How Finance Works

Key Takeaways

1. Financial Analysis: Ratios Reveal Performance

Ratios make interpretation possible because single numbers in isolation are meaningless.

Ratios provide context. Financial analysis uses ratios to make sense of raw numbers, comparing them to other relevant figures. For example, a profit of $10 million is meaningless without knowing the revenue or assets used to generate it. Ratios like profit margin (net profit/revenue) or return on assets (net profit/total assets) provide a more meaningful picture of a company's performance.

Balance sheet and income statement. Financial analysis draws on both the balance sheet (assets, liabilities, and equity) and the income statement (revenue, costs, and profits). Ratios can be used to assess a company's liquidity (ability to meet short-term obligations), efficiency (how well it uses assets), profitability (how much it earns), and leverage (how much it uses debt).

• Liquidity ratios: current ratio (current assets/current liabilities), quick ratio (current assets - inventory/current liabilities)
• Efficiency ratios: inventory turnover (cost of goods sold/inventory), receivables collection period (365/sales/receivables)
• Profitability ratios: net profit margin (net profit/revenue), return on equity (net profit/shareholders' equity)
• Leverage ratios: total debt/total assets, long-term debt/capitalization

Ratios are not static. Ratios are not static; they should be compared across time and across companies within the same industry. For example, a high inventory turnover is good for a grocery store but not for a bookstore. By comparing ratios, you can identify trends, strengths, and weaknesses in a company's performance.

2. The Finance Perspective: Cash and the Future

Many think that financial analysis and ratios are what finance is all about. In fact, it’s just the beginning.

Cash is king. Finance prioritizes cash over accounting profits because cash is less susceptible to manipulation and better reflects a company's true economic performance. While accounting emphasizes net profit, finance focuses on cash flows, particularly free cash flow (FCF), which is the cash available to capital providers after all expenses and investments.

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measure of cash generated by operations.
• Operating cash flow considers working capital and noncash expenses.
• Free cash flow (FCF) is the cash available to capital providers after all expenses and investments.

Future matters more than the past. Finance is fundamentally forward-looking, emphasizing the importance of future cash flows over past performance. The time value of money dictates that a dollar today is worth more than a dollar tomorrow, so future cash flows must be discounted to their present value. This is done using a discount rate, which reflects the opportunity cost of capital.

Discounted cash flow (DCF) analysis. DCF analysis is a method for valuing assets by discounting their expected future cash flows to their present value. This method is used to determine if an investment is worthwhile and how much it is worth. The discount rate is a critical component of DCF analysis, as it reflects the riskiness of the investment.

3. The Financial Ecosystem: Intermediaries and Information

The world of finance—of hedge funds, activist investors, investment banks, and analysts—can seem baffling and somewhat opaque.

Complex web of players. The financial ecosystem is a complex web of interconnected players, including companies, institutional investors (mutual funds, pension funds, hedge funds), sell-side firms (investment banks, broker-dealers), analysts, and the media. These players interact with each other through trades, information sharing, and the provision of services.

Information asymmetry. A key challenge in capital markets is asymmetric information, where some players (e.g., company insiders) have more information than others (e.g., investors). This information asymmetry creates opportunities for some to profit at the expense of others.

• Equity research analysts play a central role in the financial ecosystem by providing information and recommendations to investors.
• Institutional investors, such as hedge funds, use various strategies to manage risk and generate returns.
• Investment banks facilitate capital raising and M&A transactions.

Incentives matter. The incentives of each player in the financial ecosystem can influence their behavior. For example, analysts may be biased toward positive recommendations to maintain relationships with companies, and hedge fund managers may take on excessive risk to maximize their compensation. Understanding these incentives is crucial for navigating the complexities of capital markets.

4. Sources of Value Creation: Beating the Cost of Capital

The most critical questions in finance relate to the origins of value creation and how to measure it.

Value creation is about returns. Companies create value by generating returns on their investments that exceed their cost of capital. The cost of capital is the minimum return that investors expect for bearing the risk of investing in a company. If a company's returns are less than its cost of capital, it is destroying value.

The DuPont framework. The DuPont framework breaks down return on equity (ROE) into three components: profitability (net profit/revenue), productivity (revenue/total assets), and leverage (total assets/shareholders' equity). This framework helps to identify the sources of a company's ROE and how it can be improved.

• Profitability: How much profit a company generates for every dollar of revenue.
• Productivity: How efficiently a company uses its assets to generate revenue.
• Leverage: How much a company uses debt to finance its assets.

Risk and return. Investors demand higher returns from companies that they perceive to be riskier. Risk is measured by beta, which reflects how much a stock moves with the market. The capital asset pricing model (CAPM) is used to calculate the cost of equity, which is the risk-free rate plus beta times the market risk premium.

5. The Art and Science of Valuation: Discounted Cash Flows

Valuation is a critical step in all investment decisions.

Valuation is both art and science. Valuation is a process that combines rigorous financial analysis with subjective judgment. While discounted cash flow (DCF) analysis provides a framework for valuing assets, it relies on assumptions about future cash flows, discount rates, and terminal values, which are all subject to uncertainty.

Discounted cash flow (DCF) analysis. DCF analysis is the gold standard for valuation, as it explicitly considers the time value of money and the riskiness of future cash flows. The process involves:

1. Forecasting future free cash flows (FCF).
2. Determining the appropriate discount rate (WACC).
3. Discounting the future cash flows to their present value.
4. Calculating a terminal value to capture the value of cash flows beyond the forecast period.
5. Summing the present values of all cash flows and the terminal value to arrive at the enterprise value.

Multiples as a shortcut. Multiples, such as price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA), provide a quick and easy way to compare companies. However, multiples are based on historical data and may not accurately reflect future performance. They also rely on the assumption that comparable companies are truly comparable.

6. Capital Allocation: Investing or Distributing Cash

Finally, we’ll examine a fundamental problem that preoccupies financial managers at every company—what to do with excess cash flows.

Capital allocation is key. Capital allocation is the process of deciding how to use a company's excess cash flows. This is a critical decision for CEOs and CFOs, as it determines how a company will grow and create value for its shareholders. The decision tree involves:

1. Investing in positive NPV projects (organic or inorganic growth).
2. Distributing cash to shareholders (dividends or share buybacks).

Organic vs. inorganic growth. Organic growth involves investing in a company's existing operations, while inorganic growth involves mergers and acquisitions (M&A). M&A can be faster but also riskier due to integration challenges and the potential for overpayment.

Dividends vs. share buybacks. Dividends and share buybacks are two ways to distribute cash to shareholders. While the mechanics of these transactions are value-neutral, they can send different signals to the market.

• Dividends are a regular cash payment to shareholders.
• Share buybacks involve a company repurchasing its own shares.

Agency costs and signaling. The choice between dividends and buybacks can be influenced by agency costs (the potential for managers to act in their own interests rather than shareholders') and signaling (the information that a company conveys to the market through its actions).

Last updated: February 14, 2025

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