Summary A practical guide to interpreting financial statements and valuing companies

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Summary - A practical guide to interpreting financial statements and valuing companies

  • 1 Financial reporting

  • On which things do investors predominantly focus on?
    1. Growth
    2. Composition of revenues
    3. Development of operational earnings
    4. Profit margins
    5. Net earnings
    6. Cash flow figures
    7. Dividends
  • On which things do regulators predominantly focus on?
    1. Capital expenditures
    2. Other investments
  • On what do lenders predominantly focus on?
    Company's debt serviceability
  • On which things do (trade) unions predominantly focus on? Why?
    1. Development of staff
    2. Employee expenses
    3. Earnings
    4. Dividends
    The last two suggests a possible magnitude of potential salary increases.
  • Next to his/her predominant interest, every stakeholder should also be interested in what? And why?
    A company's outlook and financial health.

    These are the obvious key ingredients of a company's ability to deliver on any stakeholder expectation in the future.
  • Why should every stakeholder understand how the owners view their investment?
    To anticipate likely board and management actions in the future, which may affect the interest of its other stakeholders other than shareholders.
  • Why is it often very insightful to analyse the revenue breakdown companies provide in their annual reporting?
    To better understand the development of growth drivers and -draggers, and of the evolution of competitive pressure over time.
  • 2 Shareholder return

  • What does the return that a shareholder gets for being (partial) owner of a company consist of?
    • Capital gains
    • Dividends
    • Share buybacks 
  • What is capital gain?
    The price increase (or decrease) a share has enjoyed (or suffered) since a shareholder invested in it.
  • What are dividends?
    Another source of income for shareholders and are usually paid by companies that are not in aggressive growth anymore.
  • What are yield plays in the investment world?
    Shares that are considered to have a lower level of risk and volatility because they are usually found among larger, more established companies.
  • What are growth plays in the investment world?
    Shares that will usually refrain from paying out dividends and will instead reinvest back into the company to expand.
  • 2.1 Capital gains

  • What is the most straightforward way in which shareholders can earn money from being shareholders in a company?
    By buying shares at a certain price, which rise over time, and hence by profiting from a share price increase.
  • What is for young growth companies often the only way to offer positive shareholder return to its investors? And why?
    Capital gain as growth companies usually don't distribute dividends yet. Instead, companies need cash to invest into their growth.
  • On what are share prices based on? Why are share prices of growth companies so volatile?
    On future (expected) earnings and dividends.

    Because the share price is based on future (expected) earnings rather than an actually existing (and tested) dividend policy.
  • Market expectations and hence the share price can change fast.
    1. Competitive dynamics
    2. A change in the economic outlook
    3. Regulatory adjustments that could affect a whole sector or industry
    4. Changes in management confidence and perceived execution challenges
    5. Surprises in the company's performance vs earlier market expectations    
  • As shares trade, how are share prices constantly adjusted?
    By the buyers and sellers who take actions on the basis of incremental changes in expectations.
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When common stock is $100 and retained earnings is $775 and there are 100 shares at a price of $45 per share. What is the price/book value?
Book value of equity per share = common stock + retained earnings / # of shares

(100 + 775) / 100 = $8.75

Price/book value = 45 / 8.75 = 5.17
Why do shares usually trade at a higher yield than bonds?
Their earnings are exposed to more risk and as their earnings are not usually paid out in cash dividends, hence investors naturally take a long-term investment view and automatically also a higher investment risk.
Consider an asset with an original cost of $100,000, an expected life of five years, and an estimated salvage value of $20,000. Under straight-line depreciation, the net book value of the asset after two years would be?
$100,000 - 20,000 = $80,000

$80,000 / 5 = $16,000

$100,000 - 16,000 - 16,000 = $68,000
How can the EBIT figure be influenced strongly by depreciation?
Depreciation can be very different from what a business actually spends on its equipment.
Why does a company have to have enough equity?
To service a company's debt in times of suppressed times.
If a company's risk-free rate is 4%, and the company beta is 1.4, and the expected return on the S&P 500 is 10%. What is the cost of equity?
4 + 1.4 * (10-4) = 12.4%
What does WACC represent?
The return that the company has to earn, on average, to satisfy its contributors of capital.
If a company has paid $9 million in interest last year on $150 million in bank loans, what is the company's cost of debt?
6%
A private pharmaceutical company that has $200 million in EBITDA and is financed with $300 million in debt. Using the comparable average of 5.30, the equity of this company would be valued at?
By multiplying its EBITDA by the average EV/EBITDA ratio

$200 * 5.30 = $1,160 million  

Minus debt to get to the equity value

$1,160 - 300 = $760 million equity value
Price multiple valuation of many early-stage tech companies uses which multiple?
Price/sales ratio