.3 Leveraged recapitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
6.4.4 Venture financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
6.4.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
6.5 Cash on Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
6.6 Six Major Mistakes in Capital Allocation . . . . . . . . . . . . . . . . . . . . . . . . . 62

3
Chapter 1

Financial Analysis

Assets: what a company owns Liabilities and shareholders’ equity:

how assets are financed
Current assets Current liabilities
- Cash - Accounts payable
- Accounts receivable - Other current liabilities
- Inventories
- Other current assets
Noncurrent assets Noncurrent liabilities
- Property, plant, and equipment - Long-term debt
- Intangible and other assets - Other liabilities
Shareholders’ equity
- Retained earnings
- Other equity accounts
Total assets Total liabilities and shareholders’
equity

Table 1.1: Representative balance sheet

Gross prof it = Revenue − Cost of goods sold (1.1)

Operating prof it = Gross prof it − Selling, general, and administrative expenses (1.2)

P retax income = Operating prof it − interest (1.3)

N et prof it = P retax income − taxes (1.4)

1.1 Assets
• Assets are what a company owns

• Often ordered by the degree to which they can be changed into cash

• Assets that can easily be changed into cash are called current assets

4
1.1.1 Cash and marketable securities
• Marketable securiteis are assets that can be quickly converted to cash e.g. stocks, bonds,
preferred shares and ETFs

• Purpose of large cash holdings

- Insurance policy during uncertain times

- A war chest for making future acquisitions
- A manifestation of the absence of investment opportunities

1.1.2 Accounts receivable

• Amounts that a company expects to receive from its customers in the future.

• As trusts grows, companies may be willing to allow customers to pay later

• This is known as extending credit, where business allow their customers, often other businesses,
to pay after 30, 60, or 90 days.

• Thus, B2B businesses often have a higher amount of their sales reflected as receivables on their
balance sheet (more so than B2C businesses).

1.1.3 Inventories
• The goods (or the inputs that become those goods) that a company intends to sell.

• Often short-term/perishable assets e.g. Haagen-Dazs’s ice cream inventories

• Companies with no inventories are those that provide services e.g. law firms, advertising
companies or medical practices.

1.1.4 Property, plant, and equipment (PP&E)

• In contrast to more short-term assets covered under inventories, PP&E are tangible, long-term
assets that a company uses to produce or distribute its product.

• Includes its HQ, factories, machines in the factories etc.

• E.g. utility companies - hydroelectric dam, retail stores - outlets.

1.1.5 Other assets

• Likely to be intangible assets like patents and brands

• Accountants won’t assign value to intangible assets unless they those values precisely e.g. Coca
Cola has a very valuable brand, possibly the most valuable thing it owns but its exact value is
unknown, so accountants ignore it (makes people in finance distrust accounting)

• This illustrates the accounting principle of conservatism

• When a company buys another company, many intangible assets that couldn’t be valued pre-
cisely now have a value according to accounting, as someone actually paid for it as part of an
acquisition.

• This leads to a particularly important part of other assets - goodwill.

5
 • When a company acquires another company for more than the value of its assets on their
balance sheet, that difference is typically recorded on the acquiring company’s balance sheets
as good will.

• Thus, companies with lots of other assets and good will are likely those that have bought other
companies with many intangible assets that were previously unrecorded because of conservatism
e.g. Microsoft acquisition of LinkedIn for $19.2 billion more than the book value will be under
“Other assets” in Microsoft’s balance sheet (could benefit from information on 433 million
LinkedIn users)

• Overall, the rising importance of both cash and other assets are two dominant trends in finance

1.2 Liabilities and Shareholders’ Equity

• How assets are financed.

• There are two sources of finance for purchasing assets - lenders and owners.

• Liabilities are the amounts financed by lenders to whom the company owes amounts.

- Liabilities are ordered by the length of time companies have to repay them.
- Liabilities that need to be paid back soon are labelled “current”.

• Shareholders’ equity or net worth corresponds to the funds that shareholders provide.

• The difference between your assets and liabilities is your shareholders’ equity or net worth.

• The mix of financing is referred to as capital structure.

1.2.1 Accounts payable and notes payable

• Accounts payable represent amounts due to others, often over a short time, and typically to
the company’s suppliers.

• One company’s accounts payable frequently corresponds to another company’s amounts receiv-
able.

• Notes payable are a short-term financial obligation, written contracts that typically serve the
purpose of paying debts through credit companies and financial institutions.

1.2.2 Accrued items

• Amounts due to others for activities already delivered e.g. salaries.

• A balance sheet may be produced in the middle of a pay period, and the company may owe
salaries that have not been paid yet.

1.2.3 Long-term debt

• A form of long-term liability (Table 1.1).

• Unlike other liabilities, debt is distinctive because it has an explicit interest rate.

• Some companies borrow a lot with 30-40% of their assets financed by debt.

6
1.2.4 Preferred and common stock
• Shareholders’ equity represents an ownership claim with variable returns - the owners get all
residual cash from the business after costs and liabilities.

- Debt has a fixed return (interest rate) and no ownership claim, but it gets paid first before
equity holders in the event of a bankruptcy.
- Typically, shareholders’ equity, net worth, owner’s equity and common stock are all effec-
tively synonyms.
- Shareholders’ equity is not only the amount originally invested in a company by the
owners.
- As a company earns net profits, those profits can be paid out as dividends or reinvested
in the company.
- These retained earnings are a component of shareholders’ equity because it is as if the
owners received a dividend and reinvested it in the company.

• Preferred stock is a hybrid instrument because it combines elements of both debt and equity
claims.

- Like debt, a preferred dividend can be fixed and paid before common stock dividends.
- But like equity, preferred stock is associated with ownership and is paid after debt in the
event of a bankruptcy.
- When the world goes bad, preferred stockholders get paid before common stockholders.
- When things go well, they get to benefit from the upside, unlike debt holders, as share-
holders.
- Companies issue such a security to finance themselves during precarious times.
- If a company has hit hard times and faces a risky future, investors would not want to
invest in their common stock if failure is a real possibility.
- And debtors would not want to lend it money and only get a fixed return that might not
correspond to the riskiness of the business.
- VCs often provide funding to entrepreneurs in exchange for preferred stock that allows
them to protect their investment in the event that the company does poorly, whilst still
participating in the upside if the company does well by converting their preferred stock
into common stock when things go well.

1.3 Understanding Ratios

Companies are represented by their balance sheets, but financial ratios are even more meaningful
when analyzing a company. Ratios make numbers meaningful by providing comparability across
companies and through time.

1.3.1 Liquidity
Most companies go bankrupt because they run out cash. Liquidity ratios measure this risk by
emphasizing the company’s ability to meet short-term obligations with assets that can quickly be
converted into cash. Suppliers prefer high liquidity ratios because they want to ensure that their
customers can pay them. Meanwhile, for shareholders, greater liquidity creates a trade-off: acts as
an insurance against bankruptcy, but highly liquid assets (cash and marketable securities) may not
provide much of a return.

7
Current Ratio
Current assets
(1.5)
Current liabilities
The current ratio asks a question on behalf of a company’s suppliers:

• Will this company be able to pay its suppliers if it needs to close?

• Will its current assets be sufficient to pay off its current liabilities (including those owed to
suppliers)?

The ratio helps to determine if a supplier should extend credit to a company and if a company
will be able to survive the next 6-12 months.

Quick Ratio
Current assets − Inventory
(1.6)
Current liabilities
Similar to the current ratio, except it excludes inventories from the numerator. Inventories
represent risk that needs to be financed. Inventories can be very risky e.g. BlackBerry releases were
declared obsolete and its inventory was effectively zeroed. For companies with high-risk inventory
without a spot market (where financial instruments, such as commodities, currencies and securities
are traded for immediate delivery), the quick ratio provides a more skeptical view of their liquidity.

1.3.2 Profitability
Profit Margin
N et prof it
(1.7)
Revenue
Compare income after all costs and expenses to sales to represent the margin

Return on Equity (ROE)

N et prof it
(1.8)
Shareholders′ equity
Measures the annual return that shareholders earn. In particular, for every dollar of equity that
shareholders invest in a business, what is their annual flow of income?

Return on Assets
N et prof it
(1.9)
T otal assets
This ratio asks: How much profit does a company generate for every dollar of assets? This
corresponds to asking how effectively a company’s assets are generating profits.

8
EBITDA Margin
EBIT DA
(1.10)
Revenue
• EBIT - Earnings Before Interest and Taxes

- EBIT is simply operating profit.

- Since some companies have different tax burdens and capital structures, EBIT provides
a way to compare their performances more directly (e.g. America and Germany have
different tax rates - net profit, which factors in taxes, would provide a distorted view)

• DA - Depreciation and Amortization

- Depreciation refers to how physical assets, such as vehicles and equipment, lose value over
time.
- Amortization refers to that same phenomenon but for intangible assets.
- DA is emphasized because they are expenses that are not associated with the outlay of
cash - it is an approximation of the loss of value of an asset.
- In accounting, you have to depreciate assets and charge yourself an expense for that
depreciation.
- But in finance, we emphasize cash and there was no cash outlay, so EBITDA is a measure
of the cash generated by operations.

1.3.3 Financing and Leverage

Leverage in finance allows owners to control assets they couldn’t control otherwise e.g. mortgage.
It also increases your returns as a more valuable asset can increase more in value. However, it is a
double-edged sword, as your shareholders’ equity will decrease more for a more valuable asset for a
given percentage decrease in value. Overall, leverage magnifies your returns in both directions.
Private equity companies sometimes use debt in transactions known as leveraged buy-outs (LBOs)
to purchase companies. In other transactions, the company borrow to buy out many shareholders,
leaving it much more highly levered than previously. Companies with stable business models and
committed customers are good candidates for LBOs. If the business has stable cash flows, it is able
to sustain higher leverage in a more secure way than companies with very risky technologies. Classic
LBO targets include tobacco companies, gaming companies, and utilities because of their committed
customers and predictable demand with little threat of substitution.

Debt to Assets
T otal debt
(1.11)
T otal assets
Measures the proportion of all assets financed by debt. It provides a balance sheet perspective
on leverage.

Debt to Capitalization
Debt
(1.12)
Debt + Shareholders′ equity

• The ratio of long-term debt to capitalization provides a more subtle measure of leverage by
emphasizing the mix of debt and equity.

9
 • The denominator is capitalization - the combination of a company’s debt and equity.

• Debt has a fixed associated interest cost, whilst equity hold a variable rate of return along with
ownership rights.

• This ratio tracks what proportion of a company’s financing comes from debt and therefore
diverts attention from liabilities that are part of operations.

Assets to Shareholders’ Equity

Assets
(1.13)
Shareholders′ equity

• Leverage provides the ability to control more assets than an owner would otherwise have the
right to control.

• This ratio tells us precisely how many more assets an owner can control relative to their own
equity capital.

• Thus, it also measures how returns are magnified through the use of leverage.

Interest Coverage Ratio

EBIT
(1.14)
Interest expense

• The 3 previous measures were constructed from balance sheets, but the critical question is often
the degree to which a company can make its interest payments.

• The ratio of EBIT to interest expense measures a company’s ability to fund interest payments
from its operations and uses only data from the income statement.

• E.g. a ratio of 1 indicates that a company is just able to make its interest payments with its
current operations.

• The comparison between monthly income and any mortgage payments is an analogous measure.

1.3.4 Productivity or Efficiency

Productivity is the output per unit of input. Thus, increases in productivity means you can squeeze
more from less. Productivity ratios measure how well a company utilizes its assets to produce output.
Over the long run, increases in productivity are the most important contributor to economic growth.

Asset Turnover
Revenue
(1.15)
T otal assets
• This ratio measures how effectively a company is using its assets to generate revenue.

• This is a critical measure of a company’s productivity.

10
Inventory Turnover
Cost of goods sold
(1.16)
Inventory

• Measures how many times a company turns over or sells all its inventory in a given year.

• The higher the number, the more effectively the company is managing its inventory as it sells
products.

• Because inventory is essentially a risky asset that needs to be financed, a higher inventory
turnover is financially valuable.

Days of Inventory
365 ÷ Inventory turnover (1.17)
Dividing the number of days in a year by the inventory turnover provides the average number of
days a piece of inventory is kept inside a company before it is sold.

Receivables Collection Period

Sales
365 ÷ (1.18)
Receivables
• After a company sells its inventory, it needs to get paid for it.

• The lower this figure (sales > receivables), the faster a company is getting cash from its sales
(most customers pay immediately).

• Lower figures tend to indicate a B2C (retailers) business whilst higher figures tend to indicate
a B2B business (commodities).

1.3.5 The DuPont Framework

Figure 1.1: The DuPont Framework

Many financial analysts focus on return on equity (ROE) as the most important ratio since
it measures the return to owners. The DuPont framework (Figure 1.1), a method to analyse a
company’s financial health, help us understand the factors that contribute to an ROE, breaking it
down algebraically into three ingredients:

1. Profitability - how profitable a company is, for every dollar of revenue, how much does it earn
in net profit (profit margin).

11
2. Productivity - ROE can be bolstered by productivity as well, represented by the asset turnover
ratio that measures how efficiently a company can use its assets to generate sales.

3. Leverage - magnifies returns, measured by dividing a company’s assets by its shareholders’

equity.

However, ROE is imperfect, and two problems stand out:

1. Includes the effects of leverage, thus does not purely measure operational performance. Hence,
some people prefer a return on capital, that compares EBIT to a firm’s capitalization (debt
+ equity).

2. It does not correspond to the cash-generating capability of a business.

Some observations regarding these key metrics within the DuPont Framework:

• High performing companies all tend to have a similar ROE despite coming from different
industries. This is because they don’t compete in product markets, they all compete in capital
markets. Hence, their ROE can’t be too different otherwise capital will be driven away from
lower performers towards better performers.

• ROE will differ when the risk associated with the company is different. If the shareholders bear
more risk, they are going to demand a higher return. Thus, capital markets and the competition
across companies drive returns to shareholders together and risk drives them apart.

• Profitability depends on the real value added e.g. food retailers don’t add much value, thus
they have lower profit margins than chipmakers that turns sand into computers.

• Varying levels of leverage reflect the amount of business risk because it is unwise to pile financial
risk on top of business risk. Thus, it is usually the case that the higher the business risk the
lower the leverage/financial risk.

• As mentioned before the inclusion of leverage is a major problem as leverage tends to infect the
final calculation as companies overcome poor operational performance (inefficient deployment
of capital - debt + equity) by making its owners bear more risk.

12
Chapter 2

The Finance Perspective

Using accounting statements to understand corporate performance has its drawbacks as it places an
emphasis on net profit when measuring economic returns. Finance professionals turn towards cash
as a better measure of economic returns. There are three alternative definition of cash - earnings
before interest, taxes, debt, and amortization (EBITDA); operating cash flow; and free
cash flow.
In addition, the field of finance is fundamentally forward looking, leading us to consider the
time value of money and methods for translating future cash flows into the present, which will be
foundational in thinking about any investment or valuation decision.

2.1 Cash
Disadvantages of using net profit to measure corporate performance:

• Treats cash and non-cash expenses (e.g. depreciation, amortization) symmetrically.

• Net profit subtracts interest payments, which makes it hard to compare companies that finance
themselves in different ways even though their operations could be quite similar.

• Managerial decisions are involved in calculating profits. Accounting asks managers to make
decisions in order to smooth returns, as accountants consider that to be more consistent with
reality. E.g. Up-front payment for equipment has to be capitalized, placed on the balance sheet
and then depreciated over time. Revenue similarly may need to be recognized over time. This
smoothing process is subjective which allows managers to manipulate profits unlike cash that
is less susceptible to managerial discretion.

2.1.1 EBIT

Net profit
+ interest
+ taxes
EBIT

Table 2.1: EBIT equation

• EBIT (operating profit) gives a clearer view of how efficient and profitable a company is rel-
ative to net profit by not subtracting interest and taxes which are not related to operational
performance.

13
 • EBIT isn’t quite a measure of cash, as it is calculated after subtracting non-cash expenses such
as depreciation and amortization.

2.1.2 EBITDA
Hence, for a fuller picture, finance professionals use EBITDA:

Net profit
+ interest
+ taxes
+ depreciation and amortization
EBITDA

Table 2.2: EBITDA equation

Amazon in 2014 provides a compelling distinction between the three different measures:

Net profit EBIT EBITDA

-$241 million $178 million $4.924 billion

Table 2.3: Amazon 2014 Corporate Performance

The difference of $419 million between EBIT and net profit represents taxes, interest, and currency
adjustments. Overall, Amazon generated lots of cash, as measured by EBITDA, but had losses
according to profitability measures due to $4.746 billion in depreciation and amortization.
EBITDA can be more relevant for some industries than others. One way to appreciate the
difference that depreciation makes is to compare it to net profit.

Company Industry Depreciation-to-net income ratio

Electronic Arts (EA) Video Game Development 17%
The Michael Companies Arts and Crafts Retail 34%
Comcast Telecommunications Provider 106%

Table 2.4: EBITDA relevance

For instance, unlike EA, a software company, Comcast has invested heavily to create cable and
internet networks. Hence, because of those heavy investments, using net profit as a measure of
performance can result in a distorted picture and flawed comparisons, as Comcast will naturally
experience much more depreciation given its infrastructure-heavy industry. The Michael Companies
is somewhere between EA and Comcast, given its brick-and-mortar footprint.

2.1.3 Operating Cash Flow

Rather than focusing on the income statement, which has the problems of non-cash expenses and
managerial discretion, or a balance sheet, which has the problems of historical cost accounting and
conservatism, many finance professionals focus on the statement of cash flows because it looks purely
at cash.
Typically, a statement of cash flow has three parts: operating, investing, and financing sections.
The first section, operating cash flows, provides the next measure of cash:

14
 Net profit
+ depreciation and amortization
- increases in accounts receivable
- increases in inventory
+ increases in unearned revenue
+ increases in accounts payable
Operating cash flow

Table 2.5: Operating cash flow equation

Depreciation and amortization, increases in unearned revenue, and increases in accounts payable
are added to the net profit, as they are non-cash expenses. Meanwhile, increases in accounts receivable
and inventory are subtracted, as they are non-cash revenue. Operating cash flow is different from
EBITDA in several ways:

• It considers the cost of working capital (inventory, accounts receivable, accounts payable).

• It accounts for tax and interest payments by beginning with net profit.

• It includes non-cash expenses other than depreciation and amortization, such as share-based
compensation.

For the rest of the cash flow statement, the investing section emphasizes ongoing investments that
bypass the income statement and go straight into the balance sheet, such as capital expenditures
and acquisitions. Meanwhile, the financing section examines whether a company has offered debt or
paid back debt or issued equity or bought back stock, and reveals the cash consequences of doing so.

Operating activities
Net profit
+ depreciation and amortization
± cash provided by changes in operating assets and liabilities
= Net cash provided by operating activities

Investing activities
- Additions to property, plant, and equipment
± mergers/divestments
= Net cash provided by investing activities

Financing activities
- Cash dividend
- repurchase of common stock
+ issuance of debt or equity
= Net cash provided by financing activities
Net increase/decrease in cash and cash equivalents

Table 2.6: Cash flow statement summary

As Figure 2.1, the statement maps how cash positions changes over the course of the year because
of operating performance along with investing and financing decisions.

15
 Figure 2.1: Starbucks’ Cash Flow Statement, 2017

2.1.4 Working Capital

Working capital, the capital that companies use to fund their day-to-day operations, is critical to
understanding operating cash flows, as finance is deeply embedded in the daily operations of a
business.

W orking capital = current assets − current liabilities (2.1)

Working capital usually emphasizes three important components:

1. Accounts receivable - amounts that customers, typically other businesses, owe a company.
The dollar amount can be re-framed as a receivables collection period, which shows the average
number of days it takes for customers to pay the company.

2. Inventory - the goods, and the associated inputs, held by a company prior to sale. Based on
inventory, you can generate a days inventory, which shows the average number of days that the
company holds inputs and goods.

3. Accounts payable - the amounts a company owes to suppliers. Based on that, you can
generate a days payable, which indicates the average number of days the company takes to pay
the suppliers.

A slightly more narrow way to define working capital is:

W orking capital = accounts receivable + inventories − accounts payable (2.2)

For the consequences of working capital, the daily operations of a company result in an amount
that needs to be financed, like any other asset. If the amount of working capital is lowered, that
lowers the financing needs of a corporation. Hence, the management of working capital has deep
financial consequences.

2.1.5 The Cash Conversion Cycle

The financing consequences of working capital can be framed temporally rather than monetarily
using the cash conversion cycle.
For instance in a hardware store where hammers are bought from wholesalers and sold to home
improvement professionals, hammers are sold 70 days after they are bought and payment is only
received 40 days after the sale. This corresponds to a days inventory of 70 days and a receivables
collection period of 40 days.

16
 Figure 2.2: The cash conversion cycle

Thus, 110 days elapse between the time the hammer is bought to getting cash for it. In addition,
the store only pays cash for the hammer 30 days after buying it. From a cash perspective, cash needs
to be generated to pay for the hammer 80 days before receiving the cash, a funding gap (Figure 2.2).
To reduce the financing gap there are a number of options:
• Reduce the days inventory - can be done easily by stocking less inventory. The store will sell
out faster and need less financing. However, the danger is if customers can’t find the product
they want they will go to rivals.
• Reduce the receivables collection period - done by extending less credit to customers.
However, this may lead to customers going to other rivals, losing the competitive edge.
• Increase the payable period - paying suppliers late may erode relationships, they may
become reluctant to supply products or be less willing to extend credit.
During a recession, companies hold on to their inventory longer and customers take longer to
pay up. Thus, the whole cash conversion cycle expands as the days inventory and collection periods
increase, creating a larger gap that cannot be financed as banks recoil. This leads to a decrease in
global trade.
Vendors can offer companies discounts in exchange for paying faster (shortening the days payable).
If a company pays vendors in 40 days and the prevailing interest rate is 20% and a supplier offers a
1% discount if the company meets the obligation within 10 days:
• The supplier is charging an implicit interest rate of 1% for a 30 day loan.
• The bank will charge an interest rate of well over 1% for 30 days (20 / 365 * 30 = 1.64).
• The supplier’s financing is cheaper, so the company should take financing from the supplier,
not the bank.
• Hence, don’t take the deal as that would force the company to take the more expensive financing
from the bank to fund the extra 30 day gap.
There can be certain special business models that lead to special cash conversion cycles:
• Salesforce - software-as-a-service (SaaS) business that sells subscriptions. Thus, business
customers pay in advance and receive the use of software for the period they’ve paid for.
Hence, Salesforce will have a negative receivable collection period because it gets paid before it
provides services. It has no inventory and thus no days inventory, and it will not pay suppliers
immediately, creating a payables period. By taking payment first and then providing services,
Salesforce is getting customers and suppliers to finance its operations.

17
 • Dell - first takes the order from a customer and then starts manufacturing the product (just-
in-time manufacturing), thus decreasing it cash conversion cycle by lowering its days inventory
and leading to a reduction in the financing costs of its working capital.

• Tesla - takes deposit from customers for future models, although it may not be the full price
of a car, it still represents the customer financing of Tesla’s operations. Hence, customers help
reduce the amount that Tesla must rely on capital providers.

Amazon Case Study

Amazon manages its inventory, receivables, and payables in such a way that it ends up with a negative
cash conversion cycle. In 2014:

• Amazon averaged 46 days of inventory, and it collected from its customers after 21 days on
average.

• Due to its market dominance, Amazon can exert a large amount of power over its suppliers to
make them wait before getting paid. It averaged 91 days to pay its suppliers.

• Thus, Amazon had a negative cash conversion cycle of -24 days in 2014.

• Hence, it’s operations became a source of cash, allowing the company to grow rapidly without
seeking external financing.

• The cash they generate from their working capital becomes a powerful part of their business
model i.e. their suppliers are financing their growth.

• Amazon has stock-based compensation, that is recorded as an expense in the income statement
and lowers net profit. However, it is not a cash change, thus it is added back to operating cash
flows as a non-cash expense.

• When Amazon issues stock to fund its server farms, it will show up in the financing section of
the cash flow statement.

• Amazon’s working capital for 2014 seems to be a drain of cash as it’s cash conversion cycle fell
from -27 to -23 days, thus it’s working capital required a cash investment during that period
as the negative working capital cycle became less negative.

2.1.6 Free Cash Flow

Free cash flow is the final cash measure that is one of the most important measures of economic
performances in finance.
The equation for free cash flow provides a measure of the amount of cash flows truly unencumbered
by the operations of a business. It is the purest measure of cash and forms the basis of valuation:

• Removes the distorting effects of non-cash expenses such as depreciation and amortization like
EBITDA.

• Accounts for changes in working capital like operating cash flow.

• Acknowledges that capital expenditures are required for growth and have been avoided so far.

18
 In summary, free cash flow isolates the cash that is truly free to be distributed or used however
the company sees fit.

EBIT
- taxes
= EBIAT
+ depreciation and amortization
± changes in working capital
- capital expenditures
Free cash flow

Table 2.7: Free cash flow equation

As shown in Table 2.7, to calculate free cash flow:

1. Start with EBIT to get a sense of operational performance.

2. Account for taxes since this has to be free cash flow which results EBIAT - earnings before
interest after taxes.
3. Then, add back non-cash expenses, such as depreciation and amortization.
4. Penalize the company if its working capital needs are such that you must constantly invest
capital into the working capital cycle (similar to operating cash flows).
5. Make sure you subtract any planned or required capital expenditure on an ongoing basis
because this is a cash charge not yet considered.

Figure 2.3: Free cash flow

Figure 2.3, a simplified balance sheet, provides an alternate way to visualize free cash flow:

• The net assets side of the balance sheet is divided between the working capital (e.g. inventories
and accounts receivables less accounts payable) and fixed assets (e.g. property, plant, and
equipment).
• The financing side of the balance sheet is divided between debt and equity.
• This modified balance sheet now distinguishes between the operations (left-hand side) and the
capital providers (right-hand side).
• The flow that operations generate that end up with the capital providers are the free cash
flows, calculated as follows.

19
 - The operations of a business generate EBIT, but the government takes its share to make
it EBIAT.
- From there, you must consider the company’s ongoing investments into working
capital and fixed assets (capital expenditure) as it grows.
- Finally, non-cash expenses such as depreciation and amortization that should never
have been expensed must be added back.
- Whatever is left is free cash flow (can also be calculated by subtracting capital
expenditure from operating cash flow).

Finance has slowly been moving towards free cash flow (Figure 2.4) for evaluating returns over
the last 50 years because it captures all the cash consequences of a business, and it ensures that the
underlying flows are free to the capital providers.

Figure 2.4: The shift from revenues to free cash flows, 1960s-2020s

2.2 The Future

The source of all value today to finance professionals is future performance as manifested in cash
flows. However, not all future cash flows are created equal, finance prescribes thinking about the
free cash flows an asset will generate in the future (opportunity cost) and figuring out what they are
worth now.
That exercise is more complicated than just adding up all those future cash flows due to the time
value of money - $1 today is worth more than $1 a year from now. This is because you can use the
$1 today to earn an return and end up with more than $1 a year later. Hence, $1 received a year
from now must be worth less than $1 received today.
The differential depends on the opportunity - what opportunity for earning a return are you
giving up? Once you determine the cost of waiting, you then “punish” that future cash flow by
assessing a penalty that accounts for that opportunity cost - a discount rate.
This idea of punishing cash flows may seem counter intuitive, but you are punishing people who
make you wait to receive your money because you don’t like to wait and because of the opportunity
cost associate with that money.

2.2.1 Discounting
The equation below illustrates the effect of the discount rate, r, when you wait a year:
Cash f low
(2.3)
(1 + r)
For example, to determine how much $1,000 received one year from now is worth today:

• Assuming that a bank offers you an interest rate of 5%.

• Thus, a $1,000 payment received one year in the future has present value of 1000
1+0.05
= $952.38.

20
 • In other words, if you give the bank $952.38 today, it will give you $1,000 next year.

• If the interest rate is 10%, you would need to deposit $909.09 in the bank, instead of $952.38
to receive $1,000 in a year.

• Meanwhile, if interest rates fell to 2%, you would need to deposit $980.39 to get $1,000 a year
later.

• You punish future cash flows much more in the 10% interest rate scenario because your oppor-
tunity cost is higher whilst you punish the future cash flows much less in the 2% scenario.

For cash flows over multiple years into the future, the one-year discounting process has to be
repeated:
Cash f low1 cash f low2 cash f low3
+ + ... (2.4)
(1 + r) (1 + r)2 (1 + r)3
where r is still the annual discount or interest rate and the subscripts next to the cash flow
indicates the year that the cash will be received. In this case, if the bank offers a $1,000 payment
for each of the next three years with an interest rate of 5 %:
1, 000 1, 000 1, 000
+ 2
+ = $952.38 + $907.03 + $863.84 = $2, 723.25
(1 + 0.05) (1 + 0.05) (1 + 0.05)3

2.2.2 Sunk Costs and Net Present Value

Sunk costs are costs have already been incurred and can’t be recovered. They don’t matter during
the process of discounting. For example, if a company spent $100,000 on market research for a new
product, that amount is gone no matter what they find out about the product’s future. It should be
irrelevant to any decision about the future of the product.
Overall, assessing values requires you to:

1. Look into the future.

2. Think about what incremental cash flows will be generated over time.

3. Discount them back to the present using the notion of an opportunity cost of capital.

Working out the present value of a project involves adding up all the potential cash flows,
positive and negative, after they’ve been discounted today:
cash f low1 cash f low2 cash f low3 cash f low4
P resent value0 = + + + ... (2.5)
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4
Determining the net present value entails the same calculations, but it includes the initial cost
of the project:

cash f low1 cash f low2 cash f low3 cash f low4

N et present value0 = cash f low0 + + + + (2.6)
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4

If managers care about value creation, then the most important financial decision rule they should
follow is to undertake only positive NPV projects.

21
Nike Factory Case Study
If Nike is building a new show factory at a cost of $75 million, assuming the plant will produce
$25 million in cash every year for the next 5 years with a 10% discount rate:
25 25 25 25 25
1
+ 2
+ 3
+ 4
+ = $94.8M
(1.10) (1.10) (1.10) (1.10) (1.10)5
The present value of the project is $94.8 million and by paying $75 million, Nike will generate
$19.8 million in net present value. Thus, Nike should go ahead and build the factory.
However, after the next year, Nike has only made $10 million and expects this trend to continue
for the next 4 years:
10 10 10 10
1
+ 2
+ 3
+ = $31.7M
(1.10) (1.10) (1.10) (1.10)4
If a rival company offers Nike $40 million to buy the factory, Nike should take the offer. This is
because despite spending $75 million, that is a sunk cost that cannot be recovered and is irrelevant
to the current decision. Meanwhile, the offer has a positive NPV of $8.3 million.

22
Chapter 3

The Financial Ecosystem

Capital markets critical for the growth of the economy and increasingly guide policymakers and
managers. However, these markets have also caused great skepticism about their value and wisdom.

Figure 3.1: A simpler financial world

For a simple version of capital markets (Figure 3.1), there will be individuals and households on
one side that have savings that they want to invest. On the other side are companies that need
capital to build new projects and grow. However, in reality there are many more intermediaries that
make the world of finance much more complex (Figure 3.2):

Figure 3.2: The reality of capital markets

23
 Centring our perspective from that of an equity research analyst we can analyse the capital mar-
kets. The analyst’s job is to value companies by creating forecasts and then make recommendations
to investors.

3.1 The Companies

• Analysts evaluate companies, having conversations with CEOs and CFOs about new product
launches, strategy, and forecasts.
• They look for new information beyond the raw numbers about the company’s performance to
formulate forecasts that will guide recommendations.
• This conversation is a two-way street - CFOs will have their own questions for the analysts
who are valuable sources of industry knowledge and provide a better understanding of the
competitive landscape.
• In capital markets, interactions take the form of trades that may not only be in capital, but in
information or knowledge too.

3.2 The Buy Side - Institutional Investors

Institutional investors are simply entities that invest large amounts of capital on behalf of others and
allocate it in ways that they feel will best support their clients.

3.2.1 Mutual Funds

• Manage money on behalf of individuals and invest those funds in diversified portfolios of stocks
or bonds.
• E.g. Black Rock and Fidelity manage nearly $10 trillion through various mutual funds.
• Mutual funds invest on behalf of individuals with varying amounts of wealth and sophistication
(e.g. through retirement accounts), thus they are tightly regulated.
• Manage risk by holding a wide selection of stocks so that the funds are not overly exposed to
any one stock.
• Diversification limits exposure since the stocks don’t all move together, their movements can
offset each other and reduce the overall riskiness of the portfolio without sacrificing that much
return.
• Active Mutual Funds - a manager personally decides which stocks to hold in the portfolio.
• Passive Mutual Funds - invest in all stocks in a broad market index such as the S&P 500
e.g. index funds and exchange traded funds.
• Given their mechanical nature, passive funds are relatively cheap to invest in.
• Passive funds are a manifestation of efficient market theory - if information is widely available
to investors, then it’s impossible to outperform the market because prices already reflect that
available information, so trying to beat the market over the long term is a useless endeavour.
• The underlying logic that it’s difficult to beat the market on a sustainable basis, combined
with the promise of increased gains from diversification has proven true and driven the rise of
low-cost, passive investing at the expense of actively managed funds.

24
3.2.2 Pension Funds
• Large pools of money that represent the retirement assets of workers from a particular company,
union, or government entity.

• Defined Benefit (DB) Plans - employees receive payments after retirement from their em-
ployers, which are funded by pension plans run by those companies or organisations.

• Defined Contribution (DC) Plans - companies contribute to individual pension accounts

that the employee manages.

• The shift away from DB plans towards DC plans has fueled massive growth in mutual funds.

3.2.3 Foundation and Endowment Funds

• Non-profit foundations and organisations sometimes retain and invest funds over long periods
to create more stability for their operations.

• These foundations and endowments are now large innovative players in capital markets e.g.
Harvard controls a $37.1 billion endowment (2017).

3.2.4 Sovereign Wealth Funds

• Countries with extra savings (typically from natural resources) often invest those savings
through a sovereign wealth fund.

• E.g. Norwegian sovereign wealth fund manages more than $1 trillion (2017).

3.2.5 Hedge Funds

• Have grown from $260 billion in assets in 2000 to $3 trillion in 2017.

• Although similar to mutual funds, they are differentiated by their lower level of regulation, use
of leverage and their different approach to managing risk.

• Hedge funds which include many pension, endowment and sovereign wealth funds as customers,
have lower levels of regulation because only rich investors can buy them.

• Hence, managers are less constrained in their attitude towards risk and can use leverage to
amplify returns.

• Unlike mutual funds, hedge funds can also take more concentrated positions in companies,
which allows them to become activist shareholders that promote policies and strategies most
beneficial to their investors.

• Hedge funds manage risk by hedging:

- Going long - buying the stock, expecting its value to increase and then selling it at a
higher price to earn a profit.
- Going short - borrow shares from another investor, such as a mutual fund, which charges
a fee for lending the shares to you. Once you’ve borrowed the shares, you sell them. At
some point in the future, you buy back the shares hopefully at a lower price and return
them.

25
 Figure 3.3: Comparison of stock prices for Merck and Pfizer, Dec 2011-Dec 2014

- For example, a hedge fund that invests in Merck, a global pharmaceutical company, man-
ages the risk of that investment by shorting Pfizer, another pharmaceutical company to
manage its exposure.
- During 2012, both stocks were moving together quite tightly and had gone up 20% by
December. If you sold your Merck shares and repurchased Pfizer shares at year end you
would end up at the same place, as the gains from you long position (+20%) are offset by
the losses on your short position (-20%).
- In 2014, Merck outperformed Pfizer, it rose 70% whilst Pfizer rose 60%. Because your
long outperformed your short, you made money (+10%).
- Hedging can help insulate an investor from sector-wide or market-wide movements and
isolate the relative performance of a given company.
- Thus, risk is effectively managed as you are now only exposed to the relative out-performance
or under-performance of a given company’s stock.

• Hedge fund managers also receive carried interest, allowing them to participate in the economic
returns of their funds.

3.3 The Sell Side

Analysts typically work for investment banks that constitute the sell side. Within these banks, equity
analysts speak to three constituencies - traders, salespeople, and investment bankers to provide ideas
about the companies they cover.

3.3.1 Traders
• Ensure that there are buyers and sellers for various financial instruments.

• They make money largely from the gap known as the bid-ask spread.

• A bid is the highest price an investor is willing to pay for a share, while the ask is the lowest
price that a seller is willing to sell a share for.

• Those on the buy side don’t pay analysts directly for their reports, rather they can choose to
trade through the trader associated with equity analyst they like, who then makes commissions
on those trade. However, these commissions have narrowed significantly over time and don’t
form a large part of an analyst compensation.

26
 • Despite declining commissions, it is still valuable for broker-dealers to process trades, as it is
valuable to know the trading activity of large institutional investors because these transactions
contain information.

• Thus, good equity analysts ensure that their traders get a share of trade flow.

3.3.2 Salespeople
• Salespeople sell financial instruments to investors on the buy side.

• Analysts might talk directly to the larger institutional investors, but salespeople disseminate
the analyst’s ideas to the broader community to woo the buy side more directly.

• This can generate commissions and trade flow.

3.3.3 Investment Bankers

• Investment bankers work with companies that either want to raise capital or want to buy or
sell operating assets.

• Financing arranged by investment banks, such as initial public offerings (IPOs), equity offerings,
and debt offerings, allows companies to access new funding.

• The mergers and acquisitions (M&A) departments help companies divest portions of their
businesses or acquire new businesses.

• In effect, investment banks are brokers for businesses.

• Both IPOs and M&As are extremely lucrative, fees for equity financings can be as high as
7% of the proceeds for an IPO, whilst advisory fees on M&A can be close to 1%. These fees
typically dwarf other trading revenue streams.

3.4 The Media

• Equity research analysts use the media to disseminate their ideas to a broader audience, in-
cluding households that invest directly.

• Analysts often provide commentary on the latest developments and will use those occasions to
communicate their more general views of a company.

3.5 Incentives for Equity Analysts

• A critical component of analyst compensation is a ranking system deployed by the buy side to
signal sentiments about which analysts provide the best advice. Compensation drops sharply
as you move down the rankings.

• In theory, analysts should supply the buy side with the best analysis possible to make capital
markets work well. However, in reality, analysts can often be biased towards being positive,
rarely issuing “sell” recommendations and instead issuing a disproportionate share of “buy”
recommendations.

27
 • If an analyst issues a negative report on a stock, which says a company is overvalued, investors
will appreciate the truth and rank the analyst highly. However, the CEO and CFO of the
company may try shut out the analyst by not engaging with them or not taking their questions
on the next conference call.

• In addition, they may also signal to the analyst’s investment banking colleagues that they won’t
work with them on future M&A and financing deals.

• Thus, analysts instead say things like “market perform” or “neutral”, which really means “sell”.

• The ranking system also creates additional problems:

- Young research analysts at less prestigious investment banks with nothing to lose often
say crazy, extreme things. If they’re right, they shoot up in the rankings, and it they are
wrong, no one was paying attention anyway.
- Meanwhile, higher-ranked analysts may “herd” alongside closely ranked analysts to pre-
vent being overtaken. This can be done by estimating earnings to be precisely in between
the estimates of other analysts. However, this is not what analysts should be doing.

• Thus, incentives for the people at the center of the capital markets are considerably more
complicated.

3.6 The Problem at the Heart of Capital Markets

• Managers of companies have all the information about the future of companies that we as
investors want to know. However, we can’t necessarily trust what managers tell us, as they
want our capital and may tell us things that aren’t true in order to get it.

• These leads to asymmetric information - the inability to credibly share information.

• In a world of perfect information, capital markets are relatively simple - they just need to pool
resources and price risk.

• However, in a world of asymmetric information, capital markets need to figure out how to
allocate capital when you don’t know whom to believe.

• The problem of capital markets is a manifestation of an even more general problem known as
the principal-agent problem.

3.6.1 The Principal-Agent Problem

• In modern capitalism, the scale of enterprise has grown and owners are no longer managers;
now owners (the principal) have to monitor managers (their agents) to ensure that they’re not
misbehaving.

• The separation of ownership and control creates the problem of corporate governance: how do
shareholders ensure that managers are pursuing their interests?

• For example, if a CEO advises the owners that a large acquisition is a great idea - does she
just want to run a larger company and get the prestige that comes along with it to get a better
job with more pay? So is the acquisition great for the company or the CEO?

• This problem pervades all of a company’s interactions with financial markets:

28
 - For instance, if a CEO misses an earnings forecast by a penny and attributes it to bad
weather conditions. Is it true or does the mistake signal the beginning of the end of the
company?
- Suspicion by investors about the company helps explain the large price drops associated
with small earnings misses because those misses may be for more than one quarter. It’s
about credibility and asymmetric information.
- When a CEO announces that she is divesting part of her shareholding in a normal portfolio
rebalancing plan, it could be true. However, the reality is that someone who knows much
about the future of the company is selling shares and that is alarming.
- For companies, the problem of asymmetric information can also affect whether they finance
their projects through equity, debt, or internally generated profits, as each method signals
a different message to investors.
- For example if a company uses equity, investors may balk because: If the project is so
great, why issue new shares and share the upside if the owners are so confident about the
future? Why wouldn’t they keep the upside for themselves by issuing debt?
- This is the reason equity issuance is usually associated with stock price declines. It’s not
because of dilution or an accounting argument, it’s because it sends a negative signal.
- To some investors, the company seems unwilling to finance the project internally that no
longer seems that attractive. Thus, equity becomes the most expensive source of financing.
- Debt seems a little better as although the company is still relying on external capital
providers, it’s not giving up ownership. However, investors will always question why a
company goes to outside sources for funding.
- The best source of financing is internally generated funds, as there’s no informational cost
associated with it, but it can be a limited source.
- Lastly, when a CEO announces a stock buyback, she’s implicitly telling investors she
thinks the stock is undervalued. Hence, stock buybacks are good news, not because fewer
shares are outstanding, but because they send a powerful signal of confidence from the
managers who know more than investors.

• There a few possible solutions to the principal-agent problem:

- Punish managers more when they lie - however this can lead them to say less and less,
thus increasing the level of asymmetric information.
- Pay managers with more equity - encourage them to behave like owners want them to.
Has become more popular recently, however managers may orient their performance to
short-term results and then sell their shares at peak-level.
- Create a board of directors - above managers to monitor them. However, managers often
pick those directors, leading to conflict of interest.
- Potential solutions lead to collateral consequences that can amplify rather than alleviate
the problem.
- Private equity - can help by effectively replacing dispersed owners with one large owner
who carefully monitors, and uses leverage to constrain management. However, private
equity also creates its own issues - these investors realise profits by issuing stock to capital
markets and have incentives to make their companies appear better than they are prior
to going public.

29
Chapter 4

Sources of Value Creation

4.1 Market-To-Book Ratio

• Book value - an accounting of the capital that shareholders have invested in a company, solely
focused on the dollars in a company (provide an incomplete picture of value)

• Market value - measures how much a company is worth according to the financial markets (a
forward-looking assessment of the value of a company)

• The market-to-book ratio is calculated by dividing the market value by the book value
of a company.

- For instance in 2017, the market value of Facebook’s equity was $512.8 billion, whilst its
book value was much lower, $74.3 billion.
- This yielded a market-to-book ratio of 6.9.
- Given that market values emphasize future cash flows, the market clearly thought highly
of Facebook’s prospects and its ability to create value.

4.1.1 Influencing Factors

Overview
Consider a company that relies solely on equity financing:

• The firm has a book value of $100, as it has just been capitalized with $100.

• The return on equity is projected to be 20%.

• The company is expected to reinvest 50% of its profits in the company. The re-investments
represent growth opportunities and earn similar returns to its current ROE.

• The company will end its operations after 10 years, and anything that’s left will be dis-
tributed to the shareholders. It will sell all of its assets for a onetime cash flow (assume
it can do so at the book value of those assets at that time).

• Future cash flows will be discounted at a rate of 15% because shareholders expect a
return of 15%.

The company’s book value is simply $100. To determine its market-to-book ratio, we need to
determine its market value by forecasting and discounting future cash flows:

30
 1. Take the initial book value of $100, apply the 20% ROE ($20) and then distribute half to
shareholders ($10) and reinvest the other half ($10) in the company.

2. The apply the 15% discount rate to those dividends (1/1.15 = 0.87).

3. Repeat the first two steps until the 10th year, when whatever is left in the company is liquidated
and returned to the shareholders.

Figure 4.1: Value creation exercise

In this particular case, the current market value, based on future expectations is greater than 100
(Figure 4.1), giving a market-to-book ratio greater than 1.3.

Figure 4.2: Sources of value creation

Return On Equity (ROE)

• If the company’s ROE drops from 20% to 15% and everything else stays the same, the ratio
will logically go down given that a lower ROE is not good for shareholders.

• In Figure 4.2, it is evident that the market value drops to exactly 100, giving a ratio of 1.

31
 • This is because the company has merely met expectations as its ROE is equal to the cost
of capital, thus the company is not creating value.

• A company only creates value if the expected return exceeds the cost of capital.

• If the ROE were to drop below 15% (the cost of capital), the ratio would be less than 1 and the
company is now destroying value as it is not providing returns commensurate with the capital
provider’s expectations.

Project Duration
Now factoring in project duration too, we examine the first section of Figure 4.2 with 30% earnings
reinvested and the discount rate remains fixed at 15%:

• The highest market-to-book ratio is at the bottom right, as the company is earnings its highest
ROE, leading to higher market values, for the longest period of time.

• Hence, high ROEs over a long time span is what what makes market-to-book ratios and
value creation significant.

• In contrast, the smallest market-to-book ratio is in the bottom left, as the company’s ROE
doesn’t beat the cost of capital (the discount rate) and this situation persists for the longest
duration (30 years), resulting in the most value destruction.

• Finally, when the ROE is 15% and equal to the cost of capital, the market-to-book ratio will
always be 1 regardless of how long the project duration is as the company is not going
to create or destroy value no matter how long it operates.

Reinvestment Rate
Investigating the effect of varying the reinvestment rates from 30% to 70% to 100%, we can observe
from all sections of Figure 4.2 that:

• The highest market-to-book ratio (by a large margin) is in the bottom right corner of the table,
as the company is consistently beating its cost of capital by a wide margin over the
longest duration (30 years), and is reinvesting all those profits at this higher rate for
the whole duration, creating lots of value.

• The worst scenario is at the bottom left, as the company is not meeting the cost of capital
and does so over a long period of time (30 years), constantly destroying value.

• Furthermore, it never distributes any money until the very end and so even more value
is being destroyed when the company invests more profits at that relatively low rate of
return.

• Similar to the previous sections, the 15% ROE scenario always gives a market-to-book
ratio of 1 because the company is just meeting its cost of capital.

• It can keep cash inside or release it, and it can do so for many years or just a few; it doesn’t
matter because value is being neither created or destroyed.

32
4.1.2 Summary
To create value, companies must do three things:
1. They must beat their cost of capital.
2. They must beat their cost of capital for many years.
3. They must reinvest additional profits at high rates through growth.
These measures correspond to business strategy, as beating a cost of capital is all about creating
a competitive advantage through innovation. Furthermore, keeping the gap open between returns
and costs of capital for longer periods is what barriers to entry, brands, and intellectual property are
all about. Finally, reinvesting more profits is all about growing an opportunity through expansions,
adjacencies, or integration.

4.2 The Weight Average Cost of Capital (WACC)

The cost of capital is critical to value creation. Discount rates are often referred to as costs of capital
because they refer to the penalties (costs) associated with deploying that capital. Firms have two
types of capital providers - lenders who provide debt capital and owners who provide equity capital.
Overall, the costs of capital are a function of the returns that investors expect.
• The costs of debt and equity will be different; equity is a residual claim with a variable return,
whereas debt has a fixed return that has priority for repayment. Providers of capital will
measure the risk that they are exposed to and expect returns to compensate for that risk.
• The demand for additional returns to bear risk is a foundational idea in finance and relates
to risk aversion. In order to measure the reward for bearing risk, investors often divide the
returns of an asset class by the associated standard deviation. This ratio, known as the Sharpe
ratio, enables investors to determine how much return they receive per unit of risk.
The weighted average cost of capital (WACC) is the most common way to discount future cash
flows. It averages the cost of debt and equity to account for their relative proportions and different
costs. The formula for WACC festures the two costs of capital, two weights to account for their
relative proportion, and a tax term:
D E
W ACC = ( )rD (1 − t) + ( )rE (4.1)
D+E D+E
where rd is the cost of debt, re is the cost of equity, D is the market value of the firm’s
debt, E is the market value of the firm’s equity, D + E is the total market value of the
firm’s financing (equity and debt), and t is the corporate tax rate:
• The cost of debt and equity are their expected returns.
• A simplistic perspective of the weights are the shares of the total financing needs that come
from debt and equity.
• The tax term is included as interest payments are typically deductible expenses that can lower
a firm’s tax payments. In effect, these interest payments shield a company from paying more
taxes and are known as tax shields.
• If tax rates are high, the ability to deduct interest payments is very valuable.
• For instance, if the tax rate is 40%, and a company has to pay $10 in interest payments, the
actual cost of paying the $10 is lower. The company is out $10, but its pretax income is lower
by $10, and that lowers their tax bill by 40% x $10 = $4, so the true cost is $6.

33
4.2.1 The cost of debt
• Determining the cost of debt is fairly straightforward because debt has a fixed return, hence the
cost of capital is simply the interest rate that a lender will charge you when you are undertaking
a project.

• To determine an interest rate, a bank will examine the riskiness of the underlying business, the
stability of its cash flows, and its credit rating.

• Then, it’ll charge an interest rate proportional to that risk.

• Technically, that interest rate is the promised return and there is a probability that the issuer
will default, meaning that the expected return is slightly lower.

• The interest rate has two components that correspond to the reasons we penalise cash flows
for making us wait:

rD = rrisk−f ree + credit spread (4.2)

where rD = cost of debt and rrisk−f ree = risk-free rate.

The risk-free rate

• Investors will demand, at a minimum, the rate on a risk-free investment.

• This idea of a risk-free investment is approximated by the interest rate on government securities
such as US Treasury bonds.

• Investors still charge a cost of capital in the absence of risk because they not only dislike risk,
but also they prefer their money now rather than later, so they want to be compensated for
any expected inflation that reduces their purchasing power, incurred by delaying their wealth.

Credit spreads
• A credit spread reflects the additional cost associated with the riskiness of the debt.

• Riskier companies feature higher credit spreads.

• In mid 2018, US Treasuries with a maturity of 10 years were yielding 2.96%.

• At that time, Walmart, an AA-rated company, issued $16 billion of debt and paid an interest
rate of 3.55%, implying a credit spread of 0.59%.

• At the same time, CVS, a BBB company, issued debt with an interest rate of 4.33%, implying
a credit spread of 1.37%.

• Cequel Communications, a cable company, issued CCC debt at 7.5%, implying a credit spread
of 4.54%.

• Overall, the relationship between risk and return is pretty straightforward.

34
Bond maturity
• Rates are also influence by the amount of time until the bond will be paid, known as the bond’s
maturity date.

• This effect is shown in Figure 4.3 below:

Figure 4.3: Yield curves for bonds with varying risk and maturities, 30 July 2018

• Yield curves normally slope upwards, as longer-term bonds typically need to offer a higher
interest rate than short-term bonds.

• A steep curve reflects that future interest rates are expected to be higher and longer-term bonds
must compensate investors for fixing their interest rates for a longer period, as future interest
rates might be expected to be higher because of future growth or inflation expectations.

• In addition, the corporate AAA and CCC bond yield curves lie above the treasury curve because
of the risk premium increasing the cost of debt, as mentioned before.

• Overall, bond yield curves change constantly in response to market expectation about the
future.

4.2.2 Optimal capital structure

• Capital structure is the relative use of debt and equity in a company,

• The right capital structure varies by industry and by the relative riskiness of those industries.

• Regulated monopolies like power companies often have capital structure heavily weighted to-
wards debt because of their steady cash flows whilst high-risk companies with unpredictable
futures are weighted toward equity.

• One way to envision the decision about capital structure is to consider the offsetting incentives
to use debt based on taxation and the costs and probabilities of failure.

• Figure 4.4 below does this by first ignoring these effects and then layering them on when
depicting the relationship between capital structure and overall firm value:

35
 Figure 4.4: Optimal capital structure

• Beginning with the blue line that ignores the effects of taxation and the costs of failure, the
value is invariant to capital structure, as all value comes from real operations of a firm. This
acts a reminder that the deployment of assets, not financial engineering, is the source of all
real value creation.

• However, because interest payments are deductible, they allow you shield income from taxation.
As you take on more debt relative to equity, you shield more income from the government, and
value increases, as shown by the orange line.

• Now, considering the effect of too much leverage on business operations, companies that go
bankrupt or approach bankruptcy incur significant operations costs. Customers and employees
leave, and financing becomes more of a strain. Hence, as leverage goes up, it’s more likely that
firms will experience these operational costs and value will decrease quickly given the precarious
status of the firm as shown by the green line. The way these costs begin destroying value will
vary by the nature of the business. Very stable businesses won’t incur those costs until they’re
at really high levels of leverage. In contrast, very risky businesses could incur costs of financial
distress early on.

• When combining tax effects with the costs of financial distress to produce the red line, it
is evident that weighing tax benefits relative to the costs of financial distress will provide
the value-maximising capital structure. Firms from different industries will have different
capital structures that reflect a trade-off between tax benefits and the costs of financial distress
associated with that underlying industry. The optimal capital structure for a given industry
will provide the weights for costs of equity and debt used in the WACC calculation.

4.2.3 The cost of equity

The capital asset pricing model helps to determine the cost of equity by following the same logic as
the cost of debt: a risk-free rate plus a risk premium. The amount equity investors charge for risk has
two components: the quantity of risk of a given stock and the price of that risk. Risk entailed by the
variability of a stock (highly volatile stock creates a lot of uncertainty and investors would demand
a higher rate of return) can be managed via diversification as shown in Figure 4.6. Diversification
enables investors to maintain expected returns and reduce risk, as the volatility of any one given
stock isn’t impactful due to the size of the portfolio.

36
 Figure 4.5: Impact of diversification on portfolio risk

As Figure 4.6 shows, as you add more securities to a portfolio, the overall volatility of the portfolio
decreases, but there is a level above which the gains from diversification diminish. Importantly, there
is some volatility you can never fully diversify away, the system risk or the risk of holding the
market. Hence, every security’s risk is not measured by how much it moves around in general, but
rather by how much each stock moves with the market, which represents the risk that will never be
diversified away.

Betas
• The measure of how a stock moves with the market is called a beta..

• If a company has a beta of 1, it generally moves in sync with the market: if the market is up
by 10%, the stock will go up by 10%.

• If the company has a beta of 2: if the market goes up by 10%, then the company’s stock goes
up by 20%.

• If a company has a beta of -1: if the market goes up by 10%, then the stock will go down by
10%.

• To calculate a beta follow the procedure below:

Figure 4.6: Sample beta graph

- Plot the monthly returns for a given company against the monthly returns for the market.
- Draw a line that best fits the data i.e. a regression line.
- The slope of that line is equal to the beta, a measure of the correlation between a given
company’s returns and the market’s returns.

• The central intuition behind betas relates to insurance.

37
 • High-beta companies expose shareholders to larger amounts of systematic risk that they can’t
diversify away.

• Hence, investors charge them a higher cost of equity and these firms have a higher WACC.

• A high discount rate is applied as a result, leading to lower present values.

• In contrast, for a negative beta company, the costs of equity are going to be low.

• They might even be negative, which means that their WACC will be lower, which means their
values will be higher.

• When the market goes up, this asset will perform poorly, whilst the opposite occurs when the
market does poorly.

• Overall, investors don’t demand much return from negative beta assets, leading to high values.

The price of risk

• Now that we can measure the quantity of risk associated with a company using a beta, we need
to combine the quantity of risk with a price of risk to figure out the cost of equity.

• The price of risk is the out-performance of equities relative to risk-free instruments like treasury
bonds, acting as the compensation investors demand for bearing equity risk, also known as the
market risk premium.

CAPM
When we put together the ideas of the price of risk and the quantity of risk, we get an equation for
the cost of equity:

re = rrisk−f ree + beta × market risk premium (4.3)

where re = cost of equity and rrisk−f ree = risk-free rate. Furthermore, we can determine that:

• At a minimum, investors will demand at least the risk-free rate or the amount you charge when
you lend money to the government.

• In addition, there has to be some notion of a risk adjustment that will be composed of the
quantity of risk and the price of risk.

• Betas, that represent the quantity of risk, in combination with the price of risk, gives you the
expected return for a given industry or company, and thus the cost of equity.

Figure 4.7: The security market line

38
 • Figure 4.7 graphs the equation for expected returns to investors.

• As betas increase, expected returns increase. Note that zero beta assets have an expected
return equal to the risk-free rate.

• Active investment management is all about pursuing assets that deviate from the line and
deliver more than the expected return.

• This gap is called alpha, the source of value creation, as isolating it means you’re delivering
greater-than-expected return.

Whilst the CAPM is a really powerful theory, it’s also predicated on several assumptions that
don’t always hold:

• It assumes no transaction costs and investors that are able to borrow and lend at relatively low
rates, any many of these assumptions are inconsistent with reality.

• In addition, the theory relies on the idea that investors are highly rational - an assumption
that has proven tenuous.

• Most concerning, it does not always appear that realised returns line up with betas as suggested
by Figure 4.7.

4.3 Common Mistakes with WACC

4.3.1 Using the same cost of capital for all investments
• The logic that capital have expected returns, so the cost of capital, no matter what you invest
in, has to be the same is wrong.

• All various industries and investments expose their capital providers to different risks, so every
industry requires a different cost of capital.

• Consider the scenario where a conglomerate invest in three different industries - aerospace,
healthcare, and media - with three different betas using the average cost of capital:

Figure 4.8: The cost of capital and betas in three industries

- For the media industry, the correct use of capital is actually higher than what’s being
used. Hence, the conglomerate is giving too much to projects in that industry (the cost of
capital is actually higher than what the conglomerate thinks meaning that the discount
rate is higher/the NPV is lower, making this investment more attractive than it actually
is), and end up over-investing in those businesses.

39
 - Similarly, for aerospace, the cost of capital that should have been used is lower, hence the
conglomerate is penalising those investment opportunities too much and end up under-
investing.

• Overall, the appropriate cost of capital isn’t a function who is investing but rather of what
you’re investing in.
• Risk is embedded in the asset, not the investor.

4.3.2 Lowering WACC using more debt

• The intuition that debt is typically cheaper and has a tax advantage, hence using more debt
will reduce WACC and increase value is incorrect.
• If a company is at the optimal capital structure described above, it can’t simply take on more
debt because it’s cheaper, as equity holders will demand a higher return for that risk, and that
will offset any benefit from using more debt.

Figure 4.9: Asset betas, debt betas, and equity betas as a function of leverage

• Figure 4.9 shows what happens to betas on the vertical axis as the amount of debt used increases
on the horizontal axis:

- Asset beta doesn’t change as you use more debt as the behaviour of the assets relative to
the market doesn’t change as financing changes.
- For debt beta, when a company takes on the first dollar of debt, it’s relatively risk-free,
so debt betas are close to 0. However, as a company approaches complete debt financing,
debt betas approach the level of asset betas as the company is entirely debt-financed.
- For equity betas, when there’s little to no debt, equity betas are similar to asset betas,
but increase quickly when leverage increases, as the equity has become more risky and
therefore more expensive.

4.3.3 Exporting WACC

• The final mistake managers make is thinking that they can add value by buying another
company and applying their WACC to its cash flows with the thinking that “I’m bidding for
an asset. Another company is also bidding for an asset. I’ve got a lower cost of capital than
they do because of my businesses. I’m going to be able to get this deal done and actually win
the bid because I’ll be using my cost of capital, which is lower than theirs”.

40
• However, this thinking is wrong as the right cost of capital has nothing to do with the company
or the alternative bidder.

• The right cost of capital is derived from the asset that the managers are buying, and that
should be the same for the two buyers.

• There’s no way the company can export its cost of capital to that asset, as the cost of capital
is not about who you are, but rather what you’re investing in.

• Hence, it doesn’t matter if you plan to use the cash on your balance sheet to make an acquisition
or if you have a highly levered or all-equity balance sheet, what matters is using the right cost
of capital for that investment, and that cost of capital should reflect the right capital structure
for that investment.

41
Chapter 5

The Art and Science of Valuation

5.1 Multiples
• A multiple is a ratio that compares the value of an asset to an operating metric associated with
that asset.

• A common multiple used in valuations is the price-to-earnings, or P/E, ratio, which Divides
a company’s stock price by its earnings per share.

• Alternatively, it’s the value of a company’s equity divided by its net profit.

• A P/E multiple of 15X reflects expectations of the future, you’re not just paying for $1 of
earnings, you are for a stream of future earnings that is expected to grow.

• Firms may grow earnings at very different rates and companies might be judged to have earnings
that vary in quality, hence the P/E ratio can vary across companies within an industry.

• However, earnings are a problematic measure (Chapter 2), we can use a more comprehensive
of cash, EBITDA, to construct multiples as well.

• In addition, there is another important capital to account for, a lender who provides debt, so
the multiples should reflect the fact companies can use debt as capital too.

• These two factors are considered in the use of enterprise value (EV) to EBITDA multiples
(EV/EBITDA), where EV is the sum of the market value of debt and equity, or the
value of the business.

• The EV/EBITDA multiple helps us compare companies of varying capital structures.

• However, we have to be careful when using multiples for comparisons and assumptions as shown
when Twitter was valued during its IPO:

- To value Twitter, market participants emphasized its valuable user base and looked for
companies with comparable revenue models within social media.
- They turned to Facebook and calculated how much every user of Facebook was worth
(take its total stock market capitalization divided by its number of active users) and used
that multiple to value.
- At that time each Facebook user was worth slightly more than $98 and each LinkedIn
user was worth about $93.
- Right after its IPO, Twitter was trading at a valuation that indicated the market values
each of its 232 million active users at around $110.

42
 - Since then, Twitter’s share price has consistently been outperformed by Facebook’s, indi-
cating that comparing the value of Facebook and Twitter users was faulty because of:
1. Varying levels of engagement with the platform
2. Different demographics of the user base
3. Different possibilities for monetizing their users for two platforms
• This example demonstrates how faulty comparisons and assumptions can lead to significant
misvaluations.

5.1.1 Pros and cons of multiples

• Pros
- Simple to calculate and communicate
- Powerful because they are based on current market prices, and that means someone actu-
ally valued company and put their money where their mouth is (not an imaginary value
from a spreadsheet)
- Its ease of use makes comparisons between companies seemingly quick and straightforward.
• Cons
- Comparability is not straight forward, even for within-industry comparison. The earnings
stream in one company many grow substantially faster than another,making the implicit
assumptions of a multiples analysis faulty. Investors sometimes talk about the “quality”
of earnings, implying that some companies have more sustainable earnings than others.
- In addition, because many decisions associated with calculating earnings might differ
across companies, they can be incomparable for multiples purposes.
- By taking a multiple from one company and slapping it on the other, you’re assuming the
growth trajectories and quality of earnings are fundamentally similar, and that could be
a mistake, as although market-base logic can be a virture, it can also be a vice.
- Hence, we need a better way to think about valuation

5.2 Problematic Methods for Assessing Value

5.2.1 Payback periods
This method assesses projects based on the amount of time it would take for investors to get their
money back - the payback period. You simply compare the initial outflow of funds with subsequent
inflows and ask: In what year do I get my money back?
The example below illustrates the problems with this method:

Project A Project B
Year 0 -$900,000 -$900,000
Year 1 500,000 0
Year 2 500,000 0
Year 3 300,000 1,670,000

Table 5.1: The problems with payback and IRR analysis

• Project A has a payback period of less than 2 years, and project B has a payback period of 3
years.

43
 • If payback period is your decision-making criterion, you should choose project A.

• By comparing these flows over time in this way, the time value of money is ignored. The second,
and even worse, problem is that the answer to a payback period analysis is a simple number
of years, but that’s not we are interested in - we are interested in creating value.

• The payback method could lead you to choose an investment because you get your money back
faster, but turn away from from an investment that creates much more value.

• For instance, using a discount rate of 10%, project A has a NPV of $193,160 and project B has
a NPV of $354,700.

• By using payback period, you selected the project with a considerably lower net present value,
which leads to much less value creation, reflecting why payback analysis is so problematic.

5.2.2 Internal rates of return (IRR)

Using IRR to assess projects is another very common valuation. This method is not as problematic
as payback analysis because it is closely linked to discounted cash flows, but it is still not faultless.
When we calculate discounted cash flows, we use forecasted cash flows and a discount rate to find
a present value. IRR flips that analysis, it takes the forecasted future cash flows and finds the
discount rate that makes the present value 0. Here is the formula for calculating an IRR:
cash f low1 cash f low2 cash f low3
0 = Cash f low0 + + 2
+ ... (5.1)
(1 + IRR) (1 + IRR) (1 + IRR)3
In other words, IRR analysis captures the rate of return that will be experienced if the forecast
is realized for a project. Once you have an IRR, you can compare it to the weighted average cost of
capital or discount rate. However, IRRs are problematic for two reasons:

1. IRRs can give you the wrong answer because they’re focused on returns and not value creation.
You can compare 2 projects, and the higher IRR project might actually lead to less value
creation when you are interested in value creation, not in rate of return maximization.

2. If cash flows are characterized by outflows, and then inflows and outflows again, and then
inflows (as opposed to a simpler version using just ouflows and then inflows), IRRs can give
you wrong answers.

Moreover, IRRs incur these risks and don’t actually save any effort. Calculated IRRs must be
compared to a WACC using forecasted cash flows, so we need the same information as for discounting.
Referring back to the example in Table 5.1, we can illustrate the first problem:

• Assuming a discount rate of 10%, the NPV of project A was $193,160 and the NPV of project
B was $354,700.

• The IRR of project A is 22.9% and the IRR of project B is 22.9%.

• Ignoring NPV and focusing on IRR would have made you indifferent to the two projects.

There is a clearly dominant project choice that IRR analysis obscures. This difficulty occurs
in-part because managers are not interested in increasing returns, but should prioritize creating
value.

44
5.3 Discounted Cash Flows
The discounted cash flow method is the gold standard of valuation. We know that assets derive their
value from their ability to generate future cash flows, and those cash flows aren’t all created equal
- they requires discounting to translate them to today’s numbers. Furthermore, the appropriate
discount rate is a function of an investor’s expected returns as they translate into a manager’s cost
of capital. To perform the valuation we start with the present value formula:

cash f low1 cash f low2 cash f low3 cash f low4

P resent value0 = + + + ... + terminal value (5.2)
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4

This differs from Equation 2.5 with the inclusion of the terminal value, but the basic logic is the
same. All value today is derived from the expectation of future cash flows and we need to figure out
how to forecast those cash flows, decide which definition of cash, and what discount rate to use.

5.3.1 Free cash flows

Free cash flows are flows that assets generate that are truly free and truly cash. They are available
to capital providers after accounting for costs and expenses. Free cash flows can be deployed for new
investments or they can be distributed to capital providers. The basic formula is as follows:

1. Start with projected EBIT that is generated by the operating assets

2. Subtract taxes to get EBIAT

3. Add back non-cash expenses like depreciation and amortization because they should never have
been taken out

4. Accommodate the capital intensity of the business by penalizing it for investments in its working
capital and fixed assets

5.3.2 Laboratory investment valuation exercise

Step 1: Forecast future cash flows
A company is considering investing in a new laboratory:

• The lab will require an initial capital expenditure of $2.5 million in year 0.

• The expected EBIT in year 1 will be $1 million.

• The EBIT of $1 million is expected to increase by 5% every year thereafter. At the end
of year 5, operations will end and the assets will be sold for their salvage value of $1 million.

• During the life of the project, the assets will be depreciated and ongoing capital expenditures
will be made to maintain the assets. The net effects will be a $300,000 depreciation expense
and $300,000 in capital expenditures for years 1 to 5 to maintain the equipment.

• Working capital is required for the project and is assumed to equal 10% of EBIT. In other
wprds, in year 1, when EBIT goes from $0 to $1 million, the company will need to invest
$100,000 in working capital. In year 2, when EBIT goes from $1 million to $1.05
million, the company will need to invest $5,000 more in working capital. For simplicity,
let’s assume that all working capital associate with the project expires worthless at the end
of the five years.

45
 • The company’s tax rate is 30% and there are no tax consequences to selling the asset
in year 5.

To calculate the free cash flows, a few useful tips are:

• Take the initial EBIT, grow the EBIT at the prescribed growth rate and adjust for tax payments
to get EBIAT. Then, follow the formula for free cash flows.

• Following the timing of the project is critical.

• The working capital calculation is not the level of working capital but rather the change in the
level of working capital.

• Lump together capital expenditures with the asset disposal in the final year, which creates a
positive cash flow in that year.

• It’s important to settle on a system of keeping track of what the inflows and outflows are e.g.,
all outflows are negative, then the totals for the free cash flows are just sum of the figures

Applying the information and steps should get you the following spreadsheet:

Figure 5.1: Calculating free cash flows for laboratory investment - figures in 1,000s

Step 2: Apply the WACC

The free cash flows this business generates are free to the capital providers, so their expected returns
translate into the cost of capital used to discount future cash flows via the weighted average cost
of capital (WAAC). To summarize, the WAAC calculates the costs of both debt and equity, weighs
these costs by their relative importance in financing of the investment, and includes a tax effect that
captures the deductibility of interest. The capital asset pricing model (CAPM) helps us understand
where costs of equity come from, and betas capture the measure of risk by considering the perspective
of a diversified investor.
To figure out the relevant WACC for the investment in this lab, consider these facts:

• The optimal capital structure for such investments is 35% debt and 65% equity.

• The risk-free rate is 4%.

• The lender will charge 7% interest on the new project.

• The market risk premium is 6%.

46
 • The beta is 1.1 - derived by calculating the gradient of the regression line from the plot of the
monthly returns for companies that capture the risk of the project against the market return
as shown in Figure 5.2.

Figure 5.2: Beta graph

Now, use the CAPM to determine the cost of equity:

re = rrisk−f ree + beta × market risk premium = 4% + 1.1 × 6% = 10.6% (5.3)

where re = cost of equity and rrisk−f ree = risk-free rate. Then, calculate the WACC:

D E
W ACC = ( )rD (1 − t) + ( )rE = 35% × 7% × (1 − 0.3) + 65% × 10.6% = 8.61% (5.4)
D+E D+E
where rd is the cost of debt, re is the cost of equity, D is the market value of the firm’s
debt, E is the market value of the firm’s equity, D + E is the total market value of the
firm’s financing (equity and debt), and t is the corporate tax rate.
The final step is to return to the forecasted free cash flows and determine net present values.
Discount factors are simply 1 divided 1 plus the WACC. Finally multiply all of the free cash flows
by the discount factors and sum them to determine the NPV as shown in Figure 5.3:

Figure 5.3: Calculating discounted cash flows and NPV for laboratory investment - figures in 1,000s

47
 The NPV of this investment is $1.069 million and because it is positive, the lab project will create
value for the company, and it should be carried out. Alternatively, if you were to measure the present
value of the cash flows, it would be $3.569 million (simply exclude initial capital expenditure).
In addition, although multiples have their flaws, they can often double-check discounted cash
flow assumptions, so many companies use them as part of a multi-pronged valuation effort as a quick
short term proxy.

Step 3: Calculate terminal values

Most companies and many investments are expected to continue indefinitely. In these situations, it’s
typical to settle on a year when you expect the company’s growth to stabilize and then summarize
the value in all free cash flows through a simple set of calculations. This is called a terminal
value that summarizes the value of the investment at the end of forecasted cash flows.

Multiples
The first method to get terminal values is via multiples. When you’ve reached an end point, e.g., 5
years into an investment, you could say that the company has reach a valuation of, for example, ten
times free cash flow.

Perpetuity formula
The other preferred method is to deploy the perpetuity formula that effectively calculates today’s
value for a stable set of cash flows. If you want to get the present value of a stream of cash flows
that doesn’t grow over time, you can just divide that cash flow by the discount rate:
Cash f low1
P erpetuity f ormula : (5.5)
discount rate
Meanwhile, the present value of a growing perpetuity is the initial cash flow divided by the
discount rate less the growth rate:
Cash f low1
Growing perpetuity f ormula : (5.6)
discount rarte − growth rate
• When you use this as part of a discounted cash flow analysis, the present values these formulas
provide are the present value as of the year before the initial cash flow.
• For example, if the numerator of the equation is the cash flow in year 6, the formula will produce
the present value in year 5. That means you will need to discount this value again in
order to get the present value today.

These formulas are not use more commonly, as there are many short-run dynamics that can be
very important to model - new factories, sales trajectories, cost reductions - and those dynamics can
have a large impact on value. You can only use these formulas when things settle into a steady state.
There’s a danger in this step of the valuation process, especially in the assumption of the growth
rate:

• For example, if the company is in an economy that’s growing at 3% and uses a terminal growth
of 7%, that’s an untenable assumption.
• It means that ultimately the company will take over the world, which we don’t really believe
will happen.
• As a consequence, in the long run, overall economic growth rates are a useful way to think
about what growth rates should be in a terminal value calculation.

48
 Overall, one of the chief problems with discounted cash flow analysis is that so much of it depends
on the terminal value, the value for which you ultimately sell the business. So whenever you generate
a discounted cash flow analysis, you should print out what what percent of the overall valuation is
as a result of the sale of the business because then you’re not really thinking about the cash flow
generation in the business - you’re really making a bet on where you’ll be able to sell that business
ultimately.

Step 4: Compare enterprise values versus market values

Despite having the value of a given enterprise, you can’t just divide that figure by the number of
shares and compare it to the existing stock price. Through the valuation we have determined the
value of the business, not its equity. The value of the business is often called enterprise value,
a valuation of the cash flows to the capital providers, both debt and equity, that the enterprise
generates.
Sometimes, enterprise values will be much more than the market value of equity. For example,
if the enterprise value is $100, and the company holds $40 of debt, the equity value is only $60.
Thus can go the other way, especially if the company holds a great deal of cash, in which case, the
company’s market value can be greater than its enterprise value.

Figure 5.4: Apple’s market value balance sheets, 2012-2016

For example, in 2013, Apple had a market value of ∼$500 billion, but it held more than $100
billion in excess cash that it didn’t require for its operations as shown in Figure 5.4. As a consequence,
the actual implicit value of the enterprise was lower than the market value. Hence, to get the value
of a company’s equity from the enterprise value, you need to think about how much debt and
cash there is.
Figure 5.4 shows Apple’s enterprise value and cash versus the market value of its debt and equity
from 2012 to 2016. In the figure, market values are used along with cash and debt levels to arrive at
implied enterprise values. When conducting a valuation of Apple’s business, you should compare
the valuation to the implied enterprise value rather than to the market value because those values
can differ by more than 30%.

Step 5: Analyze scenarios, expected values, and bidding strategies

To really understand the investment and to arrive at a value of the asset, you have to think through
the expected value of the asset. You just valued the asset under a set of assumptions. The
appropriate way to arrive at the correct expected value is to consider alternative scenarios such
as a worst-case scenario, a best-case scenario, and a base case and attach probabilities to them.
Creating these scenarios and attaching probabilities to them is one of the most important steps.
It forces you to really think through the nature of the business and its potential outcomes. For

49
example, if there’s a 10% chance that the value is $120 (best case), a 70% chance the value is $100
(base case), and a 20% chance of a $10 value (worst-case), what is the expected value?

Expected value = 10% × $120 + 70% × $100 + 10% × $10 = $84 (5.7)
Once you get the expected present value and know it’s associated with an enterprise value, this
should inform your bidding strategy if you’re buying a company:

• The expected value should be the final offer.

• If you pay that price, your investment will have a NPV of 0, and you won’t have created any
value for yourself. Hence, it should be your final and ultimate bid.

• Your opening bid should be considerably lower.

• If you end up paying $75 for that asset, you’ve actually created $9 in value and unless you pay
less than the expected value, your purchase is not actually creating any value in expectation.

• If you pay up to the best-case scenario of $120, in the worst and base case, you have transferred
value to the seller and created no value in the best case. In expectation, you are destroying
value for your capital providers.

5.4 Valuation Mistakes

After the announcement of an acquisition, it’s fairly common for the stock of the acquirer to fall,
indicating that it likely overpaid and transferred value from itself to the target. This systematic
overpaying indicates that these firms must be doing something wrong during the valuation process
as outlined below.

5.4.1 Ignoring incentives

• The first and most pervasive mistake is that it is easy to ignore the incentives of the people
involved in an acquisition.

• Sellers of assets want acquirers to overpay and sellers control important sources of information,
including historic financial information.

• To prepare for a sale, the seller might make itself look particularly good by accelerating sales,
deferring costs, and under-investing.

• This circumstance makes due diligence a critical part of any acquisition process.

• The problem doesn’t stop with the seller. Typically, investment bankers get paid only on
completion, so they want you to make the deal.

• Even people within your company who have analysed the transaction have perverse incentives.
They may well anticipate getting a promotion to run the new division just acquired.

• Everyone involved in the transaction wants the transaction to happen and may subtly change
assumptions or forecasts to help make that outcome a reality.

• As a result, this sea of unbalanced information leads to over-payment and overconfidence.

50
5.4.2 Exaggerating synergies and ignoring integration costs
• Synergy is the idea that once merged, the value of the two companies will be greater than the
sum of the values of each individual company.

• On the surface, the idea of synergies isn’t unreasonable. For example, if you bring together two
sales forces and rationalize them, this should result in cost savings. If you bring two companies
together, you could control more capacity within the industry and gain more pricing power.

• The problem with synergies is that people tend to overestimate how quickly those synergies
will work and overestimate the magnitude of their effects.

• They ignore the fact that changing cultures and workforces takes time.

• The second, related problem is that, even if the synergies are legitimate, people will often
incorporate all those synergies into the price they pay for a company.

• That too can lead to over-payment since the rewards from the value creation of synergies are
transferred to the acquired company’s shareholders instead of being part of the value creation
the merger brings to the acquiring company.

5.4.3 Underestimating capital intensity

• One final error that eager bidders make is to understate the capital intensity of the business.

• Ongoing growth in EBIT or free cash flows typically requires increasing the asset base through
capital expenditures, but those capital expenditures reduce free cash flows dollar-for-dollar and
are conveniently ignored by people anxious to do deals.

• For example, terminal values will assume perpetual growth rates but in the final year you are
modelling (which serves as the basis of the terminal value), capital expenditures will just equal
depreciation, indicating no growth in assets.

• In effect, understating capital intensity inflates values.

• Hence, the valuation of company such as Tesla hinges not just on customer growth - it must
build factories to satisy that demand - so understating capital intensity can lead to incorrect
valuations.

51
Chapter 6

Capital Allocation

Generating free cash flows is critical for thinking about how and if companies create value. But that
leads to a few questions:

• Once a company is generating free cash flows, what should management do with that cash?
• Should managers invest that cash in new projects?
• Should they acquire companies?
• Or should they distribute the cash to their shareholders?
• In recent years, we’ve seen a large increase in share buybacks, sometimes called repurchases.
Why are companies undertaking repurchases?

Together these questions determine the capital allocation process. Capital providers entrust
managers with their capital and consider the fulfillment of the related obligation as a central indicator
of how well management is doing their job.

6.1 Capital Allocation Decision Tree

Figure 6.1: Capital allocation decision-making chart summary

52
 • The capital allocation problem is best understood as a nested series of decisions as seen in
Figure 6.1.

• The first question a manager has to address involved the availability of positive net present
value (NPV) projects to spend money on. Creating value is central to a manager’s task, and
that process involves beating the cost of capital, year over year, and growing.

• If positive NPV projects are available to you then you should undertake them.

• Those projects may involve organic growth - e.g., introducing new products or buying new
PP&E - or inorganic growth via M&A.

• If there aren’t value-creating opportunities (projects with positive NPVs) then a manager
should distribute the cash to shareholders through dividends or share buybacks.

• If you choose dividends, you’ll need to decide if you will create a regular dividend or issue a
special one-time dividend.

6.2 Retaining Cash

If you’re in a position to make investments, there are some basic criteria to use to make that decision:

• First, you need to calculate the NPV of a number of options in order to identify the best
value-creation opportunities.

• They could be organic or inorganic, and although the simple rule is to pursue the option with
the highest NPV, there are a number of trade-offs to consider.

• For example, there are many problems to consider when undergoing M&A, which can compli-
cate present value assessments.

6.2.1 The perils of inorganic growth

The lure of M&A as opposed to organic investment is often the apparent seed of buying existing
assets instead of taking the time to build those assets. Moreover, the M&A logic also implies that
buying assets, as opposed to building them, is also safer, as the risk of completion has been resolved.
While many people think mergers are faster and safer ways of achieving growth, there are many
complications that companies must contend with before and after a transaction is completed.

Before the merger

• When you buy pre-existing assets, the seller has much more information about the asset than
the buyer, and the buyer can only make educated guesses. That’s why due diligence is such an
important part of the M&A process.

• Buyers need to understand the assets they’re acquiring, but in the end, they have to remember
that the seller has a large information advantage.

• Approaching a sale, buyers might under-invest in assets to understate the capital intensity
of the business. They might accelerate revenues and delay costs and bury problems such as
bankrupt customers who owe them by declaring those receivables still open.

• Intermediaries, like consultants and investment banks, can help buyers with these problems,
and the buyer’s own deal teams can find out where the bodies are buried.

53
 • Unfortunately, everyone involved, from the seller to the intermediaries to the people within the
buyer’s organization who are on those deal teams, are incentivized to complete a transaction -
often leading to over-paying for assets.

• Hence, the notion that M&A is safer than organic investment is far from well-grounded, and
the data on the failure rates of mergers directly contradict their supposed safety.

After the merger

• Although the rationale of synergies can be tantalizing when assessing a merge, realizing those
synergies is no trivial task.

• At the time of a merger, it’s common to overestimate synergies, underestimate the time to
realize them, and underestimate the onetime costs to realize the synergies.

• Even worse, the acquirer can end up retaining two separate capacities for various functions for
along time, resulting in significantly higher costs than it had anticipated. The time it takes to
realize synergies can have a massive impact on the value creation of the merger.

• Finally, cultural issues in bringing in two organizations together must be considered. While the
difficulty of cultural integration is easy to ignore on a spreadsheet, the issues raised by cultural
differences are paramount and have significant financial consequences. Those assumptions in
the cells in spreadsheets are contingent on human actions, so ignoring them can be fatal.

• Overall, these issues signal why the seeming speed and safety of M&A versus organic growth
can be illusory.

6.2.2 Conglomerates
• Aggressive M&A strategies can also lead to conglomerates or multi-divisional companies with
broadly diversified holdings with little shared between the holdings.

• There are two financial justifications for becoming a conglomerate:

- The first is a cost-of-capital argument: by doing the diversifying acquisition, you will bring
your cost of capital to that target.
- For example, you have a 10% discount rate and the target company has a cost of capital
closer to 15% - meaning that it will get revalued higher upon acquisition because of your
10% cost of capital, creating value.
- However, this reasoning is flawed, as the correct cost of capital to use is a function of
that business, you can’t export your cost of capital.
- The second finance rationale for diversifying is to manage risk.
- By owning different types of companies in different industries, shareholders are thought
to benefit from diversification.
- The thinking equates acquisitions to stock portfolios: of one company goes south, then
the other companies in your portfolio will prop it up.
- This line of inquiry is faulty and ignores the fact that managers are undertaking diversi-
fication, while shareholders could arguably achieve that risk management themselves.
- The logic of finance is that you shouldn’t do something for your shareholders that they
can do for themselves and diversification at the corporate level is exactly that.

54
 • Conglomerates appear to destroy value rather than create it. Hence, they often trade at a
discount, which means that their combined values is less than if the businesses were traded
separately.

• This is because capital allocation within a conglomerate is distorted by the pressure to treat
all divisions equally. In the process, capital is distributed equally rather than allocated toward
the best opportunities - weak divisions expand and promising divisions are starved.

• Hence, the divisions would be worth more apart than together.

• Conglomerates aren’t always problematic. In some emerging markets, conglomerates can be

powerful because they overcome market imperfections in capital markets and labor by inter-
nalizing activity inside that conglomerate.

• Overall, managers in conglomerates must be vigilant about the possibility of “socializing”

capital.

6.3 Distributing Cash to Shareholders

If a company doesn’t have worthwhile projects to pursue, it should distribute cash to shareholders
via two primary options - dividends and stock buybacks:

• Dividends are more intuitive, a company simply pays cash to its shareholders on a pro-rata
basis.

• Dividends can be part of a predictable flow or they can be larger, one-off events (special
dividends).

• Meanwhile, a share buy-back is less intuitive, a company buys back its own shares in the open
market and retires them.

• As a result, investors who choose not to sell their shares will own a slightly larger fraction of
the company, and cash has been distributed.

• Share buybacks have become tremendously popular over the last decade as shown in Figure
6.2.

Figure 6.2: US corporations’ dividends versus buybacks, 2005-2016

In terms of the raw mechanics, the choice between dividends and buybacks is irrelevant, but
each method potentially sends a different signal to the market, and that can matter. However, some
misconceptions of distributing cash include:

55
 • Stock prices rise after buybacks because the remaining shareholders own more of the company
afterward.

• Dividends are bad for shareholders because their shares will be worth less.

To debunk these ideas and clarify the nature of the decision, we will show that whether a
company chooses to distribute cash shouldn’t matter.

Figure 6.3: Cash distribution: dividends versus share repurchases

The company in Figure 6.3 has a large amount of cash and is considering distributing some via
a dividend or buyback. Because this balance sheet is market-based, the equity values can easily
be translated to share prices and the value of operating assets are market values. If the company
distributed $70 of that cash as a dividend to shareholders the following will happen to the market
value balance sheet:

• Given that there are 100 shares outstanding, that’s a $0.70 per share dividend,

• The company’s cash holdings drop $70 from $100 to $30, but the value of the operating assets
remains the same.

• Because the debt remains the same, the equity value also has to drop $70 for the balance sheet
to balance.

• The price per share would fall from $1.40 per share to $0.70 per share.

• As a shareholder, you might seem to be taking a hit, but when you factor in the $0.70 in cash
you received, you’re left with $1.40.

• Shareholders are economically in the same position as they were before - it’s completely
value-neutral.

• They could return to where they began by buying one share with that $0.70 in cash, and they
would be left with $1.40 in shares, just as before.

Meanwhile, if the company distributes $70 of its cash by buying back $70 worth of shares:

56
 • Again, its cash drops to $30, and the operating assets and debt remains the same.

• The equity value drops to $70. The $70 used to buy shares retired 50 shares, given the stock
price of $1.40.

• Now that the total equity value is $70, and there are now 50 shares outstanding, that provides
a $1.40 share price.

• The shareholders who sold to the company are left with $1.40 in cash, and the shareholders
who stayed have a share worth $1.40.

• Again, nothing has changed, it is value-neutral.

This example has an important core intuition - value doesn’t arise from taking cash from one
pocket and placing it in the other. Value arises from pursuing positive NPV projects. Hence, neither
keeping nor distributing cash results in changed value.

6.3.1 The decision to distribute cash

The value neutrality of keeping or distributing cash is true under idealized conditions, the Modigliani
and Miller conditions of no taxes, perfect information, and no transaction costs. Under these condi-
tions there are no value consequences to the mechanics of dividends or buybacks. However, real-world
considerations have an impact on these decisions:

• Firstly, taxes can change the consequences for value.

- For example, during a share buyback, investors have to sell their shares and incur a capital
gain that may be taxed at a lower rate, while a dividend can be taxed at higher rates.
- Hence, many people think that these tax consequences are one reason to prefer share
buybacks over dividends.

• Another critical element in the real world is the asymmetric information and incentives.

- All actions are judged by the information they are thought to reveal.
- If the people with all the information about the company are buying back shares, they must
think the firm is undervalued and are willing to put real money behind that sentiment.
- This decision is a very strong signal and helps explain why buybacks have become so
popular and are often greeted with a price rise.
- Price reactions to share buybacks are driven by that signaling interpretation, not by the
mechanics of dilution.

• Dividend initiations can sometimes be met with the opposite reaction, even though dividends
effectuate the same outcome as buybacks:

- Individuals with all the information about the company’s prospects are saying that they
can’t find good investments and they don’t think the company is undervalued.
- In effect, they don’t have anything better to do with your money, so they’re giving it back
to you - not the most positive signal.

• It is possible to interpret dividend increases positively:

- Since dividends are fairly sticky (once a company starts paying dividends, it’s hard to
stop), increasing dividends may mean the company has faith in the ongoing, increased
profitability of the enterprise.

57
 - Furthermore, if the company is going to maintain that dividend, it also binds manage-
ment’s hands to some degree, which some investors think reduces the principal-agent
problem.

• Indeed, agency considerations are the other reason cash distribution decisions can have value
consequences:

- Managers can use cash inside companies to pursue their won agendas, which may not
coincide with shareholder interests.
- For example, as cash piles up, a CEO may be tempted by an acquisition that enhances
their position in the CEO labour market but actually destroys value.
- So getting cash out of the corporation can have value consequences, not because of the
mechanics of the distribution, but because it alleviates agency considerations.

• Agency considerations can also provide a distinct interpretation of share buybacks:

- If the signaling argument was all to consider, we’d expect managers to time buybacks well
and to be buying at low points in the market.
- As seen in Figure 6.2, this does not seem to be happening in aggregate, as the last market
peak was also the peak for buybacks.
- So clearly some firms are doing buybacks well and some are doing it poorly.
- Adopting an agency perspective can help explain this phenomenon - share buybacks can
also be used to achieve various operating metrics.
- Let’s say a manager is a penny short on earnings per share (EPS) for a given quarter and
knows that he’ll be punished by the market for the error, possibly making him miss out
on a bonus.
- A share buyback can be done to reduce the number of shares outstanding and increase
EPS, but the short-run illusion of higher EPS is likely not in the best interests of share-
holders.

Overall, the mechanics of cash distribution often lead people to mistake arguments about value
consequences associated with dilution or share counts. The raw mechanics of buybacks and dividends
are all value-neutral. The reason these decisions attract so much attention is because they provide
information and address the principal-agent problem.

6.4 Myths and Realities in Financing Decisions

The notion of value neutrality can help us understand a variety of financial transactions - equity
issuances, stock splits, leveraged recapitalizations, and venture financing - and the illusions and
mistake they give rise to.

6.4.1 Equity issuance

Many consider the value consequences of issuing equity problematic because of dilution. Specifically,
equity issuance is thought to lead to stock price declines because investors end up with a smaller
piece of the company.

58
 Figure 6.4: Post-financing, market-based balance sheet

Looking at the market-based balance sheet of the sample company as shown in Figure 6.4, we
can see how equity issuance works when the company decides to issue $70 more in equity:

• After the company issues $70 in equity, it will have $70 more in cash for a total of $170; its
operating assets and debt level are unchanged, so the market value of equity is now $210.

• To determine how much the shares are worth, we need to know how many shares are outstanding
after the issuance.

• Shares are selling at $1.40 each, so raising $70 would require the company to issue 50 shares
($70 ÷ $1.40 = 50).

• That leaves 150 shares outstanding to split that $210 in equity.

• Shares must therefore be selling for $1.40 per share ($210 ÷ 150 = $1.40), just as before.

• Hence, issuing equity has not diminished the price of the company’ stock - it is exactly the
same - in line with the fact that value creation comes from the assets side of the balance sheet,
not from financing.

• With regards to dilution, shareholders may now have a smaller percentage share, but it is of a
larger pie.

Even so, when companies issue stock, the stock price often does declines, as when companies
are issuing shares, they are sellers of shares. This inevitably leads to questions about why they are
choosing to raise funds by selling shares as opposed to using debt or internally generated profits. In
short, equity issuance sends a negative signal.

6.4.2 Stock splits

A similar confusion can arise about stock splits. In the scenario when the sample company decides
to split its stock two-for-one, for every share of stock that an investor currently holds, they will now
hold two shares. This can also be termed a stock dividend - every holder of a share will receive one
share. The following happens to the company’s market-based balance sheet:

Figure 6.5: Post-split, market-based balance sheet

• There are no changes to the market-based balance sheet because there have been no changes
in operations or to financing sources.

59
 • However, each share is now worth $0.70, as there’s still $140 worth of equity, but now it’s split
over 200 shares ($140 ÷ 200 = $0.70).
• Investors haven’t lost value. Each investor used to have one share worth $1.40. Now they have
2 shares worth $0.70 each, for a total of $1.40.
• No value has been created or destroyed by this stock split.
Some companies split their stock in order to make their stock price more enticing to smaller
investors. However, some companies refuse to ever split their stock, as they think that stock splits
are meaningless and only encourage short-term interest in a stock through a seemingly cheaper price.
These kind of actions can remove frictions in some circumstances too:
• In 2011, Citigroup performed a reverse stock split: for every 10 shares of stock held, investors
received one share.
• Citigroup did this because its stock price had fallen to $4, and many institutional investors
have guidelines that prevent them from purchasing stock for less than $5.
• By performing the reverse stock split, Citigroup raised its price to $40 and was able to access
an important group of investors for its shares.
Stock splits do not create value per se but can have value consequences because of market imper-
fections, just like stock issuance.

6.4.3 Leveraged recapitalization

A leveraged recapitalization is a large dividend funded by the issuance of debt. Imagine that the
PE fund that owns the sample company wants to do a leveraged recapitalization. The company will
borrow an additional $60 and combine it with $40 of its cash to pay out a special $100 cash dividend
to its shareholders, resulting in the following changes to the market-based balance sheet:

Figure 6.6: Post-recapitalization, market-based balance sheet

• Debt will increase by $60 to $120, and cash will increase by $60 to $160.
• Then, cash will decrease by $100, because it is used to pay a dividend.
• Adding up the market value of the operating assets and remaining cash and subtracting debt,
we’re left with $40 of equity value.
• For the shareholders, 100 shares are now worth $0.40 per share ($40 ÷ 100 = $0.40), but
shareholders have also received a dividend of $100, split up across those shares ($100 ÷ 100 =
$1 each).
• That adds up to the same $1.40 per share the fund had before.
The mechanics of this transaction don’t necessarily yield value consequences, but there can be
value consequences because of other factors. Specifically, the equity is now substantially riskier (as
there is more debt that gets paid out before equity), and that should be associated with higher
expected returns and lower values.

60
6.4.4 Venture financing
As companies grow and require more funding, their founders find investors, called angel investors,
to provide funding. This process often happens more than once, and the different rounds of funding
are called Series A, Series B, and so on, and can also feature professional VC firms.
Instead of the previous sample company, imagine a brand-new enterprise. Before the first round
of external financing (Series A), its balance sheet is a little ambiguous. The founders own the equity,
and the founders’ ideas are the assets of the company. The founders have allocated a hundred shares
of company stock to themselves, but the company is still entirely private.
The company needs an additional $100 to invest in a positive NPV project and goes to a venture
capitalist for that funding. The venture capitalist offers the $100 for 20% of the company in return.
By making that offer, the venture capitalist has implicitly valued the company:

Figure 6.7: Post-venture financing, market-based balance sheet

• If 20% of the company’s equity is worth $100, then 100% of the company’s equity must be
worth $500.

• The balance sheets have to balance, this $500 is the value of all assets as well.

• Since the company will have $100 in cash immediately after the financing, this means the
remaining asset (the business the founders have built so far) is worth $400.

• The $500 on the equity side is split between the founders (80%) and the venture capitalists
(20%), so the founders’ stake is worth $400 (80% × $500 = $400) and the venture capitalists’
stake is worth $100 (20% × $500 = $100).

• 25 shares are issued to the venture capitalists to represent their share of the equity for a total
of 125 shares (100 ÷ 80% = 125).

• The value of each share is $4 ($500 ÷ 124 = $4).

As Figure 6.7 shows, this round of funding implicitly values the business before the funding
(pre-money value) by valuing the business after the funding (the post-money value).
Let’s imagine that the company returns a few years later for a second round of financing (Series
B). The company doesn’t have any more cash on hand (cash balance is $0), and it’s asking for $1,000
in investment. The Series B investors ask for 50% of the company in return for the $1,000 investment
(Figure 6.7), resulting in the following changes to the balance sheet:

• After the investment, there will be $1,000 in cash and the existing business.

• If the $1,000 represents 50% of the company, then all of the equity is now worth $2,000.

• This implies that the enterprise is now worth $1,000 ($2,000 total asset value - $1,000 cash).

61
 • The founders have 100 shares and the Series A investors have 25 shares.

• These 125 shares are worth $1,000 or $8 per share ($1,000 ÷ 125 = $8).

• The founders’ shares are now worth $800 ($8 × 100 = $800) and the Series A investors’ shares
are now worth $200 ($8 × 25 = $200).

• 125 shares are issued to Series B investors to represent their 50% ownership that is worth
$1,000.

In terms of equity dilution:

• The founders have gone from owning 100% of the company and holding stock worth an unknown
amount to owning 80% (post-Series A) and holding stock worth $4 per share ($400), to owning
40% of the company (post-Series B) and holding stock worth $8 per share ($800).

• With each round of financing, their equity is diluted, but their stakes grow in value because
the pie is growing larger as well.

6.4.5 Summary
The process of share issuance is particularly fraught in the case of new ventures because those
financings actually involve telling a founder what they are worth. But the mechanics of equity
financings do not give rise to value consequences. Similarly, distributions per se don’t change value,
but distributions that change the riskiness of shares, like leveraged recapitalization, can have an
impact on value because they change risk, expected returns, and prices.

6.5 Cash on Balance Sheets

Over the last 10 years, the situation where companies neither distribute nor invest and just hoard
cash has become more common. There are several possible reasons to hold on to cash:

• There have been significant tax penalties to US companies for paying out cash if that cash is
held abroad (these penalties were lessened by Congress at the end of 2017).

• Cash balances can serve as insurance against rocky times.

• It’s possible that companies are just waiting to find the right investment.

6.6 Six Major Mistakes in Capital Allocation

1. Delaying decision making

• Not making capital allocation decisions results in rising cash levels on corporate balance
sheets.
• These rising cash levels typically frustrate shareholders as they questions why managers
are unable to deploy capital.
• Moreover, cash on balance sheets can attract the attention of activist investors who can
use that cash as financing to take that company private.

2. Trying to create value through share buybacks

62
 • Managers sometimes justify share buybacks by claiming that they create value for share-
holders by buying shares cheaply.
• In fact, value can’t be created through share buybacks.
• At best, share buybacks transfer value across shareholders, depending on the buyback
prices for shares.
• Managers can only create value by investing in positive NPV projects.

3. Preferring acquisitions over organic investment because acquisitions are faster and
safer

• Acquisitions appear to be faster and safer but can actually prove to be the opposite.
• Because of the informational problems between sellers and buyers, it can be risky to
acquire companies, and the integration issues associated with acquisitions can offset any
purported gains.

4. Preferring buybacks over dividends because buybacks are discretionary while div-
idends are not

• In fact, shareholders can become just as accustomed to a steady stream of buybacks as

they do with dividends.
• Moreover, shareholders value a company’s commitment to pay dividends, which can result
in gains to shareholders.
• Finally, special dividends are a simple way to distribute cash that explicitly will not
generate expectations for future dividends.

5. Preferring to reinvest cash to build a larger business

• Size, rather than value creation, can quickly become an objective of managers as it’s more
fun to run a larger business.
• Building empires can become a major objective for managers that can contradict their
mandate to be good stewards of capitals.

6. Excessive distribution of cash to satisfy short-term shareholders

• Overlooking positive NPV projects is as problematic as pursuing size over value creation.
• Short-term earnings goals and pressure from shareholders who care only about these short-
term earnings metrics can cause a manager to overlook good investments.

63