This is a partial preview of the document found here: https://flevy.com/browse/business-document/finance-valuation-basics-106 Description: This document explains the basics of financial analysis. It explains financial statements, financial ratios/comparables, and capital markets. This training presentation has been adopted from the ones used at global consulting firms.

1. Finance & Valuation Basics

2. The Purpose of This Module Is to Explain How We Do Financial Analysis
Objectives:
To explain why Financial Analysis is important in
strategy consulting projects, what it is, and x
where/how it is used. MV/BV
xx x x x
R 2 =?
x x x
To introduce you to basic ratio analysis and start to ROE-Ke
indicate what the different ratios mean.
Introduce valuation techniques.
To provide direction for what to do next:
• People you can contact.
• Documents you can read.
3

3. A Company’s “Life Cycle”
Raises Pays a return
Operations on funds
funds
raised
Buys and sells
fixed assets
Collect cash Buys raw
from customer materials
Bank Bank
Pay employees,
suppliers, etc. Manufacture
products
Shareholders Sell Shareholders
products
The underlying operations are virtually unaffected by the funding structure.
5

4. We Will Use Dell Computer Corporation (DELL) As Our Example in This
Module
Company Facts:
Company Website:
– Dell is the leading direct marketer
and one of the world’s 10 leading
manufacturers of personal
computers. 1998 sales -18.2B
– Sells a full range of computer
systems, desktops, notebooks,
workstations, network servers,
storage products and peripherals
– The company last week announced
that Internet sales had topped $30
million every day, or an $11 billion
annual run rate.
– Dell already leads the industry by
resolving 80 percent of technical
support issues without dispatching
service technicians, much higher
than the industry average of 27
percent
– Competitive advantage - direct
model, low inventory storage costs,
high customer satisfaction and
service, strong brand name
7

5. Income Statement for Dell Computer Corporation (DEL)
Consolidated Statement of Income Fiscal Year Ended
($ Millions)
Jan. 29, Feb. 1, Feb. 2, Income Statement Basics:
1999 1998 1997
– Revenues: are economic resources
N et R evenue: $ 1 8 ,2 4 3 $ 1 2 ,3 2 7 $ 7 ,7 5 9
earned during a time period. Revenue
C ost of R evenue 1 4 ,1 3 7 9 ,6 0 5 6 ,0 9 3
recognition is governed by the realization
G r o s s P r o f it $ 4 ,1 0 6 $ 2 ,7 2 2 $ 1 ,6 6 6
principle that dictates revenues should be
O p e r a tin g E x p e n s e s
S e llin g , G e n e r a l, & A d m in .( S G & A ) 1 ,7 8 8 1 ,2 0 2 826
recognized when (a) the firm has provided
R e s e a r c h & D e v e lo p m e n t ( R & D ) 272 204 126
all , or substantially all, the goods or
T o ta l O p e r a tin g E x p e n s e 2 ,0 6 0 1 ,4 0 6 952
services to be delivered to the customer
O p e r a tin g In c o m e ( E B IT ) $ 2 ,0 8 4 $ 1 ,3 6 8 $747
and (b) the customer has paid in cash or is
F in a n c in g C o s ts a n d O th e r In c o m e 38 52 33 expected to pay cash with reasonable
P r o v is io n f o r In c o m e T a x e s (6 2 4 ) (4 2 4 ) (2 1 6 ) certainty.
In c o m e b e f o r e E x tr a o r d in a r y Ite m s 1 ,4 6 0 $944 518 – Expense: are economic resources used in
A f te r T a x E x tr a o r d in a r y ite m s — — (1 3 ) a time period. Expense recognition is
N e t In c o m e 1 ,4 6 0 $944 518 governed by the matching principle that
W e ig h te d A v e r a g e C o m m o n S h a r e s O u ts ta n d in g 2 ,5 3 1 2 ,6 3 1 2 ,8 3 8
dictates (a) cost directly associated with
W e ig h te d A v e r a g e C o m m o n S h a r e s F u lly D ilu te d 2 ,7 7 2 2 ,9 5 2 3 ,1 2 6
revenues recognized in the some period or
E a r n in g s p e r C o m m o n S h a r e ( E P S ) $ 0 .5 8 $ 0 .3 6 $ 0 .1 8
(b) costs associated with benefits that are
E a r n in g s p e r C o m m o n S h a r e s F u lly D ilu te d $ 0 .5 3 $ 0 .3 2 $ 0 .1 7
consumed in this time period or (c)
resources whole future benefits are not
reasonably certain.
Source: Company 10K, Feb. 1999.
9

6. There Are Three Basic Steps in Any Financial Analysis
Trend analysis:
• How a given parameter has
changed over time.
Interpret it &
hopefully gain
insight
Benchmarking:
• Comparing a parameter at a point
Look it up or
in time with competitors or
calculate ratio industry.
Choose the
parameters that
interest you
11

7. Strategists Use Ratio Analysis Selectively
Ratio Useful for Strategists Less Useful for Strategists
Leverage Ratios: • Debt ratio • Times interest earned
• Debt-equity ratio
Liquidity Ratios: • Cash ratio
• Current ratio
• Quick ratio
• Net working capital to total assets
Profitability/ Efficiency • Gross Profit margin • Days receivable
Ratios: • Operating Profit margin • Return on net assets (RONA)
• Return on equity (ROE) • Earnings per share (EPS)
• Inventory turnover • Asset turnover
• Days inventory
• Return on assets (ROA)
• Return on sales (ROS)
Market Value Ratios • Price-earning ratio (P/E) • Dividend yield
• Market-to-book ratio • Book value per share
13

8. Financial Ratios Summary
Ratio Formula Significance
• Accounts payable turnover • Purchases on account ÷ average • Measure of how many times the accounts
accounts payable balance payable balance is paid
• Accounts receivable turnover • Sales on account ÷ average accounts • Tests how quickly sales are converted into
receivable balance cash
• Acid test ratio • (Cash + marketable securities + • Test of short-term debt paying ability
(Quick ratio) current receivables) ÷ current
liabilities
• Average collection period • 365 ÷ accounts receivable turnover • Test of quality of accounts receivable in terms
(days receivables) of average age in days
• Average payable periods • 365 ÷ accounts payable turnover • Days that it takes to pay an accounts payable
(days payable) balance
• Book value per share • (Stockholders equity – preferred • Measure the amount which would be
stock) ÷ number of common shares distributed to each share of common stock if
outstanding assets were liquidated at their balance sheet
amounts (based entirely on historical costs)
• Current ratio • Current assets ÷ current liabilities • Test of short-term debt paying ability
• Days in inventory (average • 365 ÷ inventory turnover • Measure of the number of days required to
sale period) convert inventory into revenues
15

9. Financial Ratios Summary (cont.)
Ratio Formula Significance
• Fixed asset utilization • Sales ÷ net fixed assets Measure the usage of a firm’s PP&E
• Fully diluted earnings per • Net Income ÷ (number of common Shows the potential effect on earnings per share of converting
convertible securities into common stock
share shares + common stock equivalent
of convertible securities)
Measure of profitability before S,G & A
• Gross profit margin • (Sales – cost of goods sold ) ÷ sales
Measure of how many times a company’s inventory has been
sold during the year
• Inventory turnover • Cost of goods sold ÷ average
inventory balance Measure market premium/discount of a stock
• Market/Book rate • Market price per share ÷ book value
per share Measure of operating profitability
• Operating profit margin • Profit before tax ÷ sales An index of whether a stock is relatively cheap or relatively
expensive
• Price earnings ratio • Current market price per share ÷ When compared to the return on total assets, measures the
earnings per share extent to which leverage is being employed for or against the
common stockholders
• Return on common • (Net income – preferred dividends) ÷
stockholders’ equity average common stockholders’
equity
17

10. Analyzing Trends for Dell …
Key Operational Ratios for Dell (1993-1998) After phenomenal
growth why has sales
ROE and started to decline
FS Items 1993 1994 1995 1996 1997 1998
Sales Growth
Sales $2,873 $3,475 $5,296 $7,759 $12,327 $18,243
are closely
Cost of Goods Sold 2,339 2,704 4,191 6,046 9,538 14,034 linked
SG&A Expense 451 489 690 952 1,406 2,060
Operating Income 52 249 377 714 1,316 2,046
Net Income (Loss) -36 149 272 518 944 1,460 Why has WC
Inventories 220 293 429 251 233 273
increased as a
% of sales
Working Capital 510 719 1,018 1,089 1,215 2,644
Stockholders' Equity 471 652 973 1,085 1,293 2,321
Key Indicators / Ratios Key Trends for Dell (1993-1998)
Sales Growth 21.0% 52.4% 46.5% 58.9% 48.0%
Gross Margin 18.6% 22.2% 20.9% 22.1% 22.6% 23.1% 80%
Operating Margin 1.8% 7.2% 7.1% 9.2% 10.7% 11.2% 70%
Inventory Turnover 10.5 11.6 17.8 39.4 55.5
60%
Days In Inventory 35 31 21 9 7
Working Capital / Sales 17.8% 20.7% 19.2% 14.0% 9.9% 14.5% 50%
SG&A / Sales 15.7% 14.1% 13.0% 12.3% 11.4% 11.3% 40%
Return On Equity (ROE) -7.6% 22.9% 28.0% 47.7% 73.0% 62.9%
%
30%
20%
10%
0%
Dell has Wow ! A computer does not
consistently -10% 1993 1994 1995 1996 1997 1998
stay for more than 7 days on Year
improved on its books — could low -20%
its margins inventory be Dell’s competitive
advantage?
Sales Grow th Gross Margin Operating Margin
Working Capital / Sales SG&A / Sales Return On Equity (ROE)
Source: All data from Compustat, Sept. 8,1999.
19

11. Important Ratios in Six Industries
Price to Inventory
Industry Profit Margin
Earnings
Price to Sales
Turnover
Debt to Equity
A 19.5% 12.9 2.5 -- 1.77
B 13.4% 14.8 2.0 -- 0.4
C 3.50% 26.0 0.9 7.4 0.48
D 2.7% 134.5 3.53 18.9 .18
E 20.8% 40.8 8.42 8.9 .00
F 11.0% 14.9 1.34 13.9 .06
Choices: Discount Stores (Wal-Mart) Internet Services (Amazon.com)
Telecom Services (Verizon)Oil and Gas (ExxonMobil)
Software (Msft) Financial Services (Citigroup)
Note: Data based in 2004
21

12. Ratio Detective Answer Key
Profit Price to Price to Inventory
Industry Margin Earnings Sales Turnover
Debt to Equity
A 19.5% 12.9 2.5 -- 1.77 Citigroup
B 13.4% 14.8 2.0 -- 0.4 SBC
C 3.50% 26.0 0.9 7.4 0.48 Wal-Mart
D 2.7% 134.5 3.53 18.9 .18 Amazon
E 20.8% 40.8 8.42 8.9 .00 Microsoft
F 11.0% 14.9 1.34 13.9 .06 ExxonMobil
Choices: Discount Stores (Wal-Mart) Internet Services (Amazon.com)
Telecom Services (Verizon)Oil and Gas (ExxonMobil)
Software (Msft) Financial Services (Citigroup)
23

13. Companies Raise Funds by Approaching Capital Markets and Issuing Debt
and/or Equity Instruments
Buys and sells
fixed assets
Bank / Bank /
Bondholders Bondholders
Collect cash Buys raw
from customer materials
Company
Pay employees,
suppliers, etc. Manufacture
products
Sell
products
Shareholders Shareholders
Bondholders and stockholders demand a return on their investments that
are specific to a company.
25

14. The Discount Rate along with Present Value Is the Most Widely Used
Tool for Making Investment Decisions
Future cash flows are discounted based on the following rationale:
• A dollar today is worth more that a dollar tomorrow (can be invested).
• A safe dollar is worth more than a risky one.
Present value has two components:
• Cash flow (as opposed to accounting earnings).
• Discount rate:
– The reward that investors demand for delayed payment.
– Also know as hurdle rate or opportunity cost of capital.
27

15. Net Present Value Formula Is an Enhancement to the PV Concept
– Net present value (NPV) of an investment is simply the present value of the
future cash flows less the cost of the investment.
– Assuming that the NPV of a plant is $4 million, one should be equally willing
(indifferent) between:
• Selling the plant for $4 million.
• Or holding the plant indefinitely.
– Formula:
• NPV = Co + PV
• Where Co = Initial Investment ( a negative number).
29

16. The Four Step Discounted Cash Flow Analysis
1. Forecast cash flows
Common Pitfalls:
2. Calculate cost of capital
• Inability to get true cash
3. Estimate residual value flow data at segment
4. Calculate shareholder/equity value level.
• Poor forecasting due to
inadequate
understanding of
segment’s strategy.
• Residual value forecast is
inaccurate or dominates
valuation.
• Failure to value debt at
market value.
31

17. Shareholders pay Close Attention to a company’s Economic Value
• Economic value = Dividends + Increase in the market price of stock
• Economic value relates to market value
Value of $1 Invested in Shares over Time
Source: www.marketguide.com, Sept. 8, 1999.
33

18. Cash Available to Shareholders (Shareholder Value) Can Be Derived from
the Company’s Financial Statements
Calculating Firm Value Calculating Free Cash Flows
—
Equity / Debt
—
Cash Flows Cash Flows
Shareholder + Value NPV Year 1 + Year 2 +
Value
EBIT = $100
—
—
Cash Flows Cash Flows Residual Value
Firm
Year 3 + Year n + Year n
Plus
Value
Non cash expenses
(e.g. depreciation) $10
EBITDA $110
EBITDA (1 - Tc) $66
Firm Value = Equity Value + Debt Value Less
Equity Value = Stock Price x Common Shares Investments:
Operating Profit (EBIT) = Earnings Before Interest & Taxes • Capital expenditures $20
Free Cash Flow = {(Operating Profit+ Non Cash Expenses) x • Increase in WC $5
(1-Tc)} - (Net Investment required to Grow Business)
Free cash flow $41
35

19. The Discounted Cash Flow Gives the Total Value of Dell with a Stock Price
of $52 …
Dell’s Future Cash Flow Projections
F is c a l Y e a r E n d 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
T o ta l S a le s 7 ,7 5 9 1 2 ,3 2 7 1 8 ,2 4 3 2 5 ,0 1 3 3 2 ,1 9 1 3 9 ,3 3 4 4 6 ,0 8 4 5 2 ,1 9 8 5 7 ,5 5 4 6 3 ,4 5 9 6 9 ,9 7 0 7 7 ,1 4 9 8 5 ,0 6 5 9 3 ,7 9 2 1 0 3 ,1 7 2
T o ta l S a le s G r o w th 59% 48% 37% 29% 22% 17% 13% 10% 10% 10% 10% 10% 10% 10%
E B IT D A 761 1 ,3 8 3 2 ,1 4 9
T a x R a te 38% 38% 38% 38% 38% 38% 38% 38% 38% 38% 38% 38% 38% 38% 38%
E B ID A T ( $ ) 472 857 1 ,3 3 2 1 ,6 9 6 2 ,1 8 3 2 ,6 6 7 3 ,1 2 5 3 ,5 3 9 3 ,9 0 2 4 ,3 0 3 4 ,7 4 4 5 ,2 3 1 5 ,7 6 7 6 ,3 5 9 6 ,9 9 5
E B ID A T ( $ ) / S a le s 6 .1 % 7 .0 % 7 .3 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 % 6 .8 %
N e t W C b a la n c e 76 112 154 198 243 284 322 355 391 431 476 524 578 636
N e t W C /S a le s R a tio 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 % 0 .6 2 %
C h a n g e in N e t W C 36 42 44 44 42 38 33 36 40 44 49 54 58
C a p . E x p e n d itu r e / S a le s 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% 2%
C a p it a l E x p e n d it u r e 114 187 296 406 522 638 748 847 934 1030 1135 1252 1380 1522 1674
N e t P P E B a la n c e 342 523 746 1018 1330 1669 2020 2372 2732 3106 3499 3919 4369 4853
D e p r r a te 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%
D e p r e c ia tio n 67 103 183 250 326 409 495 582 670 762 858 961 1071 1190
R e p o r t e d D e p r T a x S h ie ld 70 95 124 156 188 221 255 289 326 365 407 452
FCF 1 ,3 1 8 1 ,7 1 1 2 ,1 0 9 2 ,4 9 1 2 ,8 4 3 3 ,1 5 6 3 ,4 9 1 3 ,8 5 8 4 ,2 6 1 4 ,7 0 4 5 ,1 9 1 5 ,7 1 6
A c c o u n t in g e a r n in g s 1 ,5 8 3 2 ,0 2 8 2 ,4 6 5 2 ,8 7 1 3 ,2 3 2 3 ,5 4 2 3 ,8 8 7 4 ,2 7 2 4 ,6 9 9 5 ,1 7 2 5 ,6 9 5 6 ,2 5 7
FREE CASHFLO W S ===>
P V o f F C F u p to te rn in a l y r 1 6 ,9 8 4
P V o f T e rm in a l F C F 1 1 5 ,5 9 6
WACC
H id d e n a s s e ts 0
Calculated Ke 1 2 .3 1 %
H id d e n lia b ility 0
Share Price T o ta l 1 3 2 ,5 8 0 Kd 8 .2 3 %
Less D ebt 861 D /E 2 0 /8 0
T o ta l E q u ity V a lu e 1 3 1 ,7 1 9 W ACC 1 1 .4 9 %
N u m b e r o f S h a re s 2 ,5 3 1
V a lu e P e r S h a r e 52
Source: Historical data, Dell 10K, Feb. 1999.
37

20. Comparing Dell to Other Players in the PC Market Reveals Its “Star”
Performance
Ticker DELL CPQ GTW IBM
Comparable Analysis
Stock Price $ 47.63 $ 22.75 $ 48.31 $ 130.80
SHSO 2,543 1,687 157 1,831
Market Capitalization 121,123 38,379 15,000 239,495
Sales 18,243 31,169 7,468 81,667
Cost of Goods Sold 14,034 23,087 5,816 46,320
A stock price by SG&A Expense 2,060 6,331 1,052 21,708
itself signifies Operating Income 2,046 858 494 9,164
little Net Income (Loss) 1,460 -2,743 346 6,328
Inventories 273 2,005 168 5,200
The market is bullish on
Working Capital 2,644 4,434 799 5,533
Dell…hence pricing the
EBITDA 2,149 -1,769 600 13,639
stock at a higher
Debt 512 0 3 15,508
premium then its
Stockholders' Equity 2,321 11,351 1,344 19,433
competitors
EPS 0.57 -1.63 2.21 3.46
Key Indicators / Ratios
Sales Growth (97-98) 48.0% 26.8% 18.7% 4.0%
Gross Margin 23.1% 25.9% 22.1% 43.3%
Operating Margin 11.2% 2.8% 6.6% 11.2%
Inventory Turnover 55.5 12.9 27.9 9.0
Days In Inventory 7 28 13 41
Working Capital / Sales 14.5% 14.2% 10.7% 6.8%
SG&A / Sales 11.3% 20.3% 14.1% 26.6%
Return On Equity (ROE) 62.9% -24.2% 25.8% 32.6%
Firm Value 121,635 38,379 15,003 255,003
Source: Dell 10K, Feb. 1999; Other Firm Value / EBITDA 56.6 N/A 25.0 18.7
companies, Compustat. Price / Earnings (P/E) 83.0 N/A 21.8 37.8
39

21. Key Lessons
• The three financial statements are closely linked and provide a picture of a company’s financial and operation
health
Balance Balance
Sheet 19x1 Sheet 19x2
Income
Statement
Cash Flow
Statement
• Accounting earnings can be manipulated by management choosing to adopt specific accounting standards
(Inventory recording, Depreciation schedule, etc)
• Operating and financial ratios highlight trends within a company and can be compared to other players in the
industry
• Since accounting earnings are open to interpretation….cash is king !
• Net Present Value (NPV) is a useful too in calculating the economic value of an investment, business unit or
company
• The value of a firm is the discounted future free cash flows
• Firm Value = Equity Market Value + Debt Market Value
• A company’s stock price has more to do with future performance rather than historical track record and is
closely to tied to the operational and financial health of a company
• As consultants we must understand the strategic and operational levers of a company’s stock price in order to
deliver measurable value
41