Grab your hobnobs, this is the first entry in my “Behind the City Curtain” series where I explain various processes from my perspective as an investment banker forcussing on UK companies. I’ll use this to link to all my ‘stories’ so bookmark it!
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I thought this should be the first post so you can understand the way the City talks to understand what the City is talking about…. If that makes sense. I’m going to set out the day to day terms we use, what they mean, and whether you should be thinking the same way.
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City Jargon – what terms do you need to know? Most of you already know this but I thought it’d be helpful to make sure everyone starts from the same place before I start covering some more technical stuff….
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EBITDA = earnings before interest, tax, depreciation and amortisation. Excludes impact of debt - useful for comparing co's across sectors. Beware businesses suggesting EBITDA is a proxy for cash generation! Excludes capex and working capital - often a material use of cash.
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Underlying earnings – applies to operating profit, profit before/after tax etc. Typically earnings excluding restructuring costs, M&A amortisation and other one-off or non-cash costs. Reasonable to accept these numbers but check that real cash costs aren’t being added back!
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Operating cashflow – EBITDA less tax, minus working capital, pension cost and other cash items. Measure of how effectively a co converts operating profit into cashflow. Beware any business where this is consistently lower than operating profit, red flag for accounting fraud!
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Free cash flow – Operating cash flow less capital expenditures. I.e. how much cash the company generates after working capital and necessary capital investment. If you deduct interest as well, this is a fair measure of money available for a company to repay to shareholders
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Worth flagging that if free cash flow is low due to high capital expenditures, this is not necessarily a bad thing! If a company invests capex at a rate of return higher than you can expect from the market, that is called ‘value creation’
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Leverage – debt relative to ability to pay the costs of this debt. Calculated as net debt divided by EBITDA. Appropriate levels vary by sector, but would use 2-3x as a rule – higher leverage than this is going to limit what it can do with its cash - negative sign!
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Enterprise Value (EV) – value of the entire business. Market cap is the value of all the shares but EV includes the cash and debt. EV = market cap + net debt (sometimes pension liability) and basically shows how much someone would have to pay to buy out the entire business.
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Price / Earnings – most common valuation metric. Share price dividend by earnings per share. Shows how many years of earnings you are paying for the current price. I.e. 100p share price and 15p underlying EPS = 6.7x PER. EPS is most easily “managed” number for co's.
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EV/EBITDA – most common valuation multiple for private equity or M&A. Looks at the total business cost including debt against earnings before debt service cost. Useful for comparing business and stripping out the effects of different capital structures (i.e. debt loads).
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Return on Capital – useful measure of profitability, i.e. showing the return on operating assets. Calculated as underlying operating profit after tax (NOPAT) divided by operating assets (net working capital + net fixed assets). Best indicator of true profitability IMO
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Forecasts – estimated figures for future years as forecast by research analysts. FY1 = current year (i.e. FY1 in Mar-20 for a company with Dec-20 year end would be 2020 numbers). Consensus is an average of all analyst forecasts in the market and usually forms expectations.
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Value Creation – does a business earn a higher return on investment than cost of capital? I.e. if management invests in a project with capital that costs 10%, do they earn >/< 10% a year on that investment? Return on investment > cost of capital = value creation.
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Organic Growth – how a business grows revenue without having to acquire new companies. I.e. opening stores, developing products, selling into new markets etc. Organic growth typically treated as more ‘certain’ than M&A growth as less uncertainty around ability to execute.
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Self Help – what a company can do by itself to improve margins. Usual items are improved inventory management, reduction of central costs, price increases (that won’t be rejected by customers). Very important to an investment case as its basically ‘free upside’!
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Once you understand these basic terms, you can get a better idea of what analysts/investors are talking about when they look at a business. Now onto what investors typically look for as a ‘good’ investment. Need to caveat that this will vary hugely across sectors!
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A good business is one that can:
- grow organically, preferably with M&A options
- improve margin by fixed costs growing less than revenue (operating leverage) and therefore increasing profitability – either by business model, cost control, working capital etc
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- grow organically, preferably with M&A options
- improve margin by fixed costs growing less than revenue (operating leverage) and therefore increasing profitability – either by business model, cost control, working capital etc
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- convert earnings into cash – i.e. operating profit turns into actual cashflow which can be invested at higher rates of return or distributed to shareholders
- strong balance sheet – leverage is manageable so that a downturn won’t cause restrict management
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- convert earnings into cash – i.e. operating profit turns into actual cashflow which can be invested at higher rates of return or distributed to shareholders
- strong balance sheet – leverage is manageable so that a downturn won’t cause restrict management
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