1. business and industrial

BROCK FINANCE & INVESTMENT GROUP
Equity Desk Manual
Version 1.0
1/16/2013
This manual is for the training and ongoing educational development for associates and analysts of Brock
Finance and Investment Group (BFIG). It is a reference for how research should be conducted and what
parameters shareholders, the executive team and faculty will be looking for.
Brock Finance & Investment Group
EQUITY DESK MANUAL
Table of Contents
1.0
RESEARCH PROCESS
2
2.0
CONDUCTING BACKGROUND RESEARCH
Business Profile Analysis
Financial Profile Analysis
2
2
3
3
4
8
9
Financial Statements
Calculating Key Ratios
Comparable Companies Analysis
Sources of Information
3.0
PRODUCING THE ANALYST REPORT
Company Overview
Business Risk Analysis
Bankruptcy Analysis
DCF Valuation
Recommendation
10
10
10
13
16
21
4.0
SUBMITTING REPORT FOR REVIEW
Sourcing/Referencing
Full Disclosure
22
22
22
5.0
DEVELOPING SHAREHOLDER PRESENTATION
22
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Research Process
This manual is for the training and ongoing educational development for associates and analysts of Brock
Finance and Investment Group (BFIG). It is a reference for how research should be conducted and what
parameters shareholders, the executive team and faculty would be looking for.
Conduct
Background
Research
Produce
Analyst
Report
Submit
Report for
Review
Develop
Shareholder
Presentation
Ongoing
Review
Conducting Background Research
When studying the target company there are two profiles that need to be evaluated: The business profile and
the financial profile. This will give an overall of the business practices and financial stability.
Business Profile
 Sector
 Products and Services
 Customers and End Markets
 Distribution Channels
 Geography
Financial Profile
 Size
 Profitability
 Growth Profile
 Return on Investment
 Credit Profile
Sources of Information
Analysts that issue of Buy, Hold, or Sell, recommendations to investors get the majority of their information
from EDGAR, the Electronic Data-Gathering, Analysis, and Retrieval system, and SEDAR, the System for
Electronic Document Analysis and Retrieval. This depends on whether the company is on the American or
Canadian stock exchanges. The U.S. Securities and Exchange Commission, SEC, enforces all publically traded
companies in the various American stock exchanges (NASDAQ, NYSE, and AMEX), to disclose all relevant
information to investors. The Canadian Securities Administrators (CSA) established SEDAR and is regulated by
the Canadian Depository for Securities (CDS). All companies that trade on the various Canadian stock exchanges
(TSX, VSE, MX, etc.) are forced to disclose their information to the public. The primary goal for both exchanges is
to provide transparency, reliability, and liquidity to investors.
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Business Profile Analysis
Sector
Sector refers to the industry or markets in which a company operates (e.g., chemicals, consumer products,
healthcare, industrials, and technology). A company’s sector can be further divided into sub-sectors, which
facilitates the identification of the target’s closest comparable. Within the industrials sector, for example, there
are numerous sub-sectors, such as aerospace and defense, automotive, building products, metals and mining,
and paper and packaging. For companies with distinct business divisions, the segmenting of comparable
companies by sub-sector may be critical for valuation.
A company’s sector conveys a great deal about its key drivers, risks, and opportunities.
For example, a cyclical sector such as oil & gas will have dramatically different earnings volatility than consumer
staples. On the other hand, cyclical or highly fragmented sectors may present growth opportunities that are
unavailable to companies in more stable or consolidated sectors.
Products and Services
A company’s products and services are at the core of its business model. Products are commodities or valueadded goods that a company creates, produces, or refines. Examples of products include computers, lumber, oil,
prescription drugs, and steel. Services are acts or functions performed by one entity for the benefit of another.
Examples of common services include banking, installation, lodging, logistics, and transportation. Many
companies provide both products and services to their customers, while others offer one or the other. Similarly,
some companies offer a diversified product and/or service mix, while others are more focused.
Customers and End Markets
Customers A company’s customers refer to the purchasers of its products and services.
Companies with a similar customer base tend to share similar opportunities and risks. For example, companies
supplying automobile manufacturers abide by certain manufacturing and distribution requirements, and are
subject to the automobile purchasing cycles and trends.
The quantity and diversity of a company’s customers are also important. Some companies serve a broad
customer base while others may target a specialized or niche market. While it is generally positive to have low
customer concentration from a risk management perspective, it is also beneficial to have a stable customer core
to provide visibility and comfort regarding future revenues.
Distribution Channels
Distribution channels are the avenues through which a company sells its products and services to the end user.
As such, they are a key driver of operating strategy, performance, and, ultimately, value. Companies that sell
primarily to the wholesale channel, for example, often have significantly different organizational and cost
structures than those selling directly to retailers or end users.
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Financial Profile Analysis
To fully understand the financial profile and properly analyze a company you must read and understand all
reporting and financial statements available.
Step 1: Financial statements
Financial statements are a company’s way of delivering information to their shareholders. Financial statements
are generally released every quarter and are summed by an annual report. Financial statements contain future
outlook as well as past performance for a particular company and may give the analyst a lot of information with
regards to their current and future value.
There are three key components of a financial statement: balance sheet, statement of cash flows and income
statement.

Balance sheet
A balance sheet is a company’s assets, liabilities and shareholders’ equity. It explains what the company
is holding in cash and less liquid tangible and intangible assets.

Income statement
An income statement would be the equivalent of a verb if the balance sheet is a noun where an income
statement is all the activity that has occurred during the period. This includes items such as revenue,
operating income and as such also includes profit.

Statement of cash flows.
The statement of cash flows is a further break down of the income statement describing all of the
sources of revenue and all expenditures. This can be used to determine investing activities and insight
into current and future cash operations.
How do the three financial statements tie together?
Balance Sheet is a snapshot in time. In other words, it shows the company’s total assets, liabilities, and equity
since inception.
Income statement shows what the changes are from period to period and the Net income ties into the Balance
sheet’s Equity account.
Statement of Cash Flows is a summary of the change of Cash on the Balance Sheet from period to period. The
sum of that plus the beginning cash period will equal to the total cash in the balance sheet. It is broken down
into three parts: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing.
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Step 2: Calculating Key Ratios
There are five main categories in which ratios will be calculated: Size, profitability, growth profile return on
investment and credit profile.
Size
Size is typically measured in terms of market valuation (e.g., equity value and enterprise value), as well as key
financial statistics (e.g., sales, gross profit, EBITDA, EBIT, and net income). Companies of similar size in a given
sector are more likely to have similar multiples than companies with significant size discrepancies. This reflects
the fact that companies of similar size are also likely to be analogous in other respects (e.g., economies of scale,
purchasing power, pricing leverage, customers, growth prospects, and the trading liquidity of their shares in the
stock market).
Equity Value: This value is also known as market
capitalization.[2]
Enterprise Value: This is a measure of a company’s
value and is a more accurate representation than the
market capitalization.[2]
Gross Profit: The residual profit after selling a product
or service and subtracting the costs associated.[2]
Net Income: This will be found on the bottom line of
all income statements. It is the total earning after
deducting all business costs, taxes,
depreciation/amortization and other expenses. [2]
EBITDA: Is the net income with tax, interest
depreciation & amortization added back to it. This
number is important as allows for a better comparison
of companies across similar industries. [2]
EBIT: Is a good indicator of a company’s profitability.
This calculation can often be referred to as “operating
profit” or “operating income”. [2]
(excluding tax, interest,
depreciation & amortization)
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Profitability
Gross Profit Margin
This ratio explains the business model and how
demand driven it is. In a business with a low profit
margin we require many more customers. In a
business with a high profit margin there doesn’t need
to be as many customers. Institutional business (IT
solutions, Engineering firms, construction) do not need
many clients and tend to have a very high profit
margin. Other businesses such as dollar stores have a
smaller profit margin and require a lot of customers.[2]
EBITDA Margin
This ratio provides a measurement of the company’s
operating profits. It represents a clean view of core
profitability.[2]
Net income Margin
Return on investment
Return on Investment Capital
Return on Equity (ROE)
The amount of net income returned as a percentage of
shareholders equity. Return on equity measures a
corporation's profitability by revealing how much
profit a company generates with the money
shareholders have invested. [2]
Return on Asset (ROA)
An indicator of how profitable a company is relative to
its total assets. ROA gives an idea as to how efficient
management is at using its assets to generate
earnings. Calculated by dividing a company's annual
earnings by its total assets, ROA is displayed as a
percentage. Sometimes this is referred to as "return
on investment".[2]
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What are some of the issues that ROE has compared to ROA?
ROE is levered. It includes debt. Therefore, ROE may increase due to an increase of equity leverage, not
operating margin. Net income/Assets * Assets/Equity
Credit Profile
Leverage Ratio:
Capitalization Ratio
This ratio can be used as a risk
measure of financial distress of
the firm. A higher ratio is a
higher risk. [2]
Debt to Capitalization Ratio
Coverage
The coverage ratio depicts the
ability of a firm to pay off its
interest expense obligations.[2]
Growth Profile
To estimate future growth we must look at previous years Diluted EPS and calculate the Compounded Annual
Growth Rates (CAGR). This calculation will automatically be done in the excel document provided.
Other Key Trading Multiples
Price to Earnings (P/E)
The P/E ratio is the current stock price divided by the
company’s diluted earnings-per-share (EPS). This ratio
can be used to determine is the company is overvalued
or undervalued. [2]
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Price to earning to Growth (PEG)
This ratio takes the PE ratio and puts it up against the
rate of growth the company’s experiencing. The ratio
is PE divided by ROG (rate of growth). If the ratio is
high this would mean that the company is highly
valued in terms of its growth. If the ratio is low it
would be lowly valued in terms of its growth.[2]
Enterprise Value-to EBITDA
EV/EBITDA serves as a valuation standard for most
sectors. It is independent of capital structure and
taxes, as well as any distortions that may arise from
differences in D&A among different companies. [2]
Sector- Specific Multiples
Valuation Multiple
Sector
Enterprise Value/
Access Lines/Fibre Miles/Route Miles
Broadcast Cash Flow (“BCF”)
Earnings Before Interest Taxes,
Depreciation, Amortization, and Rent
Expense (“EBITDAR”)
Earnings Before Interest Taxes,
Depreciation, Depletion, Amortization, and
Exploration Expense (“EBITDAX”)
Population (“POP”)
Production/Capacity (in units)
Reserves
Subscriber
Square Footage






Telecommunications
Media
Telecommunications
Casinos
Restaurants
Retail


Natural Resources
Oil & Gas








Telecommunications
Metals & Mining
Natural Resources
Oil & Gas
Paper & Forest Products
Metals & Mining
Natural Resources
Oil & Gas




Media
Telecommunication
Real Estate
Retail
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Step 3: Comparable Company Analysis
Comparisons
Many of these ratios do not say much if they stand alone however; they have a lot of value when compared to
other similar companies and previous years. The ratios would compare change over years and be benchmarked
to industry standards
When analyzing competitors it is important to take a breakdown of market share and change in market share
over the last 3 years. This helps determine the company’s growth.
It is also necessary to compare with the 3 closest competitors. Calculations entail using the trading multiples.
Competitors
It is important to take a top down approach to be able to properly analyze the markets and competitors. We
would start with major economic reports, then sectors, and then news. The Bloomberg website and trading
economies dot com is very good for information regarding these reports and certain pieces of news.
Companies that are competitors are ones with similar products and services. Bloomberg can help zone in using a
stock screener for which companies can be competitors through sector analysis. The internet is a good resource
for obtaining information as to who is a direct competitor with such analysed company.
Conference Calls
Many corporations hold quarterly y conference calls for investors and stake holders to discuss where company is
going and to make sense of where the company is. Generally these conference calls will discuss earnings,
weather they met expectations, and if they didn’t then why. There is a lot of valuable information and this is
information that can be acted on in a timely fashion. Some of the things you can do as an analyst is:
1. Make a calendar of when these conferences take place
2. Ask a lot of questions
3. Find out more information about the financial statements such as who did their auditing if they were
not the people who did it.
Summarize key points about the conference call and how we can act on them
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Sources of Information
Income Statement Data
Sales
Gross Profit
EBITDA
EBIT
Net Income / EPS
Research Estimates
Balance Sheet Data
Cash Balance
Debt Balances
Shareholders’ Equity
Cash Flow Statement Data
Depreciation & Amortization
Capital Expenditures
Share Data
Basic Shares Outstanding
Options and Warrants
Market Data
Share Price Data
Credit Ratings
Most recent 10-K, 10-Q, 8-K, Press Release
First Call or IBES, individual equity research reports
Most recent 10-K, 10-Q, 8-K, Press Release
Most recent 10-K, 10-Q, 8-K, Press Release
10-K, 10-Q, or Proxy Statement, whichever is most recent
Data 10-K or 10-Q, whichever is more recent
Financial information service
Rating agencies’ websites, Bloomberg
Producing the Analyst Report
The analyst report is the report provided by the analyst and associates to the chief sector analyst for review.
Using the collected background research, the finalized report should thoroughly cover a particular company
quantitatively and qualitatively. The components of the report consist of the following.
Company
Overview
Business Risk
Analysis
Bankrupcy
Analysis
DCF Valuation
Recommendation
Company Overview
This is a key part of the report. It briefly introduces the company and what they do. The introduction should
outline what the company’s objectives are and is a general introduction of its functions
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Business Risk Analysis
Management
This is a key part of the report as it outlines who the management is. If management is has a member on their
team that have no experience this may say something about the calibre of the company being analyzed. On the
other hand, If management is experienced it is generally safe to assume that they have a strong handle on the
company. It is also important to research the executive team individually as they may have executive positions
in other corporations or may have a history that can undermine the value of the corporation such as a criminal
record. [1]
Competition
Competition is an important part of the report. Generally the key things are who are the competitors and what
are they doing. What kind of market share does the current company have and has it been growing. Is the
product being analyzed something inelastic (oil) in which competitors are analyzed in terms of supply or is it a
fast food chain in which competitors are analyzed in terms of demand. Another important factor to consider is
there competitors doing anything that can shift the market share and if so how much would it potentially shift it
by. [1]
Economic conditions
Economic conditions play an integral role in the pricing of a security. It is an important portion of this report.
Some of the things to look for are the macro economic outlook and an analysis on how this will affect the
company. From the macroeconomic outlook we can then move down to the microeconomic level. For a
farfetched example a research article published in a scientific journal and then pushed through to a magazine
stating that global warming is not real will affect the increase in car consumption thus increasing the sales in the
motor industry. This would translate into Ford’s stock increasing. [1]
Distribution
This topic tackles who the company’s distributors are and what methods of distribution they use. This is
important because an understanding of their distributors and their methodology leads to a better understand of
future cash flows. Also the rate of increase for their distribution channels and distributors can offer insights into
cash flows.[1]
Marketing
The marketing department should be analyzed for the reason that it represents the branding image and sales
strategy for the company. If there is a faulty marketing department or one that is not innovative it can lead to
problems. An understanding of how a company marketing department functions can give insight into how
effective they are at increasing sales year after year.[1]
Suppliers
The suppliers for a corporation are very important as they speak volumes about the product. If a corporation has
one supplier and the revenue they provide for this supplier is a very small portion of the supplier’s total revenue
then this creates a huge business risk. If for some reason that supplier decides not to offer their product or
service anymore, the business is now subject to finding another supplier which can make or break their pricing
and product. This analysis is very important to understand the dynamics and function of the corporation. [1]
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Customers
The customer of a corporation plays the same role as suppliers. If there is one customer that creates 90 percent
of the company’s revenue, then this creates a greater risk for the company. A safer company would have
multiple clients. This gives an insight into the possible risks that can come up if the service or product provided
suffers from a functional problem. [1]
Environmental Risk
A major business risk is environmental risk. There are many reasons why this risk is important first and foremost
is that the more environmentally friendly a company is the more likely it is that they will attract certain
accreditations making them more “prestigious”. That is not the most important reason though. The most
important reason is the fines and levies those countries in developed countries pose and the lawsuits that can
come in from damaging the environment. These play a trivial risk on certain companies and can lead to future
problems if misconduct continues. It also means that at some point for these companies to be continuous there
would need to be extra costs associated with staying environmentally friendly if the process is already not
environmentally friendly. [1]
Political risk
A major risk is associated with political risk. Generally US and Canadian companies experience political risk not
when they conduct their business within their own countries but when they conduct it within other countries. If
a mining company in 2008 decided to go into Yemen it currently would have lost all of its investment into finding
the resource it was looking for. This is definitely an important aspect of the report and should not go
unrecognized. Some of the things looked into is how many countries does this business operate in and what is
the political situation in each country. [1]
Highlight of annual report
The highlight of the annual report within relation to business risk is also very important. The Annual report
contains a lot of important information that can help determine exactly the kind of risks that said business may
have to deal with. Understanding these risks will help us deal with these investments in a more prudent
manner.[1]
Bankruptcy Analysis
Altman’s Z Score Analysis - Corporate Credit Scoring Model
In attempt to predict corporate collapse and assess any signs of looming bankruptcy investors resort to
such financial ratios as working capital, profitability, debt levels and liquidity. Issue being with ratio
analysis is that each ratio is independent and reflects a different story; Altman’s Z score is a predictive,
ratio weighted model that incorporates these concepts from five key performance ratios into a single
score. This score gives a snapshot of corporate financial health leading to more informed investment
decisions.
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The formula consists of an optimal independent weighting assigned to each ratio multiplied by the
respective ratio.
Z-Score Formula:
1.2
+ 1.4
+ 3.3
+ 0.6
+ 1.0
Interpreting the score:
Z > 2.99 - “Safe Zone”
1.8 < Z < 2.99 - “Gray Zone”
Z < 1.8 - “Distress Zone”
Working Capital (Current Assets – Current Liabilities) / Total Assets:
A firm with negative working capital is likely to experience problems meeting its short-term obligations
because there simply are not enough current assets to cover those obligations. By contrast, a firm with
significantly positive working capital rarely has trouble paying its bills. This ratio is a good test for
corporate distress.
Retained Earnings / Total Assets
This ratio measures the amount of reinvested earnings or losses, which reflects the extent of the
company's leverage. Companies with low RE/TA are financing capital expenditure through borrowings
rather than through retained earnings. Companies with high RE/TA suggest a history of profitability
and the ability to stand up to a bad year of losses.
Earnings Before Interest and Tax / Total Assets
This is a version of return on assets (ROA), an effective way of assessing a firm's ability to squeeze
profits from its assets before factors like interest and tax are deducted.
Market Value of Equity / Total Liabilities
This is a ratio that shows, if a firm were to become insolvent, how much the company's market value
would decline before liabilities exceed assets on the financial statements. This ratio adds a market
value dimension to the model that isn't based on pure fundamentals. In other words, a durable market
capitalization can be interpreted as the market's confidence in the company's solid financial position.
Sales / Total Assets
This ratio tells investors how efficiently the firm uses assets to generate sales. Failure to grow market
share translates into a low or falling S/TA.
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A deteriorating Z-score can signal trouble ahead and provide a simpler conclusion than the mass of
ratios. The Z-score is probably better used as a gauge of relative financial health rather than as a
predictor. Arguably, it's best to use the model as a quick check of financial health, but if the score
indicates a problem, it's a good idea to conduct a more detailed analysis.
Various statistical errors can arise with discriminant analysis (Altman’s z score) such as Type 1 and Type
2 errors. Type 1 errors occur when something good is deemed bad (firm assessed as non-bankrupt but
is bankrupt) and Type 2 errors occur when something bad is deemed good (firm being assessed
bankrupt but is not bankrupt). Type 1 errors are much more costly as investors can lose 100% of their
investment when a company goes bankrupt; where Type 2 errors leads to 0-10% loss of investment as
the severity of the investment failure is much lower. A way to decrease on Type 1 errors is to increase
on Type 2 errors, a more economical error. Increasing the passing grade (confidence interval) that
firms require to enter the safe zone will lead to less Type 1 errors and save investors’ money.
Z’ Score – Private Firm Model
Formula:
1.2
+ 1.4
+ 3.3
+ 0.6
+ 1.0
When using the Z score to asses a private firm the formula changes the fourth ratio from the market
value of equity to book value of equity and the score results can be interpreted as:
Z’ > 2.9 = “Safe Zone”
1.23 < Z’ < 2.9 = “Grey Zone”
Z’ < 1.23 = “Distress Zone”
Z” Score – Manufactures, Non-Manufacturers, Industrials & Emerging Market Credit
Formula:
1.2
+ 1.4
+ 3.3
+ 0.6
Z” > 2.6 - “Safe Zone”
1.1< Z” < 2.6 - “Grey Zone”
Z” < 1.1 - “Distress Zone”
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Discounted Cash Flow Valuation
The Discounted Cash Flow (DCF) valuation model is a widely used technique in the industry to
determine an intrinsic value for a target company. This is done through the process of forecasting future free
cash flows to determine an intrinsic value of the target company.
i.
Free Cash Flow Model
The steps taken to project a company's FCF into the future are as follows:
1. Calculate the Industry's Revenue growth to as far back as possible. You can accomplish this by getting
access to Bloomberg or historical charts in Google finance and using the S&P/TSX composite index
tickers. For example for the S&P/TSX Capped Financials Index the ticker is - ^SPTTFS. Once you have
found the historical chart you will take the earliest index price and exact date as well as the latest index
price and most recent date. You now have enough information to calculate the annualized compounded
growth rate.
FV = PV(1+r)^n
PV
FV
n
r = (FV/PV)^(1/n)-1
31/10/2000 17/10/2012
103.3
183.05 11.96986301
4.90%
This is an example done in excel to show how we used the FV compound growth formula, re-arranged to get us
our r, or our compound annual growth rate. This gives us our industry growth rate, and we can base our
projections around this figure. For example, if you are dealing with a larger company in the industry a lower than
industry average rate would be a more accurate number. In contrast a smaller company may have a higher
growth model and a higher than industry average growth rate may be more accurate.
2. Next we have to calculate the company's weighted average cost of debt. We need to pull up the
company's latest report. We are looking for the notes to financial statements; this is found after the
financial statements. There will be a note that is specific to the company’s debt. Sometimes the
liabilities section of the balance sheet will reference the debt as to which note it is, they are labelled in
numbers. For example, “Note 10”. When you read the debt not there will be specific loans stated at
different interests’ rates. You need to calculate a weighted average of these loans to find an absolute
interest rate for the total outstanding debt. This number will be in a percentage.
3. You will now calculate the cost of equity. This equation fluctuates compared to each sector and takes a
lot of industry and specific company knowledge. The formula is as follows:
Cost of Equity =
(
)
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Rf - This is the risk free rate, use the 10 year bond yield for the country you are investing in. For Canada
use, http://www.bankofcanada.ca/rates/interest-rates/lookup-bond-yields/
β - Beta measures the volatility of a specific stock compared to the market. A beta of 1 would be the
stock generally moves with the market. A beta of less than 1 would mean it is less volatile than the
market, meaning if the market goes up 1% the stock would only rise by 0.8% and vice versa. A beta of
more than 1 would be it is more volatile than the market, the market drops by 1% it would drop by
1.2%. This can be found by using the Bloomberg terminal at the school. You can also visit
www.yahoo.ca/finance , type in the company ticker and click summary in the top left corner. This will
display beta in its general information.
Rm
- Is the expected market return. This number is different for the risk tolerance each investor has.
Someone with a larger portfolio that is more diversified might be willing to take an 8% return (closer to
the historical market return), whereas someone only invested in that one stock would need a larger
return to compensate for the risk of only holding that one stock. This rate is variable and subject to
industry and specific stock knowledge. For example, an investor might require a higher return for the
risk they are taking on with a company based out of a politically unstable country as there is higher
concern for the operations of the business. In contrast the same investor might not require such a high
return in Canada as our country has good market regulations and little to no political risk.
4. Now that you have weighted average cost of debt and the cost of equity we can plug these numbers
into our Weighted Average Cost of Capital (WACC) equation. This gives us our discount rate that we will
be discounted our cash flows back to present value with.
WACC = (Equity / (E+D)) * Re + (Debt / (D+E)) * Rd * (1 - tx)
WACC - Weighted Average Cost of Capital (or discount rate)
Equity (E) - Is found on the latest balance sheet. Make sure you read all recent news since the latest
report came out to find out if you have to change the equity value, because of issued shares for capital
etc.*
Debt (D) - Is found on the latest balance sheet. Make sure you read all recent news since the latest
report came out to find out if the company has secured more debt for financing. If this is the case you
have to include this debt in your weighted average cost of debt calculation to make sure your discount
rate will reflect real-time company conditions.
Re – This is your cost of equity. The description is in note 3.
Rd – This is your cost of debt. The description is in note 2.
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Tx - This is your tax rate, and it can be found on your latest ANNUAL report. This figure is not in the
quarterly reports. You will find this in the tax note below the financial statements.
* Make sure you talk to your sector analyst or the person training sector analysts about this. If there is
news out that shares have been issues you need to change the capital structure of the business. It will
not be as simple as taking the number off the balance sheet and plugging it in, this would be inaccurate
in that case.
5. The next step is to calculate the specific companies Free Cash Flows. You need to bring up the
company's latest annual report and quarters (if any more recent) financial statements. You will need the
income statement, balance sheet, and cash flow statement.
(
)
FCF - Free Cash Flow
Dividends - The money the company has promised to continue to pay (although they could stop paying the
dividends, we subtract dividends in order to get a more conservative estimate). We find this variable in the cash
flow statement under financing activities.
Capex - We only use the capital expenditures for the up keep on the already owned assets, we exclude any new
purchases of Property Plant & Equipment, because the firm chose to use the free cash for those investments.
You will need to check the footnotes, after the financial statements, for any long-term assets to find out if they
purchased new assets. These new assets should not be included, unless they are used specifically for a project
they are building (that they have to put money into) etc. Use the full amount of PP&E from the cash flow
statement if nothing is disclosed and you did not find any further information in the annual report. You need to
dig deeper to understand where there money is going and why. Do you believe that spending the money on that
project is a waste of the free cash flow they are bringing in? Could they allocate their capital in a more effective
manner? This variable is different for different sectors industry knowledge is important, it is not set in stone.
Non-cash Working Capital - This is found on the cash flow statement under investing activities. It can be a
negative or a positive, because it is the change in non-cash working capital. Note that change in working capital
is located under operating activities, subtract NWC from investing activities if it is negative if it is positive
subtract from 0 in order to give a more conservative estimate on how much FCF the company is bringing in.
(
)
(
)
EBIT - Is found on the income statement and is called “Earnings before Interest and Taxes”. On the income
statement it is:
Sometimes the income statement will not disclose EBIT so you would have to calculate it yourself.
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Tax Rate - This is found in the footnotes after the financial statements on the annual report (DO NOT look for
this in the quarterly report).
D&A - Depreciation and Amortization is a non-cash expense from the company's net income. Since this lowers
company profits, but does not actually affect the company's cash flow we have to exclude this number. This is
always found in the operating section of the cash flow statement.
Changes in Working Capital - This is calculated from the balance sheet (always use the most current balance
sheet):
(
)
Capex - See Capex in note 4.
6. Now that you know how to calculate FCF we will find out how much FCF the company has had in
previous years to show a trend. If you are finding a value for a business in the middle of the year you
have to calculate any new information on the FCF's that have already been made that year and project
the FCF's for the rest of the year.
For example: The company has released its first quarterly report, you can calculate the company's FCF's
for the first 3 months. You will need to project the remaining 9 months of the year to complete the total
year. We will come back to this.
Once all year years and any partial years are calculated you should show them in a row to get a look at
how much they are increasing or decreasing.
For example:
2009
2010
2011
2012 (9 months)
10000
11000
12000
9750
In real life you will not see numbers this accurate; this is to make the calculation easier. Now we have to
calculate the last 3 months of cash flows for year 2012. If you watch the trend you can assume another
3250 in this calculation, but when the numbers are not so obvious we will have to project the rest of the
cash flows. This is subject to creativity and is more of an art.
You could simply do as I did above by taking a percentage of the existing FCF's and apply the left over
33% from the 9750. This is a fair projection as the company has proven to make that amount this year
and as long as no news affecting earnings have come out it is a reasonable assumption. This is to finish
the final year.
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7. Now that we have the 2012 year completed of $13,000 in FCF we need to project the future 10 years of
cash flows. We project the next 10 years, because we would like to have a longer term outlook to find a
true value for the stock today. Try to ignore the fact that this company has been rising by $1000 every
year and imagine you could not make the numbers out. We need to apply the industry's growth rate to
project future cash flows. Using the rate alone is not an accurate judgment. For example, if you are
investing in a big player in the industry their FCF's may not grow as fast, because they do not have much
room to grow larger. Another example would be a high growth smaller company that is taking market
share fast, they should have a higher than industry growth rate. This is subject to knowledge about the
company and the industry. For simplicity in the following calculation we will use the industry growth
rate we calculated earlier.
(
)
Latest FCF - Is the latest year whether a portion is projected or not.
r - The growth rate for the industry in this case (subject to change with company and industry
knowledge)
For example: 13000 * (1 + .049) = 13637
This gives us year 2013 FCF projections.
You will project the next ten years of cash flows in excel.
*This FCF projection is based on the margins of the business staying the same (ex. no COGS increases).
8. Now that we have projected our cash flows we need to calculate a terminal value for the business. This
is done by taking the last cash flow growing it by a perpetual growth rate into the future. We need to
add the terminal value, because the company is not finished after the 10 years of cash flows. After the
10th year there will be more cash flows assuming the business is still in operations. Calculate terminal
value as follows:
(
(
)
)
TV - This is the terminal value of the business. This is all the cash flows projected past the 10th year of
future cash flows. This number will always be a significant portion of your total value of the business. It
is very sensitive to the projected growth rate into the future. Always be very conservative with this
number, using the 10 year bond yield or the current GDP growth rate is a fair assumption. Although the
company should grow cash flows at a faster rate this will ensure that you are giving a very conservative
value for the business.
g – This is the growth rate in perpetuity after the 10th year cash flow. This rate is very sensitive.
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WACC – Weighted Average Cost of Capital is the discount rate you are discounting the future cash flows
of the business by. The full description is in note 4.
*Remember the terminal value will be a great deal larger than the sum of the projected cash flows.
9. The next step is to discount the terminal value and all the future cash flows of the business back to
present value. We need to discount the cash flows back, because those cash flows will be worth less
today than in the future. For the terminal value:
(
)
*We use 10 for our period because the TV is based on the last year’s cash flows so we would need to
bring it back for the 10 years we projected the cash flows.
Next we discount each individual cash flow back to present value. This is done in excel and the formula
is copied down the list of cash flows:
(
)
n - This is the period for each cash flow. For example, year 2 cash flows n = 2, and for year 9 of cash
flows n = 9.
*In excel you will be able to project the cash flows individually
Add all the present value cash flows and the present value terminal value to get the company's
enterprise value.
10. Now that you have the enterprise value, subtract net debt from it.
This will give you the company's equity value, ultimately what you are purchasing as a common shareholder.
Divide the equity value by the diluted shares outstanding and you will have a per share intrinsic value for the
business. You can now make an investment decision based on the quantitative research you have performed.
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Submitting Report for Review
All of the sections mentioned should be in the report with clear headers. The report should not contain syntax,
spelling or grammar errors as they may be shown to faculty and employers. The reports should also contain a
table of contents and should have a recommendation of what price to buy it at and what our target price is and
how many shares. The report should also include a method for ongoing review.
Developing Shareholder Presentation
The majority of presentation will be taking place during the weekly general meetings. A copy of the report
should be given to each executive member for review 2 days at most before the presentation. Within that time
frame the executive team will investigate the validity of the report along with several ideal issues that will be
discussed. These things may include a bankruptcy analysis, a debt analysis and an acquisition or merger. There
will also be an analysis regarding the weight allocation of the portfolio if necessary.
If the investment proposal is time sensitive, a report with a recommendation should be sent out to all
shareholders for a vote. Shareholders will then have 24 hours to respond with an answer.
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Sources
1
Joshua Rosenbaum, J. P. (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers &
Acquisitions. Hoboken, New Jersey: Wiley & Sons Inc.
2
Merriam-Webster. (2013). Investopedia. Retrieved from
http://www.investopedia.com/dictionary/#axzz2IAhX5Mao
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