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Journey into Finance in MBA : Part 2

Mastering Financial Valuation and Unraveling my Own ‘A-ha’ Moment from My MBA Journey


Picking up from the previous part, I want to summarize what I have learned from each case study. All the content in this post has been derived from the notes I've compiled from various finance courses, collecting them into a single comprehensive resource. Initially, I thought of sharing the spreadsheets used, but the concern for intellectual property infringement, as these are based on educational material provided by external sources, dissuaded me. Moreover, while valuation is a simple technique—forecasting Net Operating Profit After Taxes (NOPAT) and Return On Invested Captial (ROIC) by analyzing historical financial data—the difference lies in the assumptions and capacity to discern idiosyncratic characteristics of the industry or business. These are the aspects I want to emphasize, especially for future reference in real business scenarios.

Contrary to what some might think, financial valuation isn't only for those aiming to specialize in Mergers and Acquisitions (M&A) or investment banking. During the first year of my MBA, I explored the M&A landscape, but what I genuinely enjoyed about building models and analyzing businesses was the applicability of these skills across various roles, not just in finance. Take the role of a financial analyst, for example. Typically, they are tasked with in-depth analysis of specific line items. However, if you look at it from a different angle, each line item could be considered a separate business entity that requires the same level of assumption-making as any financial modeling and valuation effort. This concept also extends to business and data analysts, who should remain focused on enhancing the long-term value of the business.

In this context, I don't see these roles as completely isolated from each other, much like a full-stack developer in software engineering. I firmly believe that a proficient analyst should be well-versed in handling data collection and processing, business-centric analysis, and effective presentation of insights. Hence, I view myself as a financial/data analyst with a robust background in Machine Learning.

With this mindset, I aim to recap the enlightening moments and insightful gaps that I encountered during my MBA journey.

  1. The Divide and Conquer Approach in Valuation

The foremost point I want to highlight is 'Divide and Conquer'. It may sound cliché, as it can be applied broadly, but in valuation, dividing the process based on functions is essential to avoid being overwhelmed by a vast range of financial data and lengthy processes. For instance, the entire process can be divided into five steps: 1) Gathering data, 2) Reorganizing balance sheet and income statement to fit the Free Cash Flow (FCF) model, 3) Calculating the discount rate (incorporating cost of capital & WACC), 4) Forecasting and valuation, and 5) Conducting risk analysis, where various risk factors are considered through sensitivity analysis. Further, one can divide the Entity into its Components, differentiating between operational (core business) items and non-operational items, followed by reorganizing balance sheet and income streams into an FCF model.

Speaking of these five steps, let me delve into some details:

 

  1. Understanding Financial Metrics and The Limited Meaning of EPS

Earnings Per Share (EPS), while a commonly used metric, can sometimes be misleading if used in isolation. As a representation of a company's earnings divided by its outstanding shares, it fails to account for aspects like capital structure, growth potential, risk, or quality of earnings. Consequently, relying solely on EPS can potentially lead to misguided investment decisions. To obtain a more rounded view of a company's financial performance and prospects, it's crucial to consider EPS alongside other metrics and valuation methods.

Conversely, Economic Profit (EP) offers a more comprehensive measure of a company's genuine economic profit by accounting for the cost of capital. Calculated as NOPAT minus the capital charge used to generate that profit, EP steps beyond traditional measures like net income or EPS that overlook the cost of capital. This broader perspective makes EP a more refined tool for evaluating a company's value creation.

Moreover, ROIC serves as a vital gauge in valuation. ROIC gives an insight into a company's efficiency at deploying its capital to generate profits. A high ROIC can often signal a competitive advantage for a company, allowing it to reap above-average returns from its investments. Factors like superior management, proprietary technology, or distinct business aspects could drive this advantage. Therefore, comprehension and calculation of ROIC are vital in determining a company's profitability and growth potential.

 

  1. The Core of Business - Cash (flow) is King

Cash flow is the lifeline of any business and plays a pivotal role in business valuation. It represents the net amount of cash that is transferred into and out of a business. Profits, when generated, can be reinvested to fuel growth and ensure continuous operations. It's worth noting that while earnings and revenues are subject to accounting standards and management discretion, cash flow provides a more transparent gauge of a company's financial health and its ability to create value.

Moreover, it's crucial to differentiate between operating cash flow and non-operating cash flow in valuation. The former pertains to cash generated through the company's regular operations, whereas the latter includes cash flow from investments or financial activities. This segregation offers a clear insight into the different income streams, their performance, and their impact on overall cash flow. Hence, the significance of cash flow in the valuation process is paramount.

  1. Navigating Mergers and Acquisitions

Mergers and Acquisitions (M&A) decisions heavily rely on financial valuation. It's about much more than just determining a fair price for the target company; it also involves assessing the potential value created through the merger or acquisition. This requires forecasting synergies, comprehending the strategic fit, and managing integration risks.

The M&A process mirrors the work of a financial analyst, especially when considering the target company as a purchasable item. It demands detailed financial evaluation, potential growth analysis, and risk assessment, just like the valuation of line items by a financial analyst. Practical examples or case studies of M&A transactions can further enrich readers' understanding of the role of valuation in M&A.

  1. The Importance of Scenario Analysis in Valuation

As I’m planning on part 3 of this series, I will delve into the importance of the cost of capital, CAPM, and modern portfolio theory, explaining how they contribute to determining the discount rate. One of the key insights is that idiosyncratic risks, unique to a business or company, should be handled through various scenario tests, as they're not accounted for in the discount rate.

Scenario analysis holds great importance in valuation, especially when considering future uncertainties and potential impacts on a business. This process becomes critical for businesses operating in volatile markets or having significant exposure to specific risks. Through modeling diverse outcomes and their influence on cash flows, one can gain a more nuanced understanding of the possible range of valuations, aiding informed decision-making.

  1. Using Relative Valuation Methods as a Cross-Check

DCF analysis is an essential tool for in-depth valuation, boasting remarkable flexibility. However, it is not infallible, especially when it comes to making complex assumptions or dealing with situations like valuing perpetuity. This is where relative valuation methods such as Price-to-Earnings (P/E), or Enterprise Value-to-EBITDA (EV/EBITDA) ratios step in, offering a critical sanity check and a different perspective.

Relative valuation methods become particularly useful when the task at hand involves uncertain assumptions, as in the case of predicting perpetuity after the explicit forecast period in a valuation exercise. Sometimes, relying on industry multiples can yield a more realistic and believable forecast.

Comparing a company's valuation multiples with similar entities in the industry ensures the valuation derived from a DCF analysis is reasonable and consistent with market realities. This comparison not only verifies the rationality of the DCF-based valuation but also provides insights into how the market perceives similar businesses.

Furthermore, relative valuation methods can simplify the valuation narrative, making it more comprehensible to those without an in-depth knowledge of corporate finance. These methods become a bridge, translating complex financial models into intuitive and easily digestible insights. Hence, relative valuation methods serve as a sanity check, an assumption guide, and a communication tool, underscoring their importance in the valuation process.