Book Summary: "How Finance Works" by Mihir A. Desai

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Financial Analysis

Large cash holdings can generally be understood as (a) an insurance policy during uncertain times, (b) a war chest for making future acquisitions, or (c) a manifestation of the absense of investment opportunities.

Companies invest much of their cash in government securities that can quickly be turned into cash - so-called marketable securities.

Accounts receivable are amounts that a company expects to receive from its customers in the future. As trust grows in a relationship between a company and its customers, the company might be willing to allow customers to pay later.

Inventories are the goods (or the inputs that become those goods) that a company intends to sell.

“Property, plant, and equipment” (PP&E) is the term for the tangible, long term asset that a company uses to produce or distribute its product.

Other assets can mean many things, but are likely to be intagible assets - things like patents and brands. When a company acquires another company for more that the value of its assets on their balance sheet, that difference is typically recorded on the acquiring company’s balance sheets as goodwill.

Liabilities represents those amounts financed by lenders to whom the company owes amounts; shareholders’ equity, or net worth, curresponds to the funds that shareholders provide.

Accounts payable represent amounts due to others, often over a short time, and typically tothe company’s suppliers.

Sometimes firms may have notes payable, a short term financial obligations.

Accrued items broadly represent amounts due to others for activites already delivered. One example is salaries.

Unlike other liabilities, debt is distinctive because it has an explicit interest rate.

Shareholders’ equity represents an ownership claim with variable returns - in effect, the owners get all residual cash from the business after costs and liabilities.

Preferred stock is often called a hybrid instrument because it combines elements of both debt and equity claims. Like debt, a preferred dividend can be fixed and paid before common stock dividends, but like equity, preferred stock is associated with ownership and is paid after debt in the even of bankruptcy.

Ratios make numbers meaningful by providing comparability across companies and through time.

Liquidity refers to the ability of a company to generate cash quickly. If all your assets are in real estate, you are illiquid. And if all your wealth is in your checking account, you’re highly liquid.

Most companies go bankrupt because they run out of cash. Liquidity ratios measure this risk by emphasizing the company’s ability to meet short-term obligations with assets that can quickly be converted into cash.

Profit Margin = Net profit / revenue

Gross profit only subtracts the expenses related to the production of goods from revenue, while operating profit also subtracts other operating costs, such as selling and administrative costs. Net profit also subtracts interest and tax expenses from operating profit.

Return on Equity (ROE) = Net profit / shareholders’ equity (ROE measures the annual return that shareholders earn.)

EBITDA Margin = EBITDA / revenue EBIT is operating profit (earnings before interest and taxes) Since some companies have different tax burdens and capital structures, EBIT provides a way to compare their performance more directly. DA stands for “depriciation and amortization.” Depreciation refers to how physical assets, such as vechicles and equipment, lose value over time, and amortization refers to that same phenomenon, but for intangible assets.

Just as lever lets you move rock your couldn’t otherwise move, leverage in finance allows owners to control assets they couldn’t control otherwise. Managing leverage is critical because it enables you to do things you couldn’t otherwise do and because it magnifies your returns - in both directions. Debt to assets = Total debt / total assets Measures the proportion of all assets financed by debt. It provides a balance sheet perspective on leverage.

Debt to Capitalization = Debt / debt + shareholders’ equity The ratio of long-term debt to capitalization provides a somewhat more subtle measure of leverage by emphasizing the mix of debt and equity. The denominator in this ratio is capitalization—the combination of a company’s debt and equity.

Assets to Shareholders’ Equity = Assets / shareholders’ equity This ratio tells us precisely how many more assets an owner can control relative to their own equity capital.

Interest Coverage Ratio = EBIT / interest expense Measures a company’s ability to fund inter- est payments from its operations and uses only data from the income statement.

Productivity ratios measure how well a company utilizes its assets to produce outputs. Over the long run, increases in productiv- ity are the most important contributor to economic growth.

Asset Turnover = Revenue / total assets This ratio measures how effectively a company is using its as- sets to generate revenue.

Inventory Turnover = Cost of goods sold / inventory Inventory turnover measures how many times a company turns over or sells all its inventory in a given year.

Days Inventory = 365 / inventory turnover Provides the average number of days a piece of inventory is kept inside a company before it is sold.

Receivables Collection Period = 365 / (sales / receivables) The lower this figure, the faster a company is getting cash from its sales.

The DuPont framework breaks ROE algebraically into three ingredients: profitability, productivity, and leverage.

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If shareholders bear more risk, they’re going to deman a higer return. So capital markets and the competition across companies drive returns to shareholders together and risk drives them apart.

Return on capital = EBIAT / (debt + equity) It considers both capital providers and their combined return.

The Finance Perspective

Cash is the most important. Your capacity to transform your business into cash that you can use to finance your activities, repay your debt or distribute to your shareholders is the key.

EBIT Equation = Net profit + interest + taxes Operating profit gives a clearer view of how efficient and profitable a company is relative to new profit.

EBITDA Equation = Net profit + interest + taxes + depreciation and amortization

Operating Cash Flow Equation = Net profit + depreciation and amortization - increases in accounts receivable - increases in inventory + increases in unearned revenue + increases in accounts payable It considers the costs of working capital, and it accounts for tax and interest paymetns by beginning with net profit.

Working capital = current assets - current liabilities

The equation for calculating free cash flow provides a measure of the amount of cash flows truly unencumbered by the operations of a business. free cash flow

Every time you have to wait a year, you “haircut” future cash flows by one plus the interest rate, because that’s what you would have earned if you hadn’t had to wait. Discounting Formula: Cash flow / (1 + r) r = discount rate, the interest you could receive by making that relevant alternative investment.

The present value of any investment is the sum of all future cash flows discounted back to the present using an appropriate discount rate.

The emphasis on cash explains why companies that generate profits but no cash might be unsustainable and why companies that generate no profits but lots of cahs might be valuable. Cash earned today is more valuable than cahs earned tomorrow because of the opportunity cost of capital.

The Financial Ecosystem

The analyst’s job is to value companies by creating forecasts and then make recommendations to investors.

Exchange of information is one of the first key insights about capital markets - often, their interactions take the form of trades, and these trades may not only be in capital. Often, these trades are for information or knowledge.

Institutional investors are simply entities that invest large amounts of capital on behalf of others and allocate it in ways that feel will best support their clients.

Mutual Funds manage money on behalf of individuals and invest those funds in diversified portfolios of stocks and bonds.

Pension Funds are large pools of money that represent the retirement assets of workers from a particular company, union, or government entity.

Foundations and endowment funds. Not-for-profit foun- dations and organizations sometimes retain and invest funds over long periods to create more stability for their operations.

Sovereign wealth funds. Countries with excess savings often invest those savings through a sovereign wealth funds.

Hedge funds are similar to mutual funds, they are differentiated by their lower level of regulations and use of leverage and their different approach to managing risk.

“Going log” means you buy the stock. To short a company’s stock, you borrow shares from another investor, such as mutual fund, that charges fee for lending the shares to you. Once you’ve bor- rowed the shares, you sell them. At some point in the future, you buy back the shares (hopefully at a lower price) and return them to the institutional investor whom you borrowed the shares from.

Traders make money largely from the gap known as the bid-ask spread.

Salespeople sell financial instruments to investors on the buy side

Investment bankers work with companies that either want to raise the capital or want to buy or sell operating assets.

Managers and owners engage in a complex communication game where every signal coming from a manager is reevaluated with suspicion in the background.

Stock buybacks can send a powerful signal of confidence from the managers who know more that the investors.

Sources of Value Creation

Book value is an accounting of the capital that shareholders have invested in a company. Market value measures how much a company is worth according to the financial markets.

If the ROE is the same as the cost of capital, nothing else matters—the company is not creating value.

Beating a cost of capital is all about creating a competitive advantage through innovation. Keeping the gap open between returns and costs of capital for longer periods is what barriers to entry, brands, and intel- lectual property protection are all about. Finally, reinvesting more profits is all about growing an opportunity through ex- pansions, adjacencies, or integration.

The weighted average cost of capital, or WACC, is the most common way to discount future cash flows WACC

Debt has a fixed return, the cost of capital* is simply the interest rate that a lender will charge you when you are undertaking a project. **The risk-free rate. Investors will demand, at a minimum, the rate on a risk-free investment; this idea of a risk-free invest- ment is approximated by the interest rate on government se- curities such as US Treasury bonds.

A credit spread reflects the additional cost associated with the riskiness of the debt.

The relative use of debt and equity in a company is referred to as its capital structure.

Firms from different industries will have different capital structures that reflect a trade-off between tax benefits and the costs of financial distress associated with that underlyinhg industry.

When a company fails, debt holders get paid first and equity holders may get nothing. So equity holders are in a considerably riskier position. As a consequence of being in a riskier position, they’re going to demand a higher return.

Every security’s risk is not measured by how much it moves around in general but rather by how much each stock moves with the market, which represents the riskthat will never by diversified away.

The measure of how a stock moves with the market is called a beta.

Active investment management is all about pursuing assets that deviate from the line and deliver more than the expected return. This gap is called alpha.

The Art and Science of Valuation

A multiple is a ratio that compares the value of an asset to an operating metric associated with that asset.

A common multiple used in valuations is the price-to-earnings, or P/E, ratio, which divides a company’s stock price by its earnings per share.

Because firms may grow earnings at very different rates and because companies might be judged to have earnings that vary in quality, the P/E ratio can vary across companies within an industry.

By taking a multiple from one company and slapping it on the other, you’re assuming the growth trajectories and quality of earnings are fundamen- tally similar, and that could be a mistake.

Everyone involved in the transaction wants the transaction to happen and may subtly change assump- tions or forecasts to help make that outcome a reality. As a result, this sea of unbalanced information leads to overpay- ment and overconfidence.

The problem with synergies is that people tend to overestimate how quickly those synergies will work an overestimate the magniute of their effects.

Capital Allocation

The capital allocation decision tree

You need to calculate the net present values of a number of options in order to identify the best value-creation opportunities.

The lure of mergers and acquisitions as opposed to organic investment is often the apparent speed of buying existing as- sets instead of taking the time to build those assets.

Six major mistakes in capital allocation:

  • Delaying decision making.
  • Trying to create value through share buybacks.
  • Preferring acquisitions over organic investment because acquisitions are faster and safer.
  • Preferring buybacks over dividends because buybacks are discretionaty while dividends are not.
  • Preferring to reinvest cash to build a larger business.
  • Excessive distribution of cash to satisfy short-term shareholders.

Conclusion

Capital markets and finance are all about informa- tion and incentives, not money. Finance, at its heart, is trying to solve the deepest problem in modern capitalism—the principal-agent problem, or the sepa- ration of ownership and control.

Capital allocation is the most important financial problem facing a CFO and CEO. The question of when to distribute or reinvest cash, whether to grow organically or inorganically, and whether to distribute via repurchases or dividends can occasion tremendous value creation or destruction.

All value comes from the future, and today’s values reflect expectations of that future value creation. Value creation can only arise from earning returns above and beyond the cost of capital for long periods and rein- vesting cash flows at those higher returns.

Return on equity (ROE) is a critical measure of per- formance, and these returns are driven by profitability, productivity, and leverage. Analyzing financial perfor- mance requires a comparative and relative framework; no number is meaningful without reference to an- other and without considering industry and temporal dynamics.

The idea of profitability is incomplete and problematic because it detracts from the idea of cash. Economic returns are better measured by cash; there are many ways to measure cash—EBITDA, operating cash flow, and, most usefully, free cash flow.

Valuation is an art, not a science; it is an art in- formed by science, but the most critical elements of it are subjective, and the process is prone to error. Be mindful of the hidden biases inherent in the process, especially the allure of synergies and the incentives of advisers.

Returns should correspond to risks, and risks need to be considered in the context of diversified portfolios. Excess returns are hard to earn, and it’s difficult to ascertain whether you’ve ever earned them.

Managers are the stewards of capital for their capital providers. Delaying the return of capital must be associated with commensurate rewards to compensate for the delay and the risks borne by owners.

Returning cash to shareholders and various other financing decisions alone won’t create or destroy value. The significance of these decisions arises from the informational problems between managers and capital markets and other imperfections.

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