Finance 101

Agenda
An Introduction to Accounting
Types of Financing Corporate Structure Markets Valuation

Accounting in 20 minutes
Accounting is the language of business
Its a way to track and report financial status and transactions For example, accountants generate financial statements that cover where money is in the business, how much money they made, how much money they spent, etc.

The financial statements accountants generate and release every year (and fourth of a year) are investors best source of information

Accounting in 20 minutes
Accounting revolves around one key idea
The accounting equation:

Assets = Liabilities + Owners Equity

Resources of the business (assets) are either from money we got from loans (liabilities) or from our personal investment or others (Owners Equity)

The Accounting Equation

You decide to open a lemonade stand and calculate that you need $100 to cover a table, cups, lemons, and water. You crack open the piggy bank and find $50 and decide to contribute it to your new business venture. This is equity.

You talk to your parents and they offer to cover the last $50, but tell you that you have to pay them back. This is called debt.

The Accounting Equation

Assets = Liabilities + Owners Equity
$50 spent on a table $50 from parents $50 from your personal bank

$20 spent on lemons

$10 spent on cups $10 spent on water $10 left in cash to make change Notice how the resources in the business equal the resources you receive from funding sources (yourself, a bank, your parents loan)

This always happens. The accounting equation is always in balance

The Accounting Equation

Assets = Liabilities + Owners Equity
$50 spent on a table $50 from parents $50 from your personal bank Companies arent required to pay equity holders anything for their investment, but by investing in equity, these shareholders get a controlling interest in a business and a share of profits.

$20 spent on lemons

$10 spent on cups $10 spent on water $10 left in cash to make change Liabilities are legal obligations to pay creditors

Accounting Statements
Investors use 3 main financial statements to assess a company
The Balance Sheet- a snapshot of the assets, liabilities, and equity in the business on a specific day The Income Statement- shows how much money a company brought in from sales and the expenses it paid to make that revenue in the past year The Statement of Cash Flows- shows how much cash a company brought in and how much cash it paid out over the past year

Can be found by searching company name 10-k

The Balance Sheet

Broken into Assets, Liabilities, and Equity
Assets section has dollar value of the cash in bank, equipment and buildings, inventory the company plans to sell, and more Liabilities section has dollar value of loans the company took out Equity section has dollar value of money contributed by investors and owners, as well as the amount of recycled profits in the business

How do investors use this information?

We look at if a company has enough cash to cover payments of liabilities and how much interest a company has to pay on its debt

The Balance Sheet

The Income Statement

Shows the revenues (money a company has earned) and associated expenses (costs a company paid to earn that revenue).

Revenue Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Operating Income Less: Tax Expense Net Income

$100,000 ($60,000) $40,000 ($10,000) $30,000 ($5,000) $25,000

The Income Statement

How do investors use this information?
Investors want companies that are making a profit By looking at margins (the percentage of each dollar of revenue that becomes profit after costs are taken out), we can compare one company to a similar company and see which company is more efficient By comparing with previous years, we can assess trends like: is this company continually making more revenue each year? Are margins (efficiency) improving year-over-year?

The Income Statement

Revenue Less: Cost of Goods Sold Gross Profit
Less: Operating Expenses Operating Income Less: Tax Expense Net Income

$100,000 ($60,000) $40,000

($10,000) $30,000 ($5,000) $25,000

The gross margin, or % of sales that is left after taking out costs is 40%

30% operating margin

25% profit margin

The Statement of Cash Flows

Broken into 3 sections:
Net Cash Flows from Operations- Cash flows generated from normal business activities Net Cash Flows from Financing- Cash flows generated from receiving loans, or paying them off Net Cash Flows from Investing- Cash generated from selling or buying long-term assets (buildings, land, equipment)

The Statement of Cash Flows

How do investors use this statement?
Largely considered the most important to investors It is possible to earn a profit but not have enough cash to pay its bills and end up making it go bankrupt or out of business We look at operating cash flows to tell us if a company is making enough cash to pay the bills There are many accounting gimmicks to inflate the income statement. By converting to a cash basis, we can know exactly what a business earns and pays out.

Summary of Accounting
Accounting serves as our means of understanding a companys financial situation through the usage of financial statements The three financial statements we use are
The Balance Sheet- Assets = Liabilities + Equity The Income Statement- Revenues Expenses = Profit The Statement of Cash Flows- Operating CF +/- Financing CF +/Investing CF = Net CF

Financing
You realize that you are actually a lemonade-making genius and want to expand your business to the entire state of Maryland. Youve exhausted your own personal contribution ($50) and your parents refuse to loan you several million dollars. Where do you go, what do you do?

Financing
Businesses have a number of sources to tap into for financing. Can receive capital from:
Venture Capital Funds- investment funds set up to contribute money to start-up companies in return for a large share of ownership Banks- can give you a loan (a contract to pay back principal and interest periodically) Investment Banks- can set up an initial public offering (IPO) where you sell part of full ownership of your company in the form of stock to raise money or organize a bond (publicly traded debt) offering

Capital Financing
Financing is broken into two categories
Debt (found under liabilities section of balance sheet) Equity (found under equity section of balance sheet)

Capital Financing: Debt

Your lemonade stand can raise debt to fund its growth Terminology:
Par value: Initial amount paid by investor; returned at maturity Interest/Coupon: Amount paid periodically to investors

Types of Debt:
Bonds (source - public markets) Loans (source - privately traded or not traded)

So what does debt look like?

As a financial institution or lender, you give away the $100,000, and receive 5 payments of $10,000 over the course of the bonds life.

BOND
$100,000 Face Value 5 Year Life Interest paid every year end @10% of Principal At the end of the 5th year, you receive the last $10,000 interest payment and your $100,000. As an borrower, the transaction is flipped. You receive the $100,000 to finance your activities, but have to return the money (and pay interest periodically). So when you borrow money, you need a plan to pay it back, otherwise the lender has legal rights to repossess your companys assets.

Capital Financing: Equity

You can also raise equity to fund its growth Terminology:
Stock: a share of ownership in a company Initial Public Offering: initial issuance of stock by a company Secondary Markets: investors exchanging securities

Types of Equity:
Common Stock: no guaranteed dividend, voting power Preferred Stock: guaranteed a dividend, no vote

What does equity look like?

Originally, equity in a company is just the amount of money that owners contribute to the business. When the company grows, it soon needs more money to finance its expansion. These companies raise money by undergoing an initial public offering (IPO), where they agree to relinquish a portion of the company in return for money. This portion of the company is then divided up into millions of portions and sold off to investors in the form of stocks.

Debt vs Equity
Debt Advantages:
Doesnt seize ownership Not as influence by market swings Easy to raise

Equity Advantages:
No legal obligation to pay No claims on assets

Disadvantages:
Giving over ownership
Shareholder activism Outside investors (hostile)

Disadvantages:
Legal obligation to pay Claim on assets during bankruptcy

Voting rights

Issuing Equity
When looking to expand your business, you decide that you need to raise $100 million and decide to pursue it through equity financing. To raise your $100M, you can sell 1M shares at $100 apiece or 2M shares at $50 apiece or 10M shares at $10 apiece, etc. This is important because it shows that share price has nothing to do with value. You could issue 100 shares at $1M each, it doesnt make your company more valuable.

Issuing Equity
An investment bank decides how much your company is worth, then decides what percentage of the company is worth $100M. It then takes the shares to be issued to raise the money and finds investors who are willing to buy the shares.
Money to be raised / Estimated Value of the company = Percentage of the company to sell
$100M / $400M = shares issued will control 25% of the company

Corporate Structure
Shareholders

Board of Directors & Chairman

Managers, CEO, CFO, COO, CIO

Problems in the Corporate Structure

The goal of the corporation is to maximize money for shareholders. If the corporation is making a profit and management gets rewarded for profits, shouldnt their interests be aligned?
NO! Many times management is more concerned with short-term profits that maximize how good they look, where as shareholders want to maximize profits period, not at the expense of later periods. Theres also a problem of shareholders having high demands on a quarterly basis (when financial statements are released) that stress managements plans for the future.

Why is this important?

When evaluating a company to invest in, management of the company is incredibly important.
We look at a number of factors to assess the quality of management:
Historical performance at the company and at other companies Big spender vs. too frugal Plans outlined

Markets
So what exactly is a market?
Its a medium for buyers and sellers to exchange goods.

So what is a financial market?

Its a medium for buyers and sellers to exchange financial goods.

So what are the financial goods?

Anything from shares of a company (stocks) to bonds (publicly traded debt), derivatives (more on this next time), etc

Markets
Trading: when a buyer finds a seller

Buyer Looking to buy 100 shares AAPL @ 450ea Transaction: 100 shares @450

Seller Looking to sell 200 shares AAPL @ 450ea

Markets
A stocks priceline is actually just millions of trades like this plotted and traced, meaning that if you see the price quote of AAPL at $450.13, that means that the last transaction was at the agreed upon price of $450.13.

Markets
Do fluctuations in a stocks price affect the company that issued the shares?
Yes and no. While a stock price shooting up has no direct effect on the actual assets the company has (because the shares were traded for a fixed amount of money and are now out of the companys hands), some companies compensate their employees with stock options (more on these next time) that increase in value if the stock performs well.

Valuation
At this point weve discussed:
accounting methodologies that provide us with information that we can use to make informed investment decisions A general idea of where stocks come from (equity financing through IPOs) How a corporation is structured What a market is

So how do we determine where the stocks price will be in 3 years?

An Introduction to Valuation Methods

Intrinsic Valuation
Discounted Cash Flow Model- We forecast out a companies ability to make cash in the future, then add it all up and divide by how many shares it has to find what the share price should be.

Relative Valuation
Company Comparables Model- we look at how much similar companies are trading at with respect to a measurement of company profits Precedent Transaction Model- we look at how much similar companies were acquired by other companies for, and use these numbers to determine valuation

Next Time
Either relative valuation or options/derivatives markets depending on cheering.