investment banking system: building a...

INVESTMENT BANKING SYSTEM: BUILDING A MIDDLE MARKET M&A PRACTICE

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Michael Herlache MBA

Managing Director at AltQuest Group

Doctor of Business Administration Candidate 2025, California Southern University

Investment Banking System Building a Middle Market M&A Practice

Investment Banking University Publishing

www.InvestmentBankingU.com

http://www.investmentbankingu.com/


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For my wife, Svitlana, whom is my treasure.


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About the Author: Michael Herlache is the MD of M&A at AltQuest Group, a lower middle market boutique investment bank located in Wisconsin. He lives in his home in Wisconsin with his wife, Svitlana. Michael has an MBA in finance from Texas A&M University and is getting his Doctorate in Business Administration with a focus on finance. To learn more about AltQuest Group, please go to www.AltQuest.com.

For those interested in going through a formal investment banking training program associated with this text, the Investment Banking University (www.InvestmentBankingU.com) courses syllabus is based upon the content of this book.

file:///C:/Users/Michael%20Herlache/Desktop/Books/Investment%20Banking/www.AltQuest.comfile:///C:/Users/Michael%20Herlache/Desktop/Books/Investment%20Banking/www.InvestmentBankingU.com


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Contents PERPETUITY SCIENCE:

Part I: Perpetuity Science Methodology

Chapter 1: What You Learn in Business School vs. What You Should Learn in Business School

Chapter 2: What is a Perpetuity?

Chapter 3: The Typical Perpetuity

Chapter 4: The Perpetuity Index

Chapter 5: Perpetuity Coverage

Chapter 6: Perpetuity Analysis: Financial Statement Modeling & Valuation

Chapter 7: Perpetuities & the Capital Markets

Chapter 8: Capitalism as a Perpetuity Game

Chapter 9: Perpetuity Player: Corporations

Chapter 10: Perpetuity Player: Investment Banks

Chapter 11: Perpetuity Player: Private Equity & Corporate M&A

Chapter 12: Playing the Perpetuity Game: Working Your Way to the Buy-Side

FOUNDATIONS OF VALUATION:

Part I: Tracking Monetary Value (Accounting)

Chapter 13: Accounting for Monetary Value

Chapter 14: From Accounts to Financial Statements

Part II: Analyzing Monetary Value (Finance)

Chapter 15: From Financial Statements to Financial Analysis

Chapter 16: The Time Value of Money

Chapter 17: Analyzing Value with Finance

Part III: Modeling Monetary Value

Chapter 18: Finance with Excel

Chapter 19: Preparing for Financial Statement Modeling

Chapter 20: Excel for Financial Statement Modeling

Chapter 21: Gathering Historical Financial Statements

Chapter 22: Financial Statement Modeling

Chapter 23: Financial Statement Model Analysis

Chapter 24: Adjusted EBITDA Calculation

Part IV: Valuing Monetary Value

Chapter 25: Valuation Principle

Chapter 26: Valuation Build Up

Chapter 27: Public Company Valuation

Chapter 28: Comp Companies

Chapter 29: Comp Transactions

Chapter 30: Discounted Cash Flow (DCF)


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Chapter 31: Triangulating Valuation with the Football Field

BUILD-SIDE:

Part I: How to Build a Perpetuity?

Chapter 31: Building New Science

Chapter 32: Converting New Science into a Benefit Stream

Chapter 33: Converting a Benefit Stream to a Perpetuity

Part II: Strategic Planning of the Perpetuity

Chapter 34: Strategic Management

Chapter 35: From the Strategic Plan to the Financial Statement Model

Chapter 36: From Financial Statement Model to the Business Plan (Budget)

Part III: Business Unit Management

Chapter 37: From Business Plan (Budget) to Corporate Project

Chapter 38: From the Corporate Project to the Work Breakdown Structure

Chapter 39: Executing the Work Breakdown Structure (Project Management)

Part IV: Perpetuity Modeling & Valuation

Chapter 40: Financial Statement Modeling on the Build-Side

Chapter 41: Valuation Using DCF, Comp Companies & Comp Transactions

Chapter 42: Transaction Specific Modeling: Merger Modeling

Chapter 43: Ratio Analysis

Part V: Corporate Finance

Chapter 44: Decision 1: Uses (Investment)

Chapter 45: Decision 2: Sources (Financing)

Chapter 46: Decision 3: Reinvest vs. Return Capital (Dividend)

Part VI: Financial Planning & Analysis

Chapter 47: Sources & Uses Matching

Chapter 48: Cash Surplus/Shortfall Tracking

Part VII: Project Analysis

Chapter 49: Financial Functions in Excel

Chapter 50: Net Present Value (NPV)

Chapter 51: Internal Rate of Return (IRR)

Part VIII: New Science Engineering

Chapter 52: How to Be an Engineer?

Chapter 53: Mechanical Engineering

Chapter 54: Knowledge Engineering

Chapter 55: Content Engineering

Chapter 56: Platform Engineering

Part IX: Perpetuity Management

Chapter 57: The Principle of Monetary Value Creation

Chapter 58: How to Be a CEO?

Chapter 59: How to De-Risk the Benefit Stream?


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Chapter 60: How to Be a Consultant?

Chapter 61: Perpetuity Management

Chapter 62: The Market for Perpetuities

Chapter 63: Index Building & Benchmarking

Chapter 64: Financial Data Sources

SELL-SIDE:

Part I: How to Sell a Perpetuity?

Chapter 65: Investment Banking

Chapter 66: How to Build a Middle Market M&A Practice

Part II: The Middle Market

Chapter 67: Middle Market Breakdown

Chapter 68: Buyer Profile: Individuals & Search Funds

Chapter 69: Buyer Profile: Lower Middle Market Private Equity

Chapter 70: Buyer Profile: Middle Market Private Equity

Chapter 71: Buyer Profile: Strategics

Part III: M&A Multiples

Chapter 72: M&A Multiples

Part IV: Investment Banking Coverage Methodology

Chapter 73: Investment Banking Coverage Methodology

Chapter 74: Index Building & Benchmarking

Chapter 75: Financial Data Sources

Chapter 76: Coverage Marketing Material

Chapter 77: Rolodex Building

Chapter 78: Industry & State Level Coverage

Part V: M&A Origination Methodology

Chapter 79: M&A Origination Methodology

Chapter 80: Building the Pitchbook

Part VI: Mandate/Target Matching Methodology

Chapter 81: Mandate/Target Matching Methodology

Part VII: M&A Fee Methodology

Chapter 82: M&A Success Fee

Chapter 83: The M&A Engagement Letter

Part VIII: Underwriting the Financial Product

Chapter 84: Gathering the Historical Financials

Chapter 85: Finding Adjusted EBITDA

Chapter 86: Building the Financial Statement Model

Chapter 87: Building the Valuation

Chapter 88: Building the Transaction Specific Model

Part IX: Packaging the Financial Product (Marketing Material)

Chapter 89: Building the Teaser


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Chapter 90: Building the CIM (Confidential Information Memorandum)

Chapter 91: Building the Management Presentation

Part X: Buyer List Methodology

Chapter 92: How to Build a Buyer List

Chapter 93: Outreach to the Buyer List

Part XI: Deal Structuring

Chapter 94: Deal Structuring

Chapter 95: Asset Sale vs. Stock Sale

Part XII: M&A Process

Chapter 96: M&A Process

Chapter 97: Dealing with Sellers

Chapter 98: Dealing with Buyers

Chapter 99: The Letter of Intent (LOI)

Chapter 100: The Purchase Agreement

Part XIII: Investment Bank Management

Chapter 101: How to Build a Boutique Investment Bank?

Chapter 102: Running the Boutique Investment Bank

BUY-SIDE:

Part I: How to Buy a Perpetuity?

Chapter 103: The Principle of Investing

Chapter 104: How to Be a Warren Buffett?

Part II: Buy-Side Process

Chapter 105: Collecting & Reading the CIM

Chapter 106: Building the Financial Statement Model

Chapter 107: Building the Valuation

Chapter 108: Building the Transition Specific Model

Chapter 109: Writing the Investment Memo

Part III: Financial Buyer

Chapter 110: The Financial Buyer aka Private Equity

Chapter 111: Leveraged Buyout (LBO) Modeling

Part IV: Strategic Buyer

Chapter 112: The Strategic Buyer aka Corporation

Chapter 113: Merger Modeling

Part V: Additional Perpetuity Analyses

Chapter 114: Recurring Revenue Analysis

Chapter 115: Owner Dependence Analysis

Chapter 116: Customer Concentration Analysis

Part VI: Building a Portfolio

Chapter 117: Portfolio Theory

Chapter 118: How to Start a LMM Search Fund?


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Preface There are many investment banking texts out there that claim that financial modeling and valuation is the core work of the investment banker. This is simply not the truth. The core work of the investment banker is origination, mandate/target matching, and deal structuring. It should follow that a text/course on investment banking should be based upon the same. It is the good fortune that the reader has encountered such a book/course. Investment Banking: M&A Origination, Execution, Financial Modeling & Valuation explains origination, mandate/target matching, and deal structuring (i.e. how investment bankers actually make their money). For those new to investment banking you are first going to want to clarify whether you would like to work on the sell side for a few years or pursue a career in investment banking. The skills that you will need to get started in investment banking are different than those that you will need to have a long and successful career in investment banking. The role in investment banking transforms from one that is research, financial modeling & valuation-based into one focused on origination and facilitating the M&A process. M&A (Mergers & Acquisitions) is the core product of investment banking, and the other products, advisory & capital-raising, simply support this. We founded Investment Banking University (www.InvestmentBankingU.com) to prepare students for both bulge bracket and middle market investment banking career opportunities.

We see a paradigm shift occurring in the field of investment banking. The idea that you need to spend three years of your life as an analyst doing 80+ hour workweeks building financial models to become an investment banker is a faulty paradigm. The real value add of an investment banker is not financial modeling & valuation, but rather origination, mandate/target matching, and deal structuring. You dont need Goldman Sachs permission to be an investment banker just like you dont need McKinseys permission to be a consultant. Investment banking for private companies in the middle market and lower middle market is a great way


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to build your initial coverage and career as an investment banker without sacrificing a family life or your health.

Perpetuity Science


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Perpetuity Science is the body of knowledge and optimization models associated with the building, selling or buying of perpetuities, the core work of the capitalist system.

Part I: Perpetuity Science Methodology Consistent with Perpetuity Science, the Perpetuity Methodology is broken

down between the three aspects of the perpetuity and also has the

foundations of valuation to tie it all together:

Perpetuity Science as a Process:


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The first step of perpetuity science is to determine which side of the perpetuity we are on, and thus the goal of the side of the perpetuity. The second step is to gather historical performance of the existing perpetuity if there is one. If it is public, this means pulling most recent 10k and associated 10qs, equity research reports and consensus estimates, as well as press releases and news runs. Then we go about building a financial statement model for the perpetuity which will include scenarios, sensitivity, ratio analysis, and assumptions. From there we will gather business plans as the corporate level and business unit level (strategic plans) and we are going to create cases in the financial statement model for the street case (ER reports), management case, and upside and downside. We then build various analysis tools on top of the FSM including valuation and we will sensitize various operating assumptions (cases) against valuation, EPS etc. and see how the various plans effect valuation with an eye towards maximizing the valuation of the perpetuity. Perpetuity Analysis Analysis of IRR/ROA versus economy, market index (S&P 500), industry, peers in same industry and versus its own historical performance and versus the discount rate, r.


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Chapter 1: What You Learn in Business School vs. What You Should Learn in Business School

The standard MBA curriculum at most business schools is broken down along siloed subjects such as accounting, finance, management, operations, and marketing and attempts to teach students how to be a mid-level manager at a large corporation for the rest of their lives. Unfortunately, these jobs are mostly gone, having been shipped overseas or automated. This MBA curriculum is thus outdated and not appropriate for the 21st century when most individuals will have multiple jobs and roles throughout their careers and lives. The more appropriate field of study which has yet to make it to business schools is known as Perpetuity Science. Perpetuity Science is the body of knowledge, methodologies, and optimization models related to the building, selling, and buying of perpetuities. It explains how perpetuities can be built, managed and exited from to create wealth. Perpetuity science is a paradigm shift in business and finance education in that it replaces the siloed subjects traditionally taught in undergraduate and graduate business schools with a holistic methodology that integrates industry and the capital markets into one framework. Instead of a disparate business taxonomy along the lines of economics, finance, accounting, marketing, etc., we have an initial taxonomy broken down in relation to the perpetuity, namely: Build-side the building of perpetuities (entrepreneurs, corporations)


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Sell-side the selling of perpetuities (investment bankers, wall street) Buy-side the buying of perpetuities (private equity, corporate M&A)

Perpetuity science has a process for each side of the perpetuity depending on what side of the perpetuity you are on (ex. build-side, sell-side or buy-side).

The core financial statement modeling & valuation processes within each side, however, are very similar across all sides. Thus, we can generalize a financial statement modeling & valuation process across all sides which is found in the second section of the book called, Foundations of Valuation.

Within each of the three, we have various methodologies and optimization models that may touch on various subjects such as accounting, finance,


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economics. By starting with perpetuity science however, the student can better synthesize the various moving parts of industry and the capital markets.


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Chapter 2: What is a Perpetuity? A perpetuity is a stage of a business where the companys benefit stream has been de-risked along the three lines of risk; customer concentration, owner dependence and recurring revenue. Since a company has to meet a certain level of stable revenues and other financial metrics to be listed on an exchange, being public is a proxy for being a perpetuity. As such, we can study what is similar amongst public companies and establish general characteristics of perpetuities. When first learning about industry and the capital markets, one should first understand the nature of the perpetuity, which is the basis for industry & the capital markets. The perpetuity can be modeled with the following formula: Perpetuity value = CF / r Where CF represents the benefit stream associated with the perpetuity and r represents the discount rate associated with the perpetuitys risk of receiving the benefit stream.

Perpetuity Science: The corporation as a financial product called a perpetuity with a variable cash flow and thus variable interest rate, IRR. The formula for the perpetuity is: CF/r Finance is designed to find both the true cash flow and the corporate interest rate. This allows us to determine the performance of the financial product relative to other financial products of similar risk. Additionally, we can find the valuation of the corporation once we have the cash flow and the interest rate. Perpetuity & Industry:


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After understanding the nature of the perpetuity in general, we can then analyze the nature of the perpetuity within each industry. The nature of the CF, r, value chain, and value being offered will be different. We investigate each industry according to these variables by building an index for each industry and then sub-sector within the industry. After building the index and sub-sector indices we can then begin analyzing the value chain and leaders in each part of the value chain. We then build financial statement models for the leaders in each section of the value chain and understand the drivers of performance. We analyze each leader or target in relation to the phases of perpetuity in terms of where they are now and the next steps that they can take to move to the next phase. In doing so, one begins to think in terms of being a CEO. The CEOs role is to bring the company/opportunity through the stages of the perpetuity by building recurring benefit streams (i.e. cash flows) and at the same time de-risking those benefit streams. In doing so, the valuation of the perpetuity moves from backward looking towards forward looking and the valuation is thus maximized (based upon a multiple of future earnings). The CEO should thus be familiar with Perpetuity Science and the phases of the perpetuity. As the perpetuity changes, the formula for valuing the perpetuity changes as well. There are five phases of perpetuity building. As we move through the phases, the role of the owner of the perpetuity becomes more passive and the valuation becomes larger due to size of EBITDA increasing, EBITDA multiple increasing, and the discount rate decreasing. The perpetuity becomes less dependent on the owner to exist and run as an organizational structure is formed coinciding with the division of labor, processes are automated, and revenue becomes recurring.

Phases of the Perpetuity:


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I. Syndication (Getting to PMT) II. Job Shop (From PMT1 to PMT2, PMT3, etc) III. Perpetuity (From PMTi to CF/r) IV. Growing Perpetuity (From CF/r to CF/r g) V. Diversified (Perpetuity 1 + Perpetuity 2) The goal of Perpetuity Science is the building, growing, management, exit and buying of perpetuities, so ultimately, while learning about Perpetuity Science itself, we are also actively looking for:

1. Perpetuities to create 2. How to advance a perpetuity to the next phase 3. Perpetuities that should be exited from 4. Perpetuities that should be purchased

Ultimately, Perpetuity Science transforms the individual from a one-dimensional functional worker into a multi-dimensional value-creator able to execute on either of the three sides of the perpetuity; build side, sell side, or buy side.

The Perpetuity Scientist vs. The Functional Specialist The Perpetuity Scientist builds assets that generate passive benefits whereas the functional specialist uses labor to generate active benefits. The quality of life of the perpetuity scientist is thus higher than the functional specialist. It is the


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perpetuity scientist that drives the primary value with functional specialists simply serving a role in the process of building or operating a perpetuity. The Perpetuity Scientist has the three capabilities associated with the key question of each side of the perpetuity: Build-Side: Key Question: How to Build a Perpetuity? Capability: The capability to build a perpetuity Sell-Side: Key Question: How to Sell a Perpetuity? Capability: The capability to sell a perpetuity Buy-Side: Key Question: How to Buy a Perpetuity? Capability: The capability to buy a perpetuity


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Capabilities that each business student should have are associated with the 3 key questions of Perpetuity Science: Perpetuity Science:

I. Build side: How to build a perpetuity?

II. Sell side: How to sell a perpetuity?

III. Buy side: How to buy a perpetuity?

The key questions are associated with capabilities to be built learning perpetuity science.

Demand for Perpetuities There is always demand for perpetuities and especially by institutional investors which means that the market for corporate control more closely mirrors the DCF (intrinsic value) of the perpetuity (corporation). Institutional investors can pay higher multiples in order to realize returns over longer periods of time.

What is Intrinsic Value? Something is intrinsically valuable inasmuch as it is a perpetuity. Perpetuity

provides certainty that the benefit stream will be recurring in the future and

is thus, the basis for intrinsic value. Perpetuities allow us to improve our

standard of living while not sacrificing quality of life by continually dealing

with a problem/opportunity in nature and yielding passive benefits.

Discount Rate (r) vs. Return Rate (IRR) We have to make the distinction between r, the discount rate, associated with the implied cost of entering the financial product, and the IRR, or return


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rate on the financial product. We make the comparison between r and IRR, and IRR should be higher than the cost of acquiring the financial product. This means that monetary value has been created. Market Value vs. Intrinsic Value There are times when market values of the perpetuity exceed the perpetuity's

intrinsic value due to the demand for larger perpetuity's by institutional

investors. Essentially, they are willing to accept less IRR relative to the WACC

since there is a scarcity of large perpetuities to deploy capital to in order to

meet institutional investors obligations to their stakeholders.

The Business Pattern: As mentioned, business brings demand together with at least one product/service in order to build a benefit stream. The demand can be purchased and the product/service can be built, purchased or merely sold. As demand transacts to obtain the product, the benefit stream grows. The goal of the businessman is to broaden and deepen the pipeline of demand while improving the product until it is irreplaceable to consumers and moves from discretionary to a necessity. As transactions grow, the division of labor can occur within the business in order to make the ownership of the benefit stream more passive for the owner amounting in an organizational structure. As demand becomes recurring, additional products may be built, bought, or merely sold that are complementary/synergistic to the original. The pattern goes from broadening and deepening the demand pipeline for one product to broadening and deepening the product pipeline itself so that ultimately you have an infinite loop of demand and product bringing the benefit stream to ever increasing valuation. Perpetuity Phases: Business goes through phases of development including: I. Syndication initially bringing together of demand purchased or built via

databases with the initial product being, purchased or sold. II. Job shop division of labor initially with owner actively involved in day

to day. Initial pipeline of demand and products matched in one off jobs III. Perpetuity - organizational structure takes over fully for the owner.

Pipeline of demand becoming recurring in nature. IV. Growing perpetuity pipeline of demand recurring and growing

(broadening and deepening demand pipeline) V. Diversified additional benefit streams built or purchased forming a

portfolio. The Dual Existence Principle


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A business exists in both a real and financial capacity. In terms of its real existence, it produces and/or sells at least one produce or service. In its financial existence, it is a perpetuity producing a benefit stream with some degree of variability. Strategy focuses on the businesses real existence while finance focuses on the businesses financial existence. In this book, we are primarily focused on the business' financial existence as a perpetuity, hence our body of knowledge called Perpetuity Science. The business as a perpetuity can be broken down along the perpetuity game, sides of the perpetuity, phases of the perpetuity and market for perpetuities. We will explain each in the different segments of this book. It is first, however, important to get an understanding of the basis of the perpetuity which is valuation. This is how we begin the initial part of this book.

Sources & Uses When thinking about business we have to acknowledge the sources and uses associated with a corporation where sources represent the capital markets and uses represents the asset mix of the corporation. Business can be thought of as a process where the output is a benefit stream with a given level of variability. This benefit stream with a given level of variability is known as a perpetuity. Thus, the model for business is the perpetuity.


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Since we know that a perpetuity is the model for business (the integration of industry and the capital markets), we can then build a body of knowledge around the perpetuity which serves as the basis for the science of the perpetuity (Perpetuity Science):

The body of knowledge known as Perpetuity Science can be broken down in the following manner:

What is Business? Commercializing new science in order to build a benefit stream and then a perpetuity via the utilization of sources and uses of capital. Uses of capital comes in the form of assets in order to create the new science and then commercialize it. Sources of capital means tapping the capital markets to fund the assets of the corporation. After the assets are procured and utilized, the individual assets that make up the new science must be tracked to ensure that an actual benefit stream is


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being created and ultimately a perpetuity. Thus begins the need for accounting.


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Chapter 4: The Typical Perpetuity The Typical Perpetuity: The typical large company grows at about 5 to 6 percent per year in revenues, earns about a 13 percent return on equity (IRR), and has a 9 percent cost of capital. The resulting P/E ratio is 15x. The average cost of equity capital, or the price investors charged for their risk, in late 2009 for a large nonfinancial company was about 9 percent, and most large companies costs of equity capital fell in the range of 8 to 10 percent. Most large companies have P/Es between 12 and 20.


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Chapter 4: Perpetuity Indices There are general indices that track perpetuity performance. These include

the S&P 500, Dow Jones Industrial Index. We can observe perpetuity

performance in general here and see what sort of industries are leading or

lagging.


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Chapter 4: Perpetuity Coverage & Analysis Since institutional investors are looking for either perpetuities or annuities for their portfolios, they naturally begin to cover perpetuities that are consistent with their investment mandate. They build or utilize an existing index to compare with perpetuity performance (rate of return). An academic at NYU, Aswath Damadoran, provides coverage of all public perpetuities and provides analysis by tracking the discount rate, return, growth, margins & multiples. From this information, institutional investors can begin to form an investment thesis for purchasing a given perpetuity or selling a given perpetuity.


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When looking at the different industries in which perpetuities are located, it becomes helpful to understand the nature of the perpetuities including risk (as represented by the discount rate in the perpetuity formula), return, growth, margins, multiples, and cash flow:


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Risk (discount rate) on the following page:


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Return:


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Growth:


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Margins (Cash flow):


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Multiples:


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Chapter 5: Capitalism as a Perpetuity Game In order to build benefit streams (wealth), individuals engage in the perpetuity game by building or buying perpetuities. In order to build a perpetuity, a single benefit stream must be created first and then that benefit stream is to be de-risked. After de-risking that benefit stream and continuing to grow it, the individual may build another benefit stream that is synergistic with the initial benefit stream so that capabilities and functionality may be taken advantage of. Due to existing capital that is accumulated desiring passive returns from already built perpetuities, a marketplace for perpetuities emerges where the benefit stream itself is valued in a multiple capacity meaning that it is worth more than the work put into the creation of it. This marketplace means that there are those that seek to enter and exit perpetuities in order to generate passive benefit streams for themselves and thus the perpetuity game emerges. This is the essence of the capitalist system that we live in whether you are aware of it or not. Within the perpetuity game, there are different sides of the perpetuity that emerge including the build side, sell side and buy side that have different players within each category with various hurdle goals. On the build side, the perpetuity scientist seeks to build a benefit stream with the largest multiple in order to then exit the perpetuity. This means getting the benefit stream to qualify for the most liquid marketplace by going from a private perpetuity to a public perpetuity (going public). These players include entrepreneurs and corporations.


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On the sell side, the perpetuity scientist seeks to aid those that have already built perpetuities in exiting them at a strong multiple and take a fee for doing so. These players include investment bankers and Wall Street. Finally, on the buy side, the perpetuity scientist utilizes an existing or borrowed pool of capital to enter and exit perpetuities to create a passive benefit stream for themselves at some hurdle goal (hurdle rate or IRR). By entering perpetuities, operating them and then exiting them five to seven years later, the financial or strategic buyer is able to generate the new benefit stream and the rate of return in relation to the capital invested.


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Chapter 6: Perpetuity Game Player: Corporations

The FORBES Global 2000 ranking is based on a composite score from equally-weighted measures of revenue, profits, assets and market value. The 2017 list features public companies from 58 countries that together account for $35.3 trillion in revenue, $2.5 trillion in profit, $169.1 trillion of assets, and have a combined market value of $48.8 trillion. U.S. companies account for the most members of the list, 565, followed by China and Hong Kong, which is home to 263 Global 2000 companies. The worlds biggest companies have gotten bigger, more profitable and more valuable in the past year. 58 countries were represented, down from last year's 62 with Cyprus, Kazakhstan, Romania and Malta no longer boasting companies on the list.


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On the build-side, the process can be broken down into three high level steps:

McKinsey Report PLAYING TO WIN: THE NEW GLOBAL COMPETITION FOR CORPORATE PROFITS


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Chapter 6: Perpetuity Game Player: Investment Banks

On the sell-side, the process can be broken down into three high level steps:


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Chapter 6: Perpetuity Game Player: Private Equity & Corporate M&A Private Equity assets under management (AUM), now $4.7 trillion worldwide, private markets in 2016. New entrants continue to flock to the industry, and the number of active firms is at an all-time high. The larger number of general partners (GPs) reflects the industrys success but also heralds increased competition, which has contributed to rising deal multiples. As GPs have grown gun-shy about todays higher prices, deal activity has fallen, and dry powder has reached an all-time high. Most agree that public markets, despite their recent run-up, are becoming structurally less attractive to many limited partners (LPs), who will likely respond by further raising their allocations to private markets. Page 2 Mckinsey private markets report

Corporate M&A

On the buy-side, the process can be broken down into three high level steps:


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Chapter 6: Playing the Perpetuity Game The name of the perpetuity game is to build as large and passive a benefit stream as possible. There are three sides that one can engage in in order to do so as mentioned in the last chapter; the build side, sell side and buy side. Though there are different sides to the perpetuity, the perpetuity scientist should understand the entire process of playing the perpetuity game including mastering the capabilities and knowledge necessary to play the game. Process of Playing the Perpetuity Game The perpetuity scientist uses the valuation methodologies to determine a valuation range for a target perpetuity that is less than its DCF value (positive NPV project) via using the two valuation methodologies of:

1. Comp companies 2. Comp transactions The perpetuity scientist then uses an LBO or merger structure for the purchase (syndication on build side) of the perpetuity utilizing a deal structure (cash, stock, cash & stock) and goes through the syndication or M&A process to build or buy the perpetuity.


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The perpetuity scientist then operates the company, focusing on debt paydown if there is any and then in five to seven years exits the perpetuity receiving a 25%+ return on capital invested. The perpetuity scientist understand the buy side perspective to every deal, the perpetuity marketplace (multiples), the process and thus he knows the perpetuity game. The perpetuity scientist knows how to pull comps from a coverage database such as Mergr (www.mergr.com) as well as comp transactions to get an understanding of the multiples in a sector and then sub-sector. He then knows how to spread these comps into his valuation model to obtain a mean and median multiple for the sector and sub-sector to value his own target. The perpetuity scientist then knows how to collect financials and calculate adjusted EBITDA (proxy for cash flow) including addbacks (also called Total Owners Benefit in the lower middle market). The perpetuity scientist then knowns how to perform a DCF valuation in excel based upon the adjusted EBITDA and compare the NPV valuation to the multiples of comp companies and comp transactions. This gives an understanding if an investment actually exists (if DCF value > comp multiples). The perpetuity scientist then knows how to procure financing of various sorts to fund the transaction including various types of equity, debt or hybrid from their different sources (can be found in Mergr). He builds a financial model that incorporates these sources of capital along with the corresponding uses of capital in the perpetuity itself and runs an analysis according to what type of buyer he is (strategic with a merger model or financial with an LBO model) in excel to understand the returns from an IRR perspective. The perpetuity scientist then knows how to originate the M&A opportunity in terms of approaching the target and issuing an IOI in order to do a deeper dive with management and how to have a buyer/seller meeting. The perpetuity scientist then knows how to obtain longer period and more detailed financials of 3 to 5 years and confirms the analysis from before to see if still meeting the hurdle rate and performs various sensitivity analysis.

http://www.mergr.com/


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The perpetuity scientist then knows how to issue an LOI then purchase agreement to begin due diligence and then ultimately takes ownership of the perpetuity.

Chapter 6: Perpetuities & the Capital Markets The players within the perpetuity game are continuously engaging in sources & uses matching for the build-sides positive NPV projects. Sources & uses matching means accessing the capital markets for capital to finance positive NPV projects. Institutional investors provide their financial capital, their excess wealth, in order to create more wealth. While there are many financial products representing various commodities, there are two primary types of investments; perpetuities and annuities.

1. Perpetuities have variable interest rates with higher discount rates as well as higher IRRs generally. Also referred to as equity.

2. Annuities have definite interest rates generally with lower discount rates and lower IRRs generally. Also referred to as debt.

These financial products make up the capital markets. From an investor perspective (sources), institutional investors seek higher IRRs on their portfolios, so they allocate a significant portion of their portfolio to perpetuities (equity). Notes: Understanding how the global capital market is evolving is essential for CEOs and CFOs raising capital, financial institutions seeking to shape the


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market, policy makers tasked with regulating it, and investors seeking to profit from it. McKinsey created a database of the financial assets of more than 100 countries since 1980. Together, these assets comprise the global financial stock, or financial capital available for intermediation. Among the three most important types of marketsthose for capital, products, and laborthe global capital market is the farthest along the road to true global integration (marked by the operation of an international law of one price) and the one of the three that could best stake a claim to being an independent, motive force. The global capital market is thus a critical driver of growth and wealth creation. The global financial stock the total amount of capital intermediated through the worlds banks and capital markets and made available by them to households, businesses, and governments is now more than $118 trillion and will exceed $200 trillion by 2010 if current trends persist (McKinsey). The lions share of this growth in the global financial stock has come from a rapid expansion of debt


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The roles that major countries and regions play in capital markets are changing. The United States plays the largest of them, attracting foreign issuers and investors alike. European markets are gaining in market share and depth, however, as they becoming more integrated. Meanwhile, Japans role in global capital markets is diminishing while China has become a new force (McKinsey). First, the development and expansion of financial institutions such as banks and stock markets far outpaces the growth in underlying GDP, resulting in financial deepening. While the global financial stock was similar in size to the world's GDP in 1980, today it is more than three times larger. Financial deepening is usually beneficial, giving households and businesses more choices for investing their savings and raising capital as well as promoting a more efficient allocation of capital and risk. Second, debt securities are the most important asset class in the global financial stock. They hold the largest share of GFS and have been steadily expanding over time. Financial deepening is usually beneficial, giving households and businesses more choices for investing their savings and raising capital, and enabling more efficient allocation of capital and risk. financial deepening has been driven in the US by increased private sector intermediation Equities have grown faster than the overall financial stock over the long run, but with considerable year-to-year volatility: in 1999, with equity markets soaring, equities were briefly the largest asset class in the global financial stock with a 38 percent shareby 2003 this share had fallen back to 27 percent. Over the past decade, growth in equities has occurred through a combination of new issues, earnings growth, and increases in the price-toearnings (P/E) ratio, with significant differences across countries. In the US, P/E increases since 1980 have been a meaningful source of equity stock growth, while in Europe growth has come mainly through increased earnings. Moreover, in the US, IPOs are a significant source of financial stock growth, while in Europe most newly floated shares come through privatizations. Three markets account for more than 80 percent of the worlds financial stock: the US, Japan, and Europe.


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The US market is dominated by private debt and equity markets. In Europe, by contrast, banks play a larger role in finance, although European debt capital markets are growing quickly. Asian financial markets are relatively isolated from each other and display important differences. Japan has the regions largest financial stock, but is slow-growing. Chinas financial stock is among the fastest growing in the world but remains heavily reliant on bank intermediationa concern given the fragility of Chinas banking system Patterns of financial asset growth vary across geographies. In the US, initial public offerings of small companies are a significant source of equities growth, as are increases in P/E ratios. In Europe, by contrast, increases in earnings and newly floated shares from privatizations of state-owned firms explain most equity growth. In Japan, a huge expansion of government debt is the only meaningful source of financial stock growth, while the stock of equities and private debt securities has actually declined. In China, although bank deposits account for two-thirds of the financial stock, debt securities show the fastest growth (Exhibit 7).


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THE US DOLLAR AND US MARKETS REMAIN AT THE HUB OF A RAPIDLY INTEGRATING GLOBAL CAPITAL MARKET it is no longer accurate to think in terms of national financial markets. Instead, individual markets are becoming increasingly integrated into a single global market for funding, as cross-border holdings of financial assets and cross-border flows of capital grow. This growth is clear evidence that despite the financial crises and anti-globalization backlash of recent years, the global capital market continues to integrate and develop. US markets remain at the core of this rapidly integrating and evolving global capital market. The lions share of the worlds cross-border capital flows are intermediated through US financial markets. the dollar continues to dominate global finance. It is the worlds most heavily traded currency and the preferred currency for issuing equities and bonds. Many other countries, including China and Malaysia, have tightly linked their domestic currencies to the US dollar. Although the euro is gaining notice among the worlds central bankers, it is a long way


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from matching, let alone surpassing, the role of the dollar in international finance we broadly define the global capital market as the cumulative collection of markets where global capital supply is matched with global capital demand through bank and securities market intermediation.

We view the global capital market as the marketplace where five types of participants meet to match the available capital supply and demand: 1. Investors/savers: providers of capital who supply funds in exchange for financial assets that promise return and have an inherent level of risk, and who continuously make risk/reward trade-offs to allocate their financial assets. 2. Borrowers: users of capital who raise funds against a promise of future repayment (debt capital) or a share of profits, control, and residual value (equity capital). Borrowers select their preferred source of funds from among available alternatives. 3. Bank intermediaries: deposit-taking institutions that pool funds from


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depositors and redistribute them among borrowers. Banks assume liquidity, interest rate, and credit risk and retain a spread between the cost at which they extend credit and the price that they pay for deposits. 4. Securities markets: broad set of financial institutions that collectively support the issuance and trading of securities. The primary markets allow governments and corporations to raise funds directly from investors by issuing new securities, while the secondary markets provide liquidity for outstanding securities by matching buyers and sellers. In contrast to banks, markets directly match investors with borrowers (that is, they disintermediate the market for capital) and assume minimal risks. 5. Channels and asset pools: we have chosen to view asset managers and other asset pools as channels, because they manage portfolios of deposits and securities on behalf of investors, and serve as a pass-through vehicle of savings channeled toward borrowers. Mutual funds, pension funds, and insurance companies are included in this category. To size the global capital market, we have profiled the global financial stock, as defined by the sum of the global bank deposits, the market value of publicly traded equities, and the outstanding face value of debt securities


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Two important distinctions underlie the findings in this report: intermediation by markets versus banks, and government debt securities versus other asset classes. Market intermediation versus bank intermediation (also tradable versus non-tradable instruments) The stock of equity and debt securities represents the degree of market intermediation in an economy, since they are the instruments used by the financial market to directly match up those who want to invest money with those who want to raise capital. Because equity and debt securities may be traded on the markets, we often refer to them collectively as tradable instruments (although depending on their liquidity and turnover, some securities may not be actually traded). In contrast, the stock of bank deposits represents the degree of bank intermediation in an economy, since bank deposits are the capital that the banking system channels from savers to borrowers (simplistically speaking, bank deposits fund bank lending).10 Since capital intermediated through the banks is less easily transferable than stocks or bonds, we refer to bank deposits as non-tradable. In general, governments have greater ability to regulate the banking sector than they do the financial markets. Thus, the degree of government control over the financial system bears an important relation to the extent of bank intermediation. Government debt securities versus other asset classes Equity securities, private debt securities, and bank deposits (which fund bank loans) are the main classes of instruments for intermediating capital between borrowers on one hand and investors and savers on the other. As these three elements of the financial stock increase, the economy becomes more efficient at allocating capital to its best use. Government debt securities are quite different. They function more as an instrument to redistribute taxes across generations than as a means to allocate capital from savers to borrowers. Although a well-developed market for government debt securities supports the development of a private debt securities market, government debt does not directly help firms to raise capital and grow. a large financial stock dominated by government debt securities is a sign of a high degree of future generation liabilities, rather than a sign of more efficient capital allocation. pg. 45 McKinsey Global Financial Stock Report


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The US maintains a unique role as the hub for GCM, which bolsters its dominance in private debt and equity securities. Europe is integrating quickly and is gaining global share across all asset classes. Notably, the US financial stock is dominated by securitiesprivate equity and debtto a much greater extent than other markets in the world, with a relatively limited role played by US government debt securities. The US accounts for the largest share of the global financial stock (37 percent). The total US financial stock is now $44 trillion, more than double its size 10 years ago, a growth rate of 8.6 percent a year since 1993, in line with the overall global rate of 8.4 percent. The size of the US financial stock relative to GDP has increased from 179 percent in 1980 to 397 percent in 2003 due to growth in private debt and equity securities. The eurozone is now the second most important region in the global financial stock, following the monetary integration of 12 European countries and the introduction of the euro. The UK acts as Europe's financial hub and is a global foreign exchange hub. In contrast to the US, which is a single market, and Europe, which is in the process of integrating its capital markets, there is little cross-country capital market integration in Asia. Thus, the Asian capital market is largely a sum of the parts-a collection of distinct, national markets. The more developed of these markets have strong links with the global capital market, yet they seek only limited cooperation with one another. Japan is a large though declining player in the global capital market while China is emerging as a force. Korea has a developed economy and India has an untold economic potential but neither of them come close to the size of China's financial stock.


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FOUNDATIONS OF VALUATION

In order to understand the role and work of the investment banker, we need to first have a strong understanding of the foundations of valuation. This helps us to understand why it is that the investment banking industry exists and where investment bankers fit into the bigger picture.


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Part I: Tracking Monetary Value (Accounting) As a perpetuity is built, it becomes necessary to track the financial existence of the perpetuity through time. Accounting is the set of concepts, methodologies, and models that allows us to do exactly that.


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Chapter 7: Accounting for Monetary Value What is Accounting? Accounting standardizes financial information. When thinking about tracking accounts, we can think in terms of an absolute number reported, a roll forward schedule that tracks a change, a driver that creates the change and a % that represents the change. Accounting logic does this for us. Understanding the accounting logic of each line item on the financial statements along with its roll forward schedule and driver that drives the change in the roll forward The accounting logic of each financial statement including IS, BS and SCF and the accounting logic that integrates the three financial statements. Accounting & financial statements go hand in hand. The accounts and their roll forwards create financial statements that tell the story of how new science becomes a benefit stream and then how this benefit stream gets turned into a perpetuity Financial statements drive sources and uses decisions inside and outside the firm Accounting is financial figures in a standardized way allowing for comparisons across companies


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Accounting is a language which was written by FASB and the rules of the language is called GAAP. Presentation of financial information. SEC monitors FASB Accounting rules are always changing consistent with new business models. IFRS is international. US GAAP and IFRS are almost identical Accounting assumptions, 1. Entity separate from owners 2. Entity is a going concern and will continue to exist 3. Can only show measurable phenomena with cash 4. Annual and quarterly filed, calender and fiscal year may be different Accounting Principles: 1. Company's resources are reported at initial historical cost (book value). This undervalues certain assets. Is more conservative. IFRS allows for fair market value (barely any companies do this). 2&3. Accrual accounting driven by revenue recognition and accrual accounting. Dictates when you recognize revenues and expenses. Gaap is accrual. Rev rec not when cash, but when earned and measureable. Matching is for costs, costs associated with making product recorded during same period as revenue generated from product

Revenue earned when product is shipped, matching cost when revenues earned (same period) GAAP wants to give investors a picture of profitable the business is (core profitability). USGAAP has industry specific issues. SCF reconciles accrual accounting to cash accounting

4. Must disclose relevant economic information that is material. FSs, notes and supplementary information Constraints: Assumptions are made Materiality is different across companies (subjectivity) Prepare FSs that are consistent (ex. valuing inventory as LIFO vs. FIFO) Always want companies to operate with conservative bias (ex. historical cost principle)


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Accounts and Accounting In order to track valuation performance of the perpetuity (i..e business), companies create accounts for each item of its financial existence. These accounts are the basis of valuation. Valuation is the basis of actions taken in a capitalist economy. Accounts, Accounting & Excel Excel is the software used to model the accounts of the enterprise and determine the valuation of the perpetuity (i.e. business). Accounting: Accounting is about tracking the changes in the sources & uses of funds hence the double entry system used in accounting where each transaction increases/decreases a source & use. Determining the monetary value of accounts that make up the sources & uses of corporation. Each account has its own roll forward schedule detailing beginning of period, change and end of period.


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Chapter 7: From Accounts to Financial Statements Financial Reporting Requirements: SEC requires filings and are displayed on the website sec.gov Company websites have investor relations sections you can get financials and aggregators like yahoo finance Must file 10k report overview of business and finances. 60 to 90 day filings. Large filer 60 days, smaller 90 days. Specific and requires financial disclosures and is the most detailed. Annual report that is a marketing document and is not the complete 10k vs. the 10k (sec website) 10q is quarterly first 3 quarters. Less detailed but include financials 10k stock options, fixed and intangible assets, debt, future performance expectations, MD&A. 10k audited, 10q is not. Auditors note will note any issues 8k required announcing material significant, ex. acquisition. Within 4 days of event


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14A proxy required with shareholder meeting. Also when requires a shareholder vote. S1 goes public S4 when deal is done for acquisition 20F outside USA, file with SEC in this form 10K: Look through a bunch of 10ks 15 items required in 10k Part I: general information about business Part II: MD&A and financial statements and footnotes Part III & IV: Executive compensation and audit results Edgar is name of SEC database Basic share count is bottom of first page as of filing date Table of contents itemizes the sections Business- company background, business strategy, descriptions of products, markets and distributions, competition, suppliers Selected financial data most important financial highlights, not complete FSs MD&A what happened during the year and what expectations are even at segment level. Analyzing company, read this. Financial statements spend most time here, IS, BS, SCF (analysts) Financial footnotes disclosures The Income Statement: Revenue: First line item on IS Total dollar payments that are recognized by a company over a period Also called sales, net sales, net revenues Called top-line Not all income is revenue. Only operating income is revenue. Anything other than operating income is called Other income (ex. interest income)


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Revenue is all about the recognition principle! Revenue Recognition: Accrual which is dictated by FASB & SEC states that revenue can only be recorded when it is earned and measureable. Cannot record until order is shipped and collection is reasonable. Product and service structure determines when to recognize revenue. Bundled Products: For companies that have bundled products, values must be assigned to each of the components and the components can either be recognized immediately or over several years evenly (ex. software) Long Term Projects: Company has two options on how they will record:

1. Percentage of completion revenue recognized based upon % of work completed during the period

2. Completed contract only when the project is finished

Cost Matching Principle: Expenses should be matched to revenues Accrual accounting = Revenue recognition (when economic exchange occurs) + cost matching to associated revenues Problem is that analysts cannot track what is going on with cash since some revenue and expenses not matched to when cash was actually received or spent. SCF allows you to address this problem. Cash accounting not allowed under GAAP Accrual accounting can lead to revenue manipulation. Subjective assessments to shift revenues from one period to another. Conservative recognition vs. aggressive COGS (Cost of Goods Sold aka Cost of Sales): Direct costs to manufacture (manufacturing) or procure (merchandisers) a good or service to generate revenues Inventory cycles out through the income statement in COGS ex. Manufactured goods inventory (raw material, direct labor, factory overhead associated with manufacturing directly), depreciation of fixed assets directly used in manufacturing


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Costs here recognized only when associated revenue is recognized on IS so not immediate Does not include administrative costs. Business model determines the COGS structure (ex. manufacturing, merchandiser, service provider) Key Question: What is the structure/components of cost of goods sold (COGS)? Determine what type of company we are dealing with and what should be going into COGS. (ex. manufacturing, merchandising, service). Look at the disclosure in the footnotes the 10-k to analyze COGS Can also be called Cost of Revenue or Direct Costs on 10k Management offices are SG&A while salary of factory supervisor (factory overhead) is COGS COGS is all about the matching principle!

Revenues direct expenses (COGS) = Gross profit Gross profit is profit after direct costs (COGS) accounted for. Selling, general & administrative (SG&A): Costs not associated with the direct manufacturing or procurement of goods or services. These include marketing, payroll, wages. Still operating expenses, simply not directly tied to manufacturing. Examples: salaries and commissions of sales people, marketing and advertising, executive salaries, legal expenses May also be called Sales & Marketing or General & Administrative Key Question: What is the structure of SG&A? Look at the disclosure in the footnotes of the 10-k to analyze SG&A Not the engineers associated with developing the product, but rather the sales, marketing and management people. Engineers go in R&D costs Research & development: Costs associated with the building of new products & services (procedures).


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Industries like energy, tech, and healthcare are R&D heavy so they include another line item for R&D Industries that are not R&D heavy may include R&D in SG&A R&D is employees, equipment and facilities in R&D process. EBITDA: Proxy for cash flow. Gross profit SG&A R&D. Or EBIT + D&A. Depreciation & Amortization (D&A): Allocation of costs over a fixed assets useful life to match the benefits of asset (revenues) to cost. Depreciation: If expense is associated with generating revenue for several years, shouldnt that expense be spread out evenly over the useful life of the asset. This annual expense is called depreciation. Productive assets have expenses associated with them that are expensed in the IS over the useful life of the asset due to the matching principle with revenues associated with the productive assets. Depreciation of the asset evenly. Decrease of the book or historical value of the asset. Ex. Fixed assets such as plants and buildings, machinery and equipment, computer software and hardware, furniture and fixtures Land never affects the IS. Benefits more than one year, then depreciation Benefits more than one year, then expensed in COGS In most 10k ISs will not see specific line item for depreciation expense. Depreciation is included in COGS or SG&A depending on whether asset is associated with manufacture/procurement or with selling or marketing. Depreciation taken from SCF Depreciation is a noncash expense IS is a pool tool to track cash position Depreciation methods that companies can use:


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Straight line cost of asset spread evenly over assets useful life. SL depreciation expense = depreciable cost / useful life Depreciable cost = original cost salvage value (what you can sell it for at the end of its useful life) Asset Book Value roll forward: Beginning book value - Depreciation expense = End of period book value Accumulated depreciation tracks the sum of the roll forward changes GAAP and IFRS allow you to use accelerated depreciation methods including: Declining balance Sum of years digits Units of production Majority of companies use straight line since it shows lower depreciation and thus higher profits on the IS Amortization: Allocation of intangible assets costs instead of fixed/tangible assets over life of the asset. Matching principle associated with benefits of the asset that generate the revenue. Amortization expense is how it is recognized on the income statement. Lumped into D&A since identical to depreciation but simply for intangible assets. Ex. customer lists, franchise rights, licenses, patents, trademarks (brand name), goodwill Goodwill and trademark has indefinite useful life, so not amortized Look at 10K disclosures and read through to see what makes up the Goodwill & Other Intangible Assets footnote. Future amortization expenses are disclosed here as well. Non-cash expense


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Expenses associated with internally developed intangible assets such as trademarks and patents are expensed fully when incurred, thus no amortization Not allowed to write up value of intangible assets that are developed internally, so only showing on the balance sheet for acquired intangible assets. Key Question: Should an expense be expensed, amortized or depreciated? Does the expense go in COGS or SG&A? What are the function of the assets (manufacturing vs. marketing)? Trademarks never cycle out through the income statement Other Expenses/Income: Expenses not in COGS, SG&A, R&D or D&A Not tied to core operations Below the line (Operating income)

Operating Profit (EBIT): EBITDA D&A NOW NONOPERATING EXPENSES ON INCOME STATEMENT Interest Expense: Interest expense on debt owed. Regular interest payments Sometimes netted against interest income Revolver cash plug derivative

Interest Income: Interest income on cash balances and investments. Excess cash plug derivative Unusual income/expense: Nonrecurring income associated with sale of business (accounting gain) Nonrecurring expenses restructuring, impairments, write-offs, legal, insurance proceeds Analysts ignore, nonrecurring or unpredictable Income tax expense: Tax liability on IS US GAAP and IFRS Tax expense line is not equal to cash taxes company has to pay


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Because of deferring taxes, cash taxes using tax code from country. US GAAP is calculated using different book rules Companies have to prepare two sets of books (tax and financials) Accounting rules differences: depreciation, rev rec and how losses are treated are differences Current taxes lower, deferred is different. Current is what is actually paid. Net Income: EBIT net interest expense nonoperating income/expense taxes Final measure of profitability Bottom line Net earnings Net profit Shares Outstanding: Number of shares of common stock One unit of ownership Shareholders can vote on matters and receive dividends per share Treasury shares repurchased and nolonger outstanding Basic vs. Diluted Basic is actual shareholders (front cover of companys 10k), more important and useful is diluted shares outstanding (impact of dilutive securities that expand share base, can convert into common stock, potential shareholders must be factored in) Basic earnings per share (EPS): Net income allocated to individual basic shares outstanding Investors analyze net income by EPS Total period profits belong to each shareholder Convertible preferred Diluted EPS: Incorporates the impact of dilutive securities in calculated how much income per share. More important Diluted EPS is more real Analysts, talking about beating EPS expectations Weighted Average: EPS on weighted average basis as shares from options and preferred or repurchases During period of IS average shares Not year ending share count Dividends:


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What to do with net income? Portion of it may be returned to shareholders on quarterly basis Dividend policy set by board of directors Dividend policy discussed in footnotes of 10k Dividends below EPS on IS; what % of profits? What to do with extra cash? Keep and reinvest (acquisitions, CAPEX for growth) Grow cash Pay down debt EBIT & EBITDA: EBIT is operating income Analysts compare performance to other businesses, want operating performance to compare (EBIT), comparing profitability (debt and taxes skew comparability), want to isolate operations of the business (to ignore nonoperating) EBITDA Used more frequently Way to compare company profitability D&A is noncash (Different useful life and depreciation methods, skews comparability) Proxy for cash flow, see more real profits Accrual based profit (EBIT) with taking out biggest noncash measure Not cash flow measure (FCF) Have to go to SCF to add back to operating income D&A buried in COGS or SG&A Not GAAP recognized metric Ideal income statement, D&A would be broken out, could see EBITDA right away Profitability is a corporate arbitrage metric Operating vs. non-operating important for IS Net income, EBIT & EBITDA are profitability metrics Balance Sheet The sources & uses of capital (Double entry accounting) Resources and how they were funded Reports resources on date and time (snapshot), End of period Sources must = uses A = L + E Balance sheet is not market value but historical cost (original) The accounting equation and double entry accounting (sources change, uses must change to balance) Each change on the BS has a cash impact


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Each transaction has a source and use of funds (ex. cash & investment) A framework to track movements on the balance sheet (double entry accounting) records funding source and use of capital Double Entry Accounting: Credit is a source of capital Debit is a use of capital Credit and debit happen for every transaction together (offset eachother) Depicted in accounting as T account, looks like a T, Debits on left as increases in assets, or decreases in L or E Credits on right side decrease assets, or increases in L or E T accounts consolidated into one aggregated table that lists all the transactions together Facilitates understanding of sources & uses BS & SCF connected BS changes over periods shown as changes in SCF items From T accounts to aggregate net change in a line item (ex. Net change in cash, net change in all equity) will be a debit or a credit simply netted against eachother which will balance in the final T account Take the final T accounts for each line item and use it to build a CLOSING BALANCE SHEET. Net debits and credits change each line item in the balance sheet to get CLOSING BS. Net debits and credits act as the roll forward change in the account

Assets: Historical cost reporting of assets Asset is owned, of value and quantifiable/measurable cost Cash money held by company in bank account, US treasury (less than 90 days) Marketable securities stock or debt securities, some interest income (ST investments) Can be aggregated with cash Accounts receivable already delivered products and services (expected payments), customers are invoiced, sales on credit but not received AR is linked to revenue on the IS Inventory finished or unfinished goods, include direct cost of producing the goods. Goods waiting to be sold. Includes cost of producing finished inventory and work in progress (WIP). Inventory cycles out of BS and onto IS as COGS


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Inventory sits on BS, and then when revenue associated with the inventory is sold, matching principle dictates that we recognize the cost of the inventory, this is done as COGS Inventory roll forward = Beginning inventory + purchases of new inventory COGS = Ending Inventory Different inventory costing methods (FIFO vs. LIFO vs. Average Cost): We are trying to figure out the value of the COGS and the amount to Credit inventory assets to decrease them. FIFO Remaining inventory reflects latest cost, inventory cycled through COGS reflects the cost of first inventory LIFO Remaining inventory reflects first cost, inventory cycled through COGS reflects the cost of the latest inventory Average costing (Unit sold/total) x total value of inventory Value COGS amount of inventory depending on the method and then do the same valuing of inventory left on the balance sheet doing the same method (inventory balance after the years operations). Read the footnotes to see the inventory accounting method. It is going to effect what the profitability looks like if there is a period of rising/declining prices for inventory. If prices stay the same, wont matter. With rising prices for inputs, LIFO will show lower profitability and FIFO will show higher profitability, average costing in the middle Doesnt matter which inventory you sell, simply has to do with inventory valuation. US GAAP says you have to disclose what inventories would have been under FIFO method. The difference is the LIFO reserve. LIFO Inventory + LIFO reserve = FIFO Inventory FIFO COGS + LIFO reserve = LIFO COGS Subtract LIFO reserve from LIFO COGS to compare FIFO Marking Down Inventory Inventories cannot be marked up to market value under US GAAP due to conservatism principle. They are carried at historical cost but when the value of the inventories becomes less than the historical cost, you mark them down under the rule of lower of cost of market (LCM). It is called writing them down. The loss is recognized immediately on the IS (debit retained earnings with the


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expense in COGS, other operating or nonoperating expenses, and credit assets, inventory) Prepaid expenses insurance, utilities and rents (benefits as an assets), cash reduced, but expense not recognized, but is listed as an asset due to the accrual accounting principles BS asset, not impact the IS right away Property, plant & equipment Land building machinery used in manufacturing plus transportation and installation PP&E cycles onto IS as depreciation in COGS or SG&A Listed in order of how quickly they can be converted into cash (liquidity) with most like cash at the top and least to the bottom. This forms categories called CURRENT (can convert within 12 months to cash) and LT ASSETS (longer than 12 months) PP&E shows its roll forward of accumulated depreciation PP&E beginning + New PP&E (CAPEX) - Depreciation - Asset Sales - Write downs Ending PP&E Depreciation debits retained earnings since it decreases net income PP&E reported net of accumulated depreciation in balance sheet so it will say Net PP&E on the BS Contra account (negative account) is accumulated depreciation since reducing an asset, net PP&E Write downs need to be recognized immediately on the IS and will be in COGS or SG&A. Required LCM as well like inventory Asset sales: Gross PP&E and accumulated depreciation are removed. If there is a difference, recognize a gain on sale on the IS and thus Credit goes to the Retained Earnings for BS to balance. See this as an OTHER operating or nonoperating line item. Only book value is removed from PP&E.


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UNDERSTAND THE ROLL FORWARDS FOR EACH LINE ITEM IN THE BS Self developed trademarks are not listed as an asset on BS sheet (internally generated) Order of liquidity Value must be easily measurable Intangible Assets & Goodwill (patents, trademarks) Non-physical acquired assets, not self-built non-physical assets Linked to amortization on the income statement Identical to PP&E Accumulated amortization is the offset to intangible assets IA Roll Forward BOP IA + New purchases - Amortization expense - IA sales - Write down EOP IA Goodwill: for acquisitive companies Amount of purchase price over Fair Market Value of the company acquired and represents the intangible value of the business related to brand value Acts as a plug to balance the BS (Debit Goodwill) Goodwill not amortized but tested every year for impairment. The loss is recognized immediately on the IS and Retained Earnings is debited, decreasing it. Goodwill cannot be written up, only written down. Goodwill writedowns means company overpaid for acquisition. Goodwill is an accounting assets. Goodwill rollforward BOP Goodwill + New Goodwill - Impairments EOP Goodwill Liabilities & Equity Sources of capital, how funded resources


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Liability Accounts payable obligations to suppliers that have been purchased but not paid for (unpaid bills on credit) Accrued expenses incurred but not yet paid, employee compensation (ex. year end bonus) Short term debt due in 12 months (maturity) LT debt over 12 months (maturity) Lenders can trigger a bankruptcy if they dont get paid Listed in order of how quickly they are to be paid. This forms categories of CURRENT and LT LIABILITIES (longer than 12 months) Liabilities cycled through the IS as expenses Equity Preferred - priority over common, special stock rights (preferences) Common stock when companies issue shares (capital received) Treasury stock common stock issued then reacquired (contra account, reduction to equity) (roll forward for equity) Retained earnings Total earnings/losses over all time of existence of business Financing through retained earnings How IS Connects to BS Income Statement is connected to the balance sheet through equitys retained earnings account. Any expenses on IS reduce retained earnings (source). Revenues increases retained earnings and thus cash COGS Inventories cycled through IS decrease inventories in Assets on BS, direct labor has cash go down in Assets on BS, depreciation reduces PP&E in Assets on BS SG&A Retained earnings goes down by employee expense, depreciation on selling PP&E reduces PP&E in Assets on BS Interest expense Expense reduces retained earnings, decrease to cash, increase to cash Statement of Cash Flows is the linkage between the income statement and the balance sheet. Retained earnings is the link between the B/S and the I/S. Get D&A from SCF (CF from Operations) and CAPEX from SCF (CF from Investing) From Accounts to Financial Statements:


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Once monetary values for each account are determined via roll forward T accounts, the financial statements are then pulled together and are the output of the financial reporting process. Financial Statements: Balance sheet: Sources & uses of capital snapshot (PV outlay) Income statement: Return on uses of capital over the period (FV inflow) Statement of cash flows: Change in sources & uses over the period Example of Financial Statements: Get comfortable finding, reading, analyzing and spreading historical financial statements into financial statement models The following is a 10-K from Berkshire Hathaway:


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The following is the IS from Berkshire Hathaway:


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The following is the BS from Berkshire Hathaway:


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The following is the SCF from Berkshire Hathaway:


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The following is the MD&A on the 10k from Berkshire Hathaway:


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Part II: Analyzing Monetary Value with Models (Finance) As the economic existence of the perpetuity continues to grow, one becomes interested in the value of the perpetuity. Enter finance, whose concepts, methodologies, and models allow us to understand the valuation of the perpetuity.


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Chapter 8: Analyzing Financial Statements Structure and contents of financial statements generated by corporations

Finding financial reports: at SEC.gov (click find filings) or on company

websites (Investor Relations) or with data services like Yahoo Finance,

Google finance (free), Capital IQ, Factset or Bloomberg (paid)

The financial statements that are used to build financial statement models

(common analyses):

10-K: Annual financial statements, latest share count on front cover, select

financial data, detailed footnotes, MD&A


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Chapter 8: From Financial Statements to Finance From Accounts to Models To go from accounts (accounting) to a finance number we first need to gather historical financial performance of the company in financial statements and then spread the historical financial statements into a model and then use the projected model in excel interlink the accounting logic of the corporation. Modeling in Excel Just like our account statements, our models are built and exist in Excel


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Chapter 8: Time Value of Money Time value of money means that a dollar today is worth more than a dollar

tomorrow. Money can earn interest, so in order to move monetary value

through time or assess monetary value at different time periods, we need to

incorporate this interest rate. If we are moving values forward through time,

we are future valuing the amount by compounding it. If we are moving values

back in time, we are present valuing the amount by discounting it. The rate

at which we move, r, is referred to as the discount rate, and resembles the

risk associated with the monetary amounts (cash flows, CFs).

PV = present value

FV = future value

Interest rate (r) = discount rate

Perpetuity = type of investment with variable interest rate r (IRR)

NPV - total increase in today's dollars by undertaking a project, corporate

arbitrage amount

IRR - implied interest rate between a PV payment and FV receipt, when

compared to the discount rate, also shows the arbitrage amount


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Chapter 8: Analyzing Monetary Value with Models Analyzing Value Strategics, financials, and entrepreneurs undertake investment with the expectation of NPV & IRR. They accept projects that have positive NPV and IRR higher than the cost of capital. They actively find and structure positive NPV projects and then match financial products to them. The positive NPV project is ideally a perpetuity with the value of the business being the perpetuity value: Perpetuity value = CF / Discount rate Calculating NPV & IRR is the main analytical work of finance. *Growth statistic CAGR (Compound Annual Growth Rate) is yearly IRR Analysis of Account Statements Analysis of account statements (ratio of analysis) has various uses including from a liquidity perspective, commercial bank perspective, activity perspective, profitability perspective, and growth perspective. Ex. 4x-7x debt multiple for lending purposes The following is the adjusted financials for Berkshire Hathaway:


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We only use Free Cash Flow to determine valuation for major transactions in a capitalist economy including restructuring, growth, M&A, and capital raising. To go from account filings to models, we need to clean the numbers, scrub the financials, normalize the financials. This amounts to recasting accounts to get to a finance number. We try to get to a finance number to get to a valuation. We get to a valuation to then take actions in a capitalist economy. *We want more add backs to get to a higher valuation Modeling After getting valuation, we can then model the different actions we can take in a capitalist economy to increase the valuation of the strategic, financial or entrepreneurial firm.


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Part III: Modeling Monetary Value Continuing deeper into the field of finance we now discuss the actual work associated with understanding the value of a perpetuity. The work is done by modeling the perpetuity in Excel.


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Chapter 9: Excel for Finance

Express your decisions using Excel. Excel is the premier business computational tool Implement financial analysis using the tool for financial analysis, Excel Valuation process Heart of finance is time value of money and discounting Excel Concepts Needed for Finance Write down variables (defining the parameters of the decision) Absolute or relative values copying (=A1) (=$A$1) and formulas Functions (=fx( )) Data tables (sensitivity tables) Express Decisions with Excel Implement financial analysis with Excel

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