INVESTMENT BANKING LESSON 10 PERFECTING THE FINANCIAL RATIOS FOR INVESTMENT BANKING Investment Banking (2 nd edition) Beijing Language and Culture University Press, 2013 Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN? CHINA’S INFLATION RATE ROSE TO 1.5% IN APRIL

A. INTRODUCTION – How are important are ratios and ratio analysis to the IB. The 4 main ratios. B. VALUATION MULTIPLES - HOW MUCH IS A COMPANY WORTH? C. LIQUIDITY MULTIPLES – HOW DOES A COMPANY KEEP GROWING?

D. PROFITABILITY RATIOS – WHAT DOES A COMPANY’S “BOTTOM LINE” LOOK LIKE? E. EFFICIENCY RATIOS – HOW WELL IS THE COMPANY USING INVESTORS’ MONEY? F. CAlCULATING A COMPANY’S GROWTH RATE

How important are ratios to the IB? From ratios IB get data from financial statements and compare them with each other and with the same type of companies. This lesson will show how IB look at ratios and use ratio analysis to see what is going on with a company.

The 4 major types of multiples/ratios we will look at are: B. VALUATION MUTLIPLES – How much is a company worth? C. LIQUIDITY MUTLIPLES – Which companies need cash? D. PROFITABILITY RATIOS – How much money can a company make? E. EFFICIENCY RATIOS – How well is management putting money to use?

The first question investors ask is how much is a company worth. Most of the products IB offer is based on market valuation. This is always changing as company values rise and fall. Timing is critical as IB want to sell when the demand for securities is strong.

B. VALUATION MULTIPLES: 3. Market value = company’s stock price x number of shares outstanding This is the most common way investors know how much a company is worth.

B. VALUATION MULTIPLES: 4. Enterprise value divided by EBITDA: With the P/E ratio this better tells an IB how much a company costs. What is Enterprise Multiple or Value? Look up the definition on the website under Financial Terms. Enterprise value = market value - Cash and Short-Term Investments + Total Debt EBITDA = Net income + tax + Interest + Depreciation and amortization.

B. VALUATION MULTIPLES: One more valuation ratio: 5. EBIT (Earnings before taxes & interest EBIT = Revenue – Cost of goods sold – operating expenses – depreciation – amortization. This is an easier way to compare a company’s profit with other companies.

B. Summary of Valuation Multiples 1. P/E ratio 2. Book value 3. Market value 4. Enterprise multiple 5. EBIT Now, let’s look at Liquidity Multiples!

IB definitely help companies who need help. But how do they help companies continue to grow or stay strong? Here are some ways that IB use liquidity ratios to understand how a company is doing. IB help companies to see how they are doing on debt financing versus equity, or stock, financing. Thus, they use the: 1. DEBT-TO-EQUITY RATIO

2. In order to make sure a company can still pay all it’s bills, the QUICK RATIO will help. 3. The INTEREST COVERAGE RATIO will help a business account for their level of debt and se how much larger a company’s profit is than interest payments. So, 1. DEBT-TO-EQUITY RATIO 2. QUICK RATIO 3. INTEREST COVERAGE RATIO Let’s look at these!

1. Debt-to-Equity like all other ratios must be compared against the industry it is in. Debt-to-Equity Ratios by Industry INDUSTRYDEBT-T0-EQUITY RATIO Oil & Gas refining/marketing27% Industrial Conglomerates103% Technology Software 8% Health care 10.2%

Ratios that measure a company’s profitability come from the income statement. IB learn much from the income statement but the information is most useful when applied to ratios. There are many ratios but we will look at a few that matter the most. 1. GROSS MARGIN 2. INCOME FORM CONTINUING OPERATIONS 3. NET MARGIN Let’s look at these!

Overhead costs include things like: repairs and maintenance, office supplies, utilities, rent. Direct costs include labor, materials, third party expenses.

2. INCOME FROM CONTINUING OPERATIONS MARGIN shows the revenue that a company is able to keep after paying all its costs before interest expenses and smaller, extra costs. Income from continuing operations = (total revenue -cost of revenue - operating expenses + Net interest expense + Unusual items – Income tax expenses) Divided by Total Revenue.

Net Margin by Industry IndustryNet Margin (5-year average) Energy12.7% Technology11.8% Healthcare11.4% Industrials9.7%

Efficiency ratios are a way for investors to know if a company’s management team is using their money wisely. These ratios compare data from both the balance sheet and the income statement. These include: 1. Return on Assets 2. Return on Capital 3. Return on Equity Let’s look at these!

2. CALCULATING HERSHEY’S RETURN ON CAPITAL Financial Measure2012($millions)2013($millions) EBIT1,208.32Not needed Total equity Minority Interest (debt) Short-term debt Current portion long-term debt Long-term debt1, , Total capital2, ,769.12

HERSHEY’S GROWTH TRENDS ($ millions) Financial Measure Growth Rate Revenue$6,644.36, % Cost of Goods Sold$3,784.43, % Selling, marketing & administrative costs$1,703.81, % Interest expense $ % Net income $660.9$ % Looking at the growth rate gives an IB a different perspective from the financial statements. What do you see?

HERSHEY’S GROWTH TRENDS ANALYSIS 1.Hershey’s has near double-digit revenue growth in the chocolate business 2. They are keeping good control on its raw materials cost by 6.6% in COGS This also shows a potential trouble in the 15.3% increase in “overhead” costs. The IB will go back to 10K filings to find out what’s going on.

HERSHEY’S GROWTH TRENDS ANALYSIS During 2012 Hershey’s costs increased in 2012 due to higher advertising costs, bonuses and costs due to buying another chocolate company, Brookside Foods, a Canadian-maker of chocolate-covered fruit-juice pieces – an example of growing to fill- out their product line. This kind of information is critical for IB to know, so that they can possibly help Hershey with amother merger opportunity.