Strategic Capital Group Workshop #1: Investment Fundamentals

AgendaIntroduction to USIT & SCG

Creating a Company

Financial Statements

Raising Capital

Exercise and Closing

Meet the USIT Shirt CompanyCurrently run out of Parker’s dad’s garage, we are providers low cost, awful quality t-shirts to any suckers who will buy them.

The Business + Key TermsWe sell t-shirts for $20 each, and on sell 100 per year

The $2,000 of sales we make each year is referred to as revenue

We pay Parker’s little brother $2 per shirt to assemble and $3 per shirt for the input materials.

Price x Volume = Revenue

This $5 per shirt of costs are referred to as cost of goods sold, or the direct costs of the inputs and labor that goes into the product

Cost per unit x Volume = Cost of Goods Sold

The Business + Key Terms

Benedikt, the CEO, who does not actually make the products, gets paid a fixed $500 salary per year.

The $500 paid to him is referred to as an operating expense

Operating expenses are not the same as cost of goods sold because they reflect costs uninvolved in production

Now how to we represent the state of the business?

The Income Statement

Revenue $2,000

-COGS 500

Gross Profit$1,500

-Operating Expenses 500Net Income

$1,000

• Tells us how much the business sold and what it cost to sell the products, all the way down to the leftover profit.

• Typically shows the state of the business for a year or a quarter of a year

• Important to know how profitable the business is

The Income StatementKey terms:

Gross Profit Margin =

Net Margin =

Gross Profit

Revenue

Net Income

Revenue

$1,500

$2,000

$1,000

$2,000

= 75%

= 50%

After paying off all expenses and costs, 50% of every dollar of sales will be left over as profit.

As this percentage increases, the amount of costs per dollar of sales are declining and the business is becoming more cost efficient

The Business + Key TermsParker contributed $500 of cash when the business first started

Benedikt loaned the business $500 dollars

$200 was used to buy a t-shirt making machine.

The Balance Sheet

Assets Liabilities Equity

What you own What you owe What’s contributed and left over

= +

Cash $500Machinery $200

Loan from Ben $500 Contributed Capital $500$1,000$800

Sanity Check #1

• We’ve had an introduction to two financial statements (forms that describe a business’s condition)– Balance Sheet – tells us about the resources of the

business and how they were funded– Income Statement – tells us how much we sold

and how much we spent during a period

ExpandingA sudden fad for overpaying for cheap shirts has developed, meaning demand for USIT Co.’s shirts has skyrocketed.

Making t-shirts out of Parker’s dad’s garage is no longer enough, and we need to expand.

In order to expand, we need to buy more buildings, more machines, and more inventory.

To get more assets, we need more capital!

Options for Raising Capital – “Financing”

Debt (liabilities) Equity

Types of debt:• Loans – offers of money now

in order for a promise of a return of capital and interest later on

• Bonds – a loan that can trade ownership on public exchanges

Types of Equity:• Common stock – the traditional

stock, or shares of a company that are traded on stock exchanges. These represent fractional ownership of a company and claims on voting rights and profits

• Preferred Stock – stock that has no voting right, but has guaranteed payments from a pool of profits

Key Terms:Debt Equity

• Face Value – the amount of money returned to the lender at the end of the loan/bond

• Maturity – the amount of time before the loan is due back

• Interest/Coupon – the required payments to investors

• Initial Public Offering – the first time a company puts its stock for sale to any investor through a stock exchange

• Secondary Market – the market where investors can publicly exchange stock

So which do we choose?Debt Equity

Advantages• Your creditors (loaners) have

no control over the company• Easy to raise• Good tax implications

Advantages• You have no obligation to pay

anyone. Investors are not guaranteed distributions

Disadvantages• You are legally required to pay

interest and principal or risk bankruptcy

Disadvantages• You are essentially selling

control of your company. If you sell more than 51%, your decisions can be vetoed

• Potential for hostile investors

…and how do we do it?Step 1: Find an investment banker

Step 2: Have your investment banker overwork his junior bankers to figure out what your company is worth, then find people to invest in your newly issued securities

Step 3: Figure out how much money you need to raise, then sell that proportion of your company (if equity)

Sanity Check #2

• We’ve talked about the two ways to raise capital:– Debt – loans with obligatory interest payments– Equity – stock with no obligation to pay, but gives

away voting rights

USIT Co.’s Capital DecisionDebt Equity

• $10M of “senior” bonds at a 5% interest rate

• $10M of “junior” bonds at a 10% interest rate

• $50M of proceeds from issuing 1M shares of stock related to a 25% stake in the company

How much money in total did we receive?

How much is the total equity of the company worth?

What was the stock price we issued at?

Stock price is arbitrary!It’s important to note that the company chooses the stock price it wants to issue at.

We could have issued:

10 million shares @ $5 per share

100 million shares @ $.50 per share

1 share @ $50 million per share

Either way, we still receive $50 million dollars in proceeds

ImplicationsAfter raising publicly-traded stock, you are considered a public

company. Every quarter and at year end, you file an annual report with various financial statements and notes called a 10-K

or 10-Q

A quick update on what our new balance sheet looks like, post-financing

Assets:Cash

$70,000,800Machines $ 200

Liabilities:Loans $ 500Bonds Payable $20,000,000

Equity:Common Stock $50,000,000Contributed Capital$ 500

$70,001,000

$70,001,000

Let’s fast forward a year…

The Income Statement

Revenue $100,000,000-COGS (40,000,000)Gross Profit $60,000,000-Operating Expenses (50,000,000)Net Income $10,000,000

Earnings Per Share $10.00 Net Income (earnings)

Shares of stock outstandingEPS =

Literally…how much your company earns per each share

Stock price at issuance: $50 per share

Number of shares: 1 million

ValuationFinance is the process of raising capital for a business, but in order to know the appropriate amount of capital to raise and

how much it will cost, we need to value a company

Investors and bankers have several tools to value a company, but first…

ValuationYour exotic friend asks you to go buy this fruit you’ve never seen for him, but to not spend too much for him.

The fruit is only sold by one vendor and costs $5 per pound, but you have no idea if that’s a good price. What do you do?

You compare it to other things that are like it, namely, other fruit!

You can refine your search further by comparing to other fruit that look and taste like it.

The same concept can apply to companies:

Price = $50.00 per

share

Price = $5.00 per

shareWhich is the cheaper investment?

T-shirt Co

T-shirt Co

What about if we look at EPS?

EPS = $10.00 per

share

EPS = $3.00 per

share

USIT seems to pay out more per share…

T-shirt Co

T-shirt Co

P/E- The Price to Earnings RatioShare price is not enough!P/E: how much does one dollar of

this company’s earnings cost?

USIT P/E =Price (the amount you pay)

Earnings per share (how much the firm makes)

=$50.00

$10.00= 5x

SCG P/E =Price (the amount you pay)

Earnings per share (how much the firm makes)

=$5.00

$2.00= 2.5x

Become The Investor

So now which is the cheaper investment?

5x 2.5x

Remember: P/E ratios are a measurement of how much you pay per dollar of earnings

The answer is… there isn’t one.

• Widely varying interpretations of P/E– High P/E – investors value the earnings more,

willing to pay more• Could mean optimism

– Low P/E – cheaper earnings, better deal• Note: This is all relative– We are comparing to similar companies– “Cheap-er”, “costli-er”

Valuation

• Relative valuation is just one of the ways we value a company and has its advantages and disadvantages.

• Later during the year we will discuss different ways to value a company and will flesh out further how to use these tools.

Sanity Check #3

• We’ve learned about the P/E multiple• We’ve compared two companies and decided

which to invest in

Exercise

• Which of the following companies would you buy? Why?

Company Price Shares Assets Revenue Profit Margin P/E P/B P/S

USIT $4.00 10,000,000 $11,000,000 $100,000,000 $33,300,000 33.3% 1.20 3.64 0.40

SCG $7.57 5,000,000 $12,000,000 $125,000,000 $48,000,000 38.4% 0.79 3.15 0.30

UCF $82.53 1,000,000 $19,800,000 $228,000,000 $49,500,000 21.7% 1.67 4.17 0.36

Nike $67.73 2,000,000 $8,000,000 $48,000,000 $35,700,000 74.4% 3.79 16.93 2.82

Average $40.46 4500000 $12,700,000 $125,250,000 $41,625,000 41.9% 1.86 6.97 0.97