Preface to the Third Edition

Investment Banking: The Dream Begins is for people who want to understand value. This book can help you get your arms around the many tasks and variables involved in effective valuation of a company and help you decide what kind of help you should enlist to complete a deal.

Whats New About the Third Edition?

Firstly, the third edition of the book has a new Subtitle The Dream Begins!!! Then the book has been thoroughly revised and restructured. The book has been divided in four major parts with Part I focuses on introduction to investment banking and discusses in detail about the offerings of investment banking entities with special focus on equity offerings. It too discusses the private equity in depth. Part II discusses the financial statements, segregating operating and non-operating items to determine the core operating profits of the entity, articulation of financial statements and the key ratios to analyse the financials of the company. Part III discusses the reasons valuation happens in a business, and the various valuation tools used by investment bankers. And the last part of the book offers a step-by-step guide for analyzing and valuing a company in practice. Among the many ways to value a company, this part focuses particularly on valuation based on comparable companies and deals Relative Valuation. The book acts as the first guide to the capital markets aspirants and as a useful resource and reference for the capital market participants who quickly wish to learn the valuation of companies or refine and fine-tune their skills and compare the companies on fundamental basis for mergers, acquisitions, private equity investments, etc. This book is also highly beneficial for investment banking trainers providing various training programmes on valuation of companies. I have tried to keep the book as simple as possible and have tried to explain the concepts in the plain vanilla language in such a way that you can easily apply them on your own. This book tries to fulfil an important need as a valuable training material and reliable handbook for finance professionals. Stay with it, and I believe the payoff for both beginning and experienced professionals will be huge.

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Contents at a glance
Part I Investment Banking
Chapter 1 Chapter 2 Chapter 3 Chapter 4 The Origin of Investment Banking The Business of Investment Banks Equity Offerings & Exits Private Equity 25 35 49 65

Part II Financial Statements

Chapter 5 Chapter 6 Chapter 7 Understanding Financial Statements Cleaning of Financial Statements Analysing Financial Statements Part III Valuation Valuation Overview Part IV Relative Valuation Comparable Company Analysis Comparable Deals Analysis Part V Excel Shortcuts 85 133 151

Chapter 8

181

Chapter 9 Chapter 10

205 253

267

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Part I - Investment Banking

Chapter 1: The Origin of Investment Banking
1.0 1.1 1.2 1.3 1.4 Introduction The First Investment Banks Regulatory Environment The Recession of 2008 Investment Banking Post Financial Crisis 25 26 28 29 30

Chapter 2: The Business of Investment Banks

2.1 2.2 2.3 2.4 2.5 2.6 What is Investment Banking What Investment Banks Do? Investment Banking Hierarchy Functions on Investment Bank Fund Raising Via Private Equity Initial Public Offerings (IPOs) 36 37 37 38 42 42

Chapter 3: Equity Offerings & Exits

3.0 3.1 3.2 3.3 3.4 3.5 3.6 Introduction Instruments Involved In Equity Offerings Parties Involved In Equity Offerings Initial Public Offerings (IPOs) Book Building IPO Process Delisting of Shares IPO Activity in India 49 50 50 52 54 58 60

Chapter 4: Private Equity

4.1 4.2 4.3 4.3 4.4 4.5 What Is Private Equity How Private Equity Works Need for Private Equity Investments What Private Equity Firms Look For Private Equity Process Private Equity in India 65 69 70 73 74 78

Investment Banking
The Dream Begins

Part II - Financial Statements

Chapter 5: Understanding Financial Statements
5.0 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 Introduction Sourcing the Financial Statements Location of Company Reports Understanding Financial Statements Statement of Financial Position Income Statement Statement of Comprehensive Income Statement of Cash Flows Statement of Shareholders Equity Articulation of Financial Statements 85 86 88 89 95 111 118 120 126 127

Chapter 6: Cleaning of Financial Statements

6.0 6.1 6.2 6.3 6.4 6.5 6.6 Introduction Sourcing Non-operating Expenses and Onetime Charges Typical Non-operating Expenses and Onetime Charges Special Items Clean/Adjusted Profits Adjusted Capital Using Clean or Reorganised Financials 133 134 135 137 141 144 147

Chapter 7: Analysing Financial Statements

7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 Introduction Measuring Performance with Ratios Categories of Ratios Liquidity/Short Term Solvency Ratios Capital Structure and Coverage Ratios Turnover Ratios/Resource Management Profitability Ratios Application of Ratios in Evaluating Performance and Decision Making 151 152 152 152 155 159 162 175

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Investment Banking
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Part III - Valuation

Chapter 8: Valuation Overview
8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.10 8.11 8.12 Introduction Approaches to the Business Valuation The Assets Approach Comparable Company Analysis Comparable Deal Analysis Discounted Cash Flows Leveraged Buyouts Breakup Analysis +VEs and VEs of Valuation Methodologies Is There A Best Valuation Tool? Which Method Results in the Highest Valuation? 182 183 184 185 186 187 188 189 193 195 198

Part IV - Relative Valuation

Chapter 9 : Comparable Company Analysis
9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 Introduction Why Trading Comps Tool is Popular Uses of Trading Comps Steps for Trading Comps Valuation Tool Step I: Selection of Peer Group Companies Step II: Calculate Enterprise Value Step III: Making Financials Comparable Step IV: Calculate Multiples Step V: Benchmarking & Valuation Sourcing the Information for Trading Comps Summary of Multiples Is Comparable Valuation Better than DCF 206 206 209 209 210 212 222 231 239 245 246 250

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Investment Banking
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Chapter 10: Comparable Deals Analysis

10.1 10.2 10.3 10.4 10.5 10.6 10.7 Introduction Steps for Deal Comps Valuation Tool Step I: Selection of Comparable Deals Step II: Calculate Enterprise Value Step III: Source Key Financials Step IV: Calculate Multiples Step V: Benchmarking and Valuation 253 254 256 257 261 262 263

Part V - Excel Shortcuts

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Investment Banking
The Dream Begins

SNAPSHOTS FROM 3RD EDITION

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Investment Banking
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1.4 INVESTMENT BANKING POST FINANCIAL CRISIS

The recovery of investment banking industry has been as dramatic as its decline. At the start of 2009, the worlds banks and brokers were in a deep hole. They had recorded some US$1 trillion in credit losses and write-downs of their mortgage holdings in the financial crisis of 2007 and 2008, and markets were still reeling. The sky cleared in the second half, making 2009 a year of recovery. By the year-end, the Stock indices across the world shot up by more than 50%, which helped trigger a flood of fund raising (new stock and bond issues) and M&A activities. The year 2011 witnessed investment banks generating a total fee of $81 billion, almost consistent with 2010 level. JP Morgan ($5.5 billion), Bank of America Merrill Lynch ($4.9 billion) and Morgan Stanley ($4.1 billion) were the leading investment banks in 2011; Goldman Sachs ($3.91 billion) fell to #4, out of top 3, for the first time on the overall investment banking fee basis. Exhibit 1.1: Top Investment Banks (Fee Collection Basis)
(In $ Million)

CY Dec11 Fee Rank 1 2 4 3 7 5 6 8 9

1H June12 Fee 2,395 1,988 1,727 1,652 1,547 1,490 1,448 1,323 923 Rank 1 2 3 4 5 6 7 8 9

JP Morgan Bank of America Merrill Lynch Goldman Sachs Morgan Stanley Citi Credit Suisse Deutsche Bank Barclays UBS

5,518 4,920 3,908 4,052 3,140 3,398 3,184 2,799 2,358

The year 2012 started on a bad not in terms of investment banking fee with the total fees declining to $33.94 billion in the first half of 2012, down by 23% compared with the year ago period. JP Morgan maintained its lead position in the first six months of 2012 with total investment banking revenues of $2.4 billion. Bank of America Merrill Lynch was at second position with total fee of $1.99 billion. Goldman Sachs re-entered in the list of top 3 with total revenues of $1.7 billion ahead of Morgan Stanley. In terms of investment banking products, Bonds and Equity Markets was lead by JP Morgan, M&As by Goldman Sachs and Loans by Bank of America Merrill lynch. Investment banks faced decline in number of deals and fees in almost all parts of the world in the first six months of 2012 with the exception of Japan where M&As and Debt markets became stronger compared with year ago period.

2.4 FUNCTIONS OF INVESTMENT BANK

They say that money makes the world go round. And, if it does, investment bankers help direct and facilitate its flow. Investment banks provide a wide range of financial services to clients. They structure M&A deals, raise capital (equity or debt) to help companies grow, analyse the prospects of listed companies, and trade in securities on behalf of clients.

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The core functions of investment banking include Raising Capital Sales and Trading of securities Mergers & Acquisitions Research

2.4.1 Raising Capital

The need to raise capital in business lead to the birth of Investment Banks. Investment banks raise capital either through equity markets or debt markets. Money from equity markets is raised primarily in form of private equity investments, seed funding, block trades, initial public offerings (IPOs) and follow public offerings (FPOs), while from debt markets it involves money raising in form of bonds, mortgage-backed securities and asset backed securities. From just raising money, the role of the investment banks, in recent times, involves advisory on optimum capital structure. To act as intermediary between issuers and investors To provide access to equity and fixed income capital To create specialized securities and derivatives Steps in raising capital Financial & Valuation Modeling Preparation of Pitch Book Organizing road shows and investor meets Due Diligence Facilitate transaction (valuation and stake to be diluted, structuring of deal) Collection of fee by Investment Bankers

4.1 WHAT IS PRIVATE EQUITY

Private Equity is a form of investment in equity capital of a company that is not quoted on a public exchange. In other words, private equity investments are normally focused towards unlisted entities that cannot or do not want to raise equity in public markets (via IPO route) in near future. Obtaining PE is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of your success or failure. Two important features of private equity investing include Its About Capital: Private equity investing means putting capital into a business to expand, develop new products or fund changes to ownership and management. Private equity investors do more than buy the rights to share in a companys return they provide working capital. And More Than Just Capital: PE investors generally provide their capital in exchange for a sizeable stake in the business. They also invest their expertise in management, finance, marketing, strategic direction and networks. By exercising some control through board seats and management agreements, PE investors can protect and grow their investments. This alignment of interests and the ability to add value to the business often means that PE investors can generate higher returns than those available from traditional hands-off equity investing.

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4.1.1. Different Equity Funding Stages

Equity investing is often divided into the broad categories described below. Maturity of Company -- Seed Stage Start-up Stage Expansion Stage VC & PE Replacement Capital Buyout

Angel Investments

Private Equity

For the purpose of this chapter, PE is the universe of all venture and buyout investing, whether such investments are made through funds, funds of funds or secondary investments. Seed Stage: Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase. Start-Up Stage: Financing for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their products commercially and will not yet be generating a profit. Expansion Stage: Financing for growth and expansion of a company, which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. This stage includes bridge financing and rescue or turnaround investments. Replacement Capital: Purchase of shares from another investor or to reduce gearing via their financing of debt. Buyouts: A buyout fund typically targets the acquisition of a significant portion or majority control of businesses, which normally entails a change of ownership. Buyout funds ordinarily invest in more mature companies with established business plans to finance expansions, consolidations, turnarounds and sales, or spinouts of divisions or subsidiaries. Financing expansion through multiple acquisitions is often referred to as a "buy and build" strategy. Investment styles can vary widely, ranging from growth to value and early to late stage. Furthermore, buyout funds may take either an active or a passive management role.

5.4 STATEMENT OF FINANCIAL POSITION

SFP or Statement of Financial Position (Popular as Balance Sheet) is the core of the financial statements. All other statements either feed into or are derived from the Statement of Financial Position. SFP gives a snapshot of the companys financial position at a given point of time showing the resources available to the management and the claims against those resources by creditors and shareholders. Of the three basic financial statements (Income Statement, Statement of Financial Position, Statement of Cash Flows), Statement of Financial Position is the only statement, which applies to a single point in time of a business' fiscal year i.e. Statement of Financial Position is always as on date and not for any period. E.g. Cash is always as on date, i.e. the company has xxx million cash as on 31 December 2012. One cannot say that the company has cash of xxx million for 12 months ending 31 December 2012. The Statement of Financial Position is just like a photograph: It represents, at a moment in time, the financial position of the business entity. Statement of Financial Position is divided into three sections: Assets, Liabilities and Shareholders Equity.
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Statement of Financial Position Assets = Liabilities + Equity

Resources of the Business

Amounts owed to the outside Capital provided by owners creditors Current Liabilities (short term loans, outstanding expenses etc.) Non-current Liabilities (long term loans, pension obligations etc.) Contributed Capital (share capital issued, securities premium) Earned Capital (Retained Earnings)

Current Assets (cash, debtors, inventories etc.) Non-current Assets (property, plant, machinery, investments, intangibles etc.)

Why analyze a statement of financial position? Its the entry point to the inner financial workings of a company. The numbers contained in this statement give important smoke signals of whether business is doing good or sliding into trouble.

6.0 CLEANING FINANCIAL STATEMENTS

Cleaning or Adjusting the reported numbers sounds a little strange, doesnt it? Well, its not. Rather it is the essence of the science of valuation. To analyze and compare the companies, it is appropriate to add or remove various financial data or apply various computations to get a true economic picture of the business. Adjusting is what analysts and business valuation professionals do to fully examine assets and companies as a whole. Historical financial statements should reflect the true operating performance of the company, so that the numbers can be used for valuation and comparison purposes. However, the reported financials may include some non-operating income or expenses and some exceptional gains/incomes or losses/expenses. Therefore, the historical financials need to be adjusted for those items that, in the analysts judgment, distort the true operating performance of the business. Reported numbers need to be cleaned, else they may lead to distorted valuations. Cleaning the reported numbers is a process to see what would have been the profits of the company, if those exceptional items (expenses/losses/incomes/gains) were not there. The objective of cleaning or normalizing historical financial statements is to present the data on a basis comparable to that of other companies in the industry, thereby allowing the analyst to form conclusions as to the strength or weakness of the subject company relative to its peers. There is no exclusive list of such extraordinary or non-operating items; however, typical examples include restructuring charges, litigation charges, impairment of assets, penalty charges, losses due to floods or earthquakes or fire, losses due to strikes, insurance claims, losses or incomes from discontinued operations, and loss or gain on sale of assets.

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8.2 APPROACHES TO THE BUSINESS VALUATION

There is no one way to establish what a business is worth. That's because business value means different things to different people. There are numerous ways to value a company. In determining value, there are several basic analytical tools that are commonly used by financial analysts. The methods, to value a company, have been developed over several years of research and refinement and are based on financial theory and market reality. However, these tools/methods are just the tools/methods and should not be viewed as final judgment, but rather, as a starting point to determining value. There are three major approaches to value a company; with each approach has different methodologies to values a company. Approached to the business valuation can be categorized as below: The Asset Approach (The Cost Approach) This valuation approach is based on finding the fair market value of assets and deducting the liabilities to determine the net asset value or net worth of the business. Simply, it aims to value an entity by valuing its assets on a carry value, replacement value or liquidation value basis. The Market Approach This valuation approach compares a target company with the similar/comparable companies. One can make comparisons to publicly listed companies or actual sales transactions for similar businesses. The two most important valuation methodologies include: Comparable Company Analysis Comparable Transactions Analysis

The Income Approach This valuation approach focuses on the future economic benefits you are anticipating from a business. The amount is expressed in todays value or as known as present value. Simply, the income approach aims to discover value of an entity through its income metrics like Net profit or Free Cash Flows etc. The two most important valuation methodologies, here, include: Enterprise Discounted Cash Flows (DCF(f)) Equity Discounted Cash Flows (DCF(e)) Discounted Dividends (DDM)

One must note that there is always a difference between an approach and a method to finding the value of a particular business. Think of an approach as the highway you need to get to the right city and think of a method as a way to get to the right address. Each approach has different methods. We explain the most popular ones in this book.

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8.11 IS THERE A BEST VALUATION TOOL?

Simply put, there is nothing like best valuation tool for valuation of companies. Choice of the relevant valuation tool depends on circumstances and the purpose of valuation. The best valuation tool depends on: (a) Investment horizon (Short-term or Long-term) A short-term investor is typically interested in determining fair value between quarterly results. Although DCF provides an intrinsic value, in the short run, share prices may be very volatile and DCF will not help such an investor in any way. Hence, short-term investors rely primarily on trends, sentiments and news to determine valuation. These factors are best captured in the Comparable Company Analysis Valuation Tool. A long-term investor on the other hand will rely more on DCF Valuation Tool. (b) Investment Type (Financial or Strategic) Financial investments are made in the secondary markets with the idea of liquidating the investment in short run instead of generating regular returns from the capital itself. Strategic investments are the ones made as part of Corporate Finance. The funds involved & risk involved is more intense, hence primary research is accrued out. For a Financial Investment one may choose a market based valuation approach. However, in case of strategic investments one should prefer on income based approach backed by an asset valuation. (c) Market Conditions (Bullish and Bearish Markets) Different market conditions mean different valuation strategies and hence different methodologies. In a bull run, analysts normally shift to comparable valuation from DCF valuation believing that DCF fails to capture that the market as a whole has moved to a higher level. In a bull-run, comparable valuation offers you the higher valuation range comparable to DCF. And in a bearish run, analysts prefer DCF valuation claiming that the comparable tool understates the valuations. (d) Purpose of Valuation (IPOs, M&A, Distressed Companies etc.) Purpose of valuation derives the valuation methodology to be used by the analysts. For example, for valuation of companies going public i.e. for IPO Valuation, it is best to use DCF as it determines the intrinsic value. However, not many will want to use it individually as it is likely to understate value as against Comparable valuation. Hence most IPOs come out in bull markets where valuations are already stretched and Comparable Valuation will result in higher values as compared to DCF.

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9.4 STEPS FOR TRADING COMPS VALUATION TOOL

In the coming pages, we will use the highly practical, step-by-step approach to perform relative valuation consistent with how it is used in real world by the analysts across the globe. This step-by-step approach is followed in almost every investment bank, research house, brokerage houses, etc. No. Step Selection of Right Set of Peer Group Companies Details Companies from the same sector to be picked for comparison Look at the key characteristics like size, products and services offered, geographical concentration, profitability, etc. Enterprise Value (EV) of the selected peers after considering convertible securities The Calculation of Financials for the Last Twelve Months (LTM) or Trailing Twelve Months (TTM) Clean the reported financial numbers adjusting exceptional or non-operating items Multiples based on Enterprise Value and Equity Value Benchmark the multiples derived Determine valuation of target appropriate benchmarked multiple based on

II

Calculate EV

III

Clean Financial Numbers Calculate multiples

IV

Benchmarking and Valuation

9.6 STEP II: CALCULATE ENTERPRISE VALUE

Enterprise Value (EV) is the effective cost of a company (at a given point of time) if someone were to acquire it. EV is simply the market value of a company from the viewpoint of the aggregate of all the financing sources: debt holders, preference shareholders and equity shareholders. In other words, it measures how much you need to fork out to buy an entire company. It is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, etc. Market Capitalization of a company tells you how much you are paying to the equity holders, while Enterprise value tells you that how much it will cost you to buy the entire company. EV is what it would cost you to buy every single share of a companys common stock, preferred stock, and outstanding debt. EV is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.

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9.9.1 Preference of Multiples

There has been an ongoing debate as to which multiple is used in which situation. There is no fixed answer to it. However, we can make a note of the following: EV/Sales multiple is a preferred multiple in case of the young companies, which do not have an established history of profits. For example while comparing the start-up companies, multiples based on EBIT or EBITDA might be meaning less if the companies are reporting losses. In such cases, one is left with two multiples EV/Sales and EV/Operating Metric. Amongst profit multiples (EV/EBIT and EV/EBITDA), the multiple of EBITDA has preference in case of capital intensive industries like manufacturing, oil & gas, industrial goods, telecom etc., as the amount of depreciation and amortization figure will have a huge impact on EBIT. And in case of service industry companies, one can use either EBIT or EBITDA multiples.

9.12 IS COMPARABLE VALUATION BETTER THAN DCF

In majority of the cases DCF & trading Comps are complimentary i.e. one provides a sanity check to the other! However, in times of conflict it is better to rely on DCF. This is because Comps do not truly attempt to arrive at Intrinsic Value, implying that the market could easily stretch valuations based on peers. One cannot substantiate whether Apple Inc. is correctly trading at an P/E multiple of 15.60x unless one can test it through at least one or more methods that Value a company based on its Fundamentals. DCF ties Stock Value to fundamentals whereas Trading Comps are driven by Sentiments & Consensus Estimates.

10.1COMPARABLE DEAL ANALYSIS

Comparable Deals Analysis is another multiples-based approach to derive an implied valuation range for the target company. The process for completing the deal comps is quite similar to the trading comps method, but the multiples derived from the two methods have different meanings. The multiples form trading comps are the potential multiples on which the deals can happen or on which the premiums or discount will be applied while doing a deal, while the multiples derived from the transaction comps are the historical multiples on which deals had happened and they are inclusive of premium or discounts given at the time of deal. Deal Comps are very similar to trading comps analysis except that the deal comps use actual transaction data instead of publicly traded companies. Potential buyers or investors look very closely at the deal multiples that have been paid for comparable acquisitions in past as it gives them an indications for negotiations while closing the deal. Precedent transactions have a broad range of applications, most notably to help determine a potential sale price range for a company, or part thereof, in a M&A transaction or PE deal or a JV deal. Note: One must note that Transaction comps method does not mean that it can be used only for Mergers and Acquisitions deal. Rather this method is useful for any stake acquisition deal - either partial stake acquisition or full stake acquisition.

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